textMy dissertation consists of two essays which investigate how the reaction of market
participants to aggregate and firm-specific information affects asset prices and firms’
corporate choices. The first essay studies the implications of investor sentiment for asset
prices. It develops a novel stock-by-stock measure of investor sentiment which I call
sentiment beta. Using this measure I test several hypotheses. First hypothesis postulates
that sentiment affects stocks of some firms more than others due to differences in firm
characteristics. Second hypothesis predicts that more sentiment sensitive stocks are more
likely to be held by individual investors. Consistent with the first hypothesis, I find that
more sentiment-sensitive stocks are smaller, younger, have greater short-sales constraints,
idiosyncratic volatility and lower dividend yields. Given size and volatility, high
sentiment beta stocks have greater analyst coverage and institutional ownership, higher
likelihood of S&P500 membership, higher turnover and lower book-to-market ratios.
Stocks that are more exposed to sentiment changes deliver lower future returns, which is
inconsistent with the risk factor interpretation of investor sentiment. Institutional analysis
reveals that institutions stayed away from sentiment-sensitive stocks in the 1980’s, but
held more of these stocks since the early 1990’s. The second essay tests a catering
hypothesis which predicts that firm managers concerned about the current stock price will
deviate from the optimal policy in setting profitability and revenue growth targets due to
the incentives to cater to the time-varying relative investor demand for firms with
different composition between revenue growth and profit margins. I develop a measure
which I call a revenue growth premium and document three results consistent with
catering interpretation: 1) time periods when the premium is high tend to be followed by
“higher-than-expected” sales and investment growth, advertising, acquisitions and R&D;
2) catering to the premium is more pronounced among firms where managers care more
about the short-term stock price; 3) consistent with “bounded rationality” version of
catering story, trading strategy based on longing stocks of firms with high margin
surprises and shorting firms with low margin surprises when the premium is high yields
40/bp per month after adjusting for risk and post-earnings announcement drift.Financ