Advertising, Investor Recognition, and Stock Returns

Abstract

This paper studies the effect of advertising on stock returns both in the short run and in the long run. We conjecture that advertising affects stock returns by attracting investor recognition to the firm's stock. According to Merton's (1987) investor recognition model, the increased degree of investor recognition attracted by advertising would cause an increase in stock return in the contemporaneous advertising year but a decrease in stock return in the long run subsequent to the advertising year. Our empirical findings support this prediction. The effect of advertising on the short-term increase and the long-run reversal in stock returns exists even after we control for other price predictors, such as size, book-to-market, and momentum, and product market considerations, such as sales and profitability, as well as sample selection concerns. To further link the investor recognition theory to the effect of advertising on stock returns, we derive five hypotheses and document consistent findings. First, advertising increases a firm's visibility among investors in the contemporaneous advertising year. Second, an increased level of investor recognition is associated with larger contemporaneous stock returns and smaller future stock returns. Third, the effect of advertising on the short-term increase and the long-run reversal in stock returns is more pronounced if a firm's advertising helps the firm attract more investor recognition in the advertising year. Fourth, the effect of advertising on the long-run reversal in stock returns is stronger if the stock experiences higher idiosyncratic volatility in the advertising year. Finally, we also find that the effect of advertising on future stock returns is stronger for small firms, value firms, and firms with poor ex-ante stock or operating performance.