Heterogeneity in Horizon, Equilibrium Clientele, and the Cross-Section of Value Premium

Abstract

When investors have heterogeneity in horizon due to preferences or constraints, their evaluations on a same company may differ, if the company sequentially compound earnings shocks into future periods. Specifically, short-term investors are willing to pay higher (lower) prices for companies with relatively good (bad) short-term investment opportunities than long-term investors, generating equilibrium overreaction and excess volatility patterns from long-term investors' point of view. These patterns diminish when companies pay out earnings as dividends period by period. The evaluation difference leads to an equilibrium clientele effect that short-term (long-term) investors are more likely to hold growth (value) companies, which adds to observed value premium because short-term investors are willing to receive lower return on growth stocks. This clientele component of value premium declines in dividends. Empirically, value premium monotonically declines in dividend yield and payout-to-earnings ratio. The monthly risk-adjusted difference between value premiums across different payout quartiles can be as high as 0.95% (1961-2006), and is highly significant in all subperiods. The clientele effect also induces value premium to increase in volatility and cause earnings momentum to decline in dividends. Both predictions are supported by data.