Market underreaction and predictability in the cross-section of Japanese stock returns

In this paper, we analyze the relationship between financial information and stock returns for a sample of firms listed on the Tokyo Stock Exchange. Firm-specific information is captured by way of a score indicative of the firm's cash flow generating potential. The results show that score-based portfolio strategies can produce significant abnormal returns. The excess return on high-score portfolios does not appear to result from a higher exposure to risk factors. The predictability of stock returns does not derive either from price momentum. We find that large firms offer little profits to score-based portfolio strategies. Most of the abnormal returns are generated by small stocks. The evidence is supportive of a market underreaction to the financial information released by smaller, hence less researched, firms. (C) 2005 Elsevier B.V. All rights reserved.