The set of underreaction theories can be further subdivided according the exact mechanism that is at work. In Barberis, Shleifer and Vishny (1997), there is a representative investor who suffers from a conservatism bias (Edwards 1968), and who does not update his beliefs sufficiently when he observes new public information. In Hong and Stein (1997) the emphasis is instead on heterogeneities across investors, who observe different pieces of private information at different points in time. Hong and Stein make two key assumptions: 1) firm-specific information diffuses gradually across the investing public: and 2) investors are unable to perform the rational-expectations-equilibrium (REE) trick of extracting this information from prices. Taken together, these twro assumptions are sufficient to generate underreaction and positive return autocorrelations. comments
Our goal in this paper is to test the Hong-Stein version of the underreaction hypothesis. In other words, we look for evidence that momentum reflects the gradual diffusion of firm-specific information. To do so. we begin by sorting stocks into different classes, for which information is a priori more or less likely to spread gradually. The central prediction is then that stocks with slower information diffusion should exhibit more pronounced momentum.
One natural sorting variable-which forms the basis for our first set of tests–is firm size. It seems plausible that information about small firms gets out more slowly; this would happen if, e.g., investors face fixed costs of information acquisition, and hence choose in the aggregate to devote more effort to learning about those stocks in which they can take large positions.