The UMO (Undervalued Minus Overvalued) Factor

Abstract

This document provides an overview of the UMO factor. It describes its motivation, construction, and how to obtain it and use it. Behavioral theories suggest that investor misperceptions and market mispricing will be correlated across firms. The UMO factor uses equity and debt financing to identify common misvaluation across firms. UMO is a zero-investment portfolio that goes long on firms that issue securities and short on firms that repurchase. UMO captures comovement in returns beyond that in standard multifactor models, substantially improves the Sharpe ratio of the tangency portfolio, and carries heavy weight in the tangency portfolio. Loadings on UMO strongly predict the cross-section of returns on both portfolios and individual stocks, even among firms not recently involved in external financing activities, and even after controlling for other standard predictors. UMO was proposed by Hirshleifer and Jiang (2010), who provide further evidence suggesting that UMO loadings proxy for the common component of a stock's misvaluation. For further details, see Hirshleifer, David, and Danling Jiang, "A Financing-Based Misvaluation Factor and the Cross-Section of Expected Returns," Review of Financial Studies (2010), 23(9), 3401-3436.

Keywords: Misvaluation Factor, New Issues, Repurchases, External Financing, Return Predictability

JEL Classification: G12, G14