The Cause of the Asset Growth Effect: Evidence from Insider Trading

Abstract

This study investigates the potential causes of a recent empirical regularity in the financial markets — the asset growth effect (Cooper et al., 2008) — by examining insider trading patterns. Insiders have a sophisticated understanding of their own firms, which they often use to trade on misevaluation. This study shows that insiders exploit the trading opportunities suggested by the asset growth effect, suggesting that the asset growth effect results from misevaluation instead of a rational discount result, as proposed by Watanabe et al. (2013). We further identify the specific information underlying asset growth that the stock market misevaluates. We show that the asset growth effect is more likely to be caused by a market misunderstanding of growth firms’ real investment activities rather than accounting disclosure distortion (e.g., earnings management before an acquisition or IPO). A comparative analysis between CEO and CFO trading indicates that insiders do not all have the same insight as to the asset growth effect. While CEO trading leads to 13.2 percent more size-adjusted returns beyond the return to the asset growth effect (20.3 percent), CFO trading does not provide any incremental returns to investors. Based on such findings, this study proposes that when relying on insider trading to understand the asset growth effect, investors need to distinguish the roles of different insiders.