A Capital Market Test of Representativeness

While Lakonishok et al. (1994) document that investors overreact to information in sales growth as consistent with representativeness bias, Chan et al. (2004) find no evidence of investor overreaction to either sales or earnings growth. Other recent studies also show that sales growth does not predict stock returns after controlling for changes in outstanding shares and asset growth. I reexamine the role of representativeness by investigating whether the effects of this bias are confounded by the presence of another effect that has been extensively documented – investors’ underreaction to fundamentals. Adjusting for investor under-reaction to fundamentals, I document strong evidence that investors overreact to sales growth as predicted under representativeness despite adding accruals, asset growth, and equity issuance as additional controls. In cross-sectional regressions of future stock returns on predictive variables that control for fundamentals, changes in equity shares, accruals, and lagged 36 month returns, I find that the coefficient on sales growth is highly significant over both the full sample period 1970-2009 (t-stat -3.12). Furthermore, asset growth, equity issuance, and accruals lose much of their significance in favor of sales growth. I also provide evidence that rejects a theory based on fixation in favor of representativeness. These results document evidence of overreaction to past sales growth in firms where underreaction to fundamentals does not confound the overreaction due to representativeness bias.