Charles M. C. Lee

• Professor Emeritus at Stanford University

SYNOPSIS This paper addresses the enduring challenge of bridging the gap between accounting research and its application in practice. Drawing upon insights from the 2024 Financial Accounting and Reporting Section (FARS) plenary panel discussion and contributions from esteemed leaders in the field, we explore the root causes of this disconnect and u...

We develop and evaluate an accounting-based Loan Portfolio Risk (LPR) variable that captures time-varying contagion effects in default risk for a portfolio of bank loans. Our results show that an Equity-to-LPR ratio (ELPR) is additive in predicting bank failure up to five years in advance, after controlling for all the capital adequacy, asset quali...

Between 2010 and 2017, Chinese investors used an investor interactive platform (IIP) to ask public companies around 2.5 million questions, the vast majority of which received a reply within two weeks. We analyze these IIP dialogues using a BERT-based algorithm and provide preliminary evidence on their causes and consequences. Our analyses show most...

Predicted stock issuers (PSIs) are firms with expected high-investment and low-profit profiles that earn extremely low returns. We evaluate alternative explanations for this empirical phenomenon. Our results show top-PSI firms are cash-strapped, have lottery-like payoffs, high volatility, high beta, low liquidity, and high shorting costs. Over the...

From 2007–2020, unlisted Chinese firms paid an average of over US $500 million to listed firms for their shell value in reverse merger transactions. We show that this large shadow price for a public listing sheds light on other features of Chinese markets, including (a) near-zero mortality rates, (b) frequent major-asset restructurings (MARs), (c)...

We re-examine the puzzling pattern of lead-lag returns among economically-linked firms. Our results show that investors consistently underreact to information from lead firms that arrives continuously, while information with the same cumulative returns arriving in discrete amounts is quickly absorbed into price. This finding holds across many diffe...

This study reports on the current state-of-affairs in the funding of entrepreneurship and innovations in China and provides a broad survey of academic findings on the subject. We also discuss the implications of these findings for public policies governing the Chinese financial system, particularly regulations governing the initial public offering...

We use trade-level data to examine the role of actively managed funds (AMFs) in earnings news dissemination. We find that AMFs are drawn to, and participate disproportionately more in, earnings announcements (EAs) that include bundled managerial guidance. When the two pieces of news are directionally inconsistent, AMFs trade in the direction of fut...

This study examines how an increase in tick size affects algorithmic trading (AT), fundamental information acquisition (FIA), and the price discovery process around earnings announcements (EAs). Leveraging the SEC's randomized Tick Size Pilot experiment, we show that a tick size increase results in a decline in AT and a sharp drop in absolute cumul...

We introduce a parsimonious framework for choosing among alternative expected-return proxies (ERPs) when estimating treatment effects. By comparing ERPs’ measurement error variances in the cross-section and in the time series, we provide new evidence on the relative performance of firm-level ERPs nominated by recent studies. Generally, “implied-cos...

We study firms that go public through reverse mergers (RMs)versus initial public offerings (IPOs)in China. Using a manually assembled data set, we show that pre-listing RM firms are larger, more profitable, and less politically connected than pre-listing IPO firms. Chinese RM firms also have superior post-listing performance, in terms of both opera...

Employing a classic measure of technological closeness between firms, we show that the returns of technology-linked firms have strong predictive power for focal firm returns. A long-short strategy based on this effect yields monthly alpha of 117 basis points. This effect is distinct from industry momentum and is not easily attributable to risk-base...

We examine whether an increase in ETF ownership is accompanied by a decline in pricing efficiency for the underlying component securities. Our tests show an increase in ETF ownership is associated with (1) higher trading costs (bid-ask spreads and market liquidity), (2) an increase in “stock return synchronicity,” (3) a decline in “future earnings...

We show that analyst coverage proxies contain information about expected returns. We decompose analyst coverage into abnormal and expected components using a simple characteristic-based model and show that firms with abnormally high analyst coverage subsequently outperform firms with abnormally low coverage by approximately 80 basis points per mont...

We show that analyst coverage proxies contain information about expected returns. We decompose analyst coverage into abnormal and expected components using a simple characteristic-based model and show that firms with abnormally high analyst coverage subsequently outperform firms with abnormally low coverage by approximately 80 basis points per mont...

We examine the economic determinants of short-sale supply, and its consequences for future stock returns. Lendable supply increases with expected borrowing costs and decreases with financial statement constructs that indicate overvaluation. Although rising loan fees help ease supply constraints, we find shares are still least available when they ar...

Applying a “co-search” algorithm to Internet traffic at the SEC's EDGAR website, we develop a novel method for identifying economically related peer firms and for measuring their relative importance. Our results show that firms appearing in chronologically adjacent searches by the same individual (Search-Based Peers or SBPs) are fundamentally simil...

This monograph is a compact introduction to empirical research on market efficiency, behavioral finance, and fundamental analysis. The first section reviews the evolution of academic thinking on market efficiency. Section 2 introduces the noise trader model as an alternative framework for market-related research. Section 3 surveys the growing liter...

In a noisy rational expectations framework with costly information, some agents expend resources to become informed, and earn a return for their efforts by trading with the uninformed. Applying this insight, we examine the proposition that an increase in ETF ownership is accompanied by a decline in pricing efficiency for the underlying component se...

Using bottom-up information from corporate financial statements, we examine the relation between aggregate investment, future equity returns, and investor sentiment. Consistent with the business cycle literature, corporate investments peak during periods of positive sentiment, yet these periods are followed by lower equity returns. This pattern exi...

We examine the financial health and performance of reverse mergers (RMs) that became active on U.S. stock markets between 2001 and 2010, particularly those from China (around 85 percent of all foreign RMs). As a group, RMs are early-stage companies that typically trade over the counter. However, Chinese RMs (CRMs) tend to be more mature and less sp...

Value investing refers to the buying or selling of stocks on the basis of a perceived gap between their current market price and their fundamental value – commonly defined as the present value of the expected future payoffs to shareholders. This style of investing is predicated upon two observations about publicly listed companies and their stock p...

This article discusses the role of GAAP accounting from an investor's perspective. For all its flaws, a historical-based system of accounting is vital to the investment community, and I believe the moves toward fair value accounting should proceed with great caution. Framing the discussion in terms of valuation theory, I argue that investors are ty...

We compare the performance of a comprehensive set of alternative peer identification schemes. Our results show the peer firms identified from aggregation of informed agents' revealed choices in Lee, Ma, and Wang (2014) perform best, followed by peers with the highest overlap in analyst coverage. Conversely, peers firms identified by Google and Yaho...

Daily mutual fund (MF) flows are highly persistent and price-destabilizing, and short-sellers (SSs) trade strongly in the opposite direction to these flows. This negative relation is associated with the expected component of MF flows (based on prior days' trading), as well as the unexpected component (based on same-day flows). The ability of SS tra...

An accounting-based earnings manipulation detection model has strong out-of-sample power to predict cross-sectional returns. Companies with a higher probability of manipulation (M-score) earn lower returns on every decile portfolio sorted by size, book-to-market, momentum, accruals, and short interest. The predictive power of M-score stems from its...

Aggregate corporate investment in the U.S. peaks during periods of positive investor sentiment (measured multiple ways), yet these higher investment periods are followed by lower equity returns (particularly for “growth” stocks). A similar pattern exists in most other developed countries. Higher levels of corporate investment also precede lower cor...

We examine the economic determinants of short-sale supply, and its consequences for future stock returns. Lendable supply increases with expected borrowing costs and decreases with financial statement constructs that indicate overvaluation. Although rising loan fees help ease supply, we find shares are still least available when they are most attra...

Using Internet traffic patterns from the Securities and Exchange Commission Electronic Data-Gathering, Analysis, and Retrieval (EDGAR) website, we show that firms appearing in chronologically adjacent searches by the same individual are fundamentally similar on multiple dimensions. In fact, traffic-based peer firms identified by our algorithm signi...

An accounting-based model has strong out-of-sample power not only to detect fraud, but also to predict cross-sectional returns. Firms with a higher probability of manipulation (MSCORE) earn lower returns in every decile portfolio sorted by: Size, Book-to-Market, Momentum, Accruals, and Short-Interest. We show that the predictive power of MSCORE is...

Characterizing a firm’s true (but unobservable) expected returns as the normative benchmark, we develop a two-dimensional framework for evaluating the relative performance of implied cost-of-capital (ICC) estimates. First, in time-series, variations in ICC estimates should reflect changes in true expected returns rather than changes in measurement...

An earnings manipulation detection model based on forensic accounting principles (Beneish 1999) has substantial out-of-sample ability to predict cross-sectional returns. We show that the model correctly identified, ahead of time, 12 of the 17 highest profile fraud cases in the period 1998-2002. Moreover, the probability of manipulation estimated fr...

We examine the information content of option and equity volumes when trade di-rection is unobserved. In a multimarket asymmetric information model, we show that equity short-sale costs result in a negative relation between relative option volume and future firm value. In our empirical tests, firms in the lowest decile of the option to stock volume...

This study investigates a particularly brazen form of corporate abuse, in which controlling shareholders use intercorporate loans to siphon billions of RMB from hundreds of Chinese listed companies during the 1996–2006 period. We document the nature and extent of these transactions, evaluate their economic consequences, examine factors that affect...

We model the capital allocation decision of informed traders with access to equity and option markets. Equity short sale costs lead informed traders to use options more frequently for negative signals. In our empirical tests, firms in the lowest decile of the ratio of option to equity volume (OVR) outperform those in the highest decile by 1.47% per...

This paper tests international asset pricing models using firm-level expected returns estimated from an implied cost of capital approach. We show that the implied approach provides clear evidence of economic relations that would otherwise be obscured by the noise in realized returns. Among G-7 countries, expected returns based on implied costs of c...

Recent events in China provide a historical opportunity to study the expropriation of minority shareholders. In this paper, we document the use of inter-corporate loans by controlling shareholders to extract funds from Chinese listed firms. Using accounting information from public sources, we show how tens of billions of RMB were siphoned from hund...

Abstract This paper presents a rationale for systematic liquidity and links time variation in the risk premium to liquidity. The driving force behind endogenous liquidity in the model is uncer- tainty about the preferences and endowments of investors. Learning about the risk premium gives rise to the price impact of trades because the order flow is...

This paper examines the link between capital market governance (CMG) and several key measures of market performance. Using detailed data from individual stock exchanges, we develop a composite CMG index that captures three dimensions of security laws: the degree of earnings opacity, the enforcement of insider laws, and the effect of removing short-...

Using a database of more than 1.85 million retail investor transactions over 1991-1996, we show that these trades are systematically correlated-that is, individuals buy (or sell) stocks in concert. Moreover, consistent with noise trader models, we find that systematic retail trading explains return comovements for stocks with high retail concentrat...

Using firm-level data from 44 countries, we investigate the relation between corruption and international corporate values. Our analysis shows that firms from more corrupt countries trade at significantly lower market multiples. The effect is both economically and statistically significant. Furthermore, using a two-stage estimation procedure, we sh...

This study documents the widespread use of corporate loans by controlling shareholders to extract funds from Chinese listed companies. Typically reported as Other Receivables (OREC), these loans represent a substantial portion of the reported assets of Chinese firms. We show that companies with large OREC balances experience worse future operating...

This study examines the role of information uncertainty (IU) in predicting cross-sectional stock returns. We define IU in terms of “value ambiguity,” or the precision with which firm value can be estimated by knowledgeable investors at reasonable cost. Using several different proxies for IU, we show that (1) on average, high-IU firms earn lower fut...

This study compares the efficiency at which the stock market and financial analysts react to corporate earnings announcements. Results show that the market is more efficient and reacts more rapidly to earnings news than financial analysts. In particular, in pre-announcement quarters (inclusive of announcement day), the market reacts more than analy...

We show that analysts from sell-side firms generally recommend "glamour" (i.e., positive momentum, high growth, high volume, and relatively expensive) stocks. Naïve adherence to these recommendations can be costly, because the "level" of the consensus recommendation adds value only among stocks with favorable quantitative characteristics (i.e., val...

This study examines the role of information uncertainty (IU) in predicting cross-sectional stock returns. We define IU in terms of “value ambiguity,” or the precision with which firm value can be estimated by knowledgeable investors at reasonable cost. Using several different proxies for IU, we show that (1) on average, high-IU firms earn lower fut...

This study compares four broadly available industry classification schemes in a variety of applications common to capital market research. Standard Industrial Classification (SIC) codes have been available since 1939 but are being replaced by North American Industry Classification System (NAICS) codes. The Global Industry Classifications Standard (...

This study presents a new methodology for estimating international cost of capital. Using a discounted cash flow model, we estimate market implied risk premia for firms in the G-7 countries during the 1990 to 2000 time period. We find that the average risk premia in G-7 countries typically fall within a narrow range of 2% to 4%, and that risk premi...

We document several factors that help explain cross-sectional variations in the post-revision price drift associated with analyst forecast revisions. First, the market does not make a sufficient distinction between revisions that provide new information ("high-innovation" revisions) and revisions that merely move toward the consensus ("low-innovati...

This paper examines the profitability of earnings momentum strategies based on analyst forecast revisions in eleven international equity markets. While analyst forecast revisions exhibit persistence in all countries, the profitability of trading strategies based on these revisions varies. Specifically, earnings momentum yields significant profits i...

for several helpful discussions and valuable comments. We thank Itamar Simonson for making the

Using firm-level data from 44 countries, we investigate the relation between corruption and international corporate values. Our analysis shows that firms from more corrupt countries trade at significantly lower market multiples. The effect is both economically and statistically significant. Furthermore, using a two-stage estimation procedure, we sh...

This study presents a general approach for selecting comparable firms in market-based research and equity valuation. Guided by valuation theory, we develop a “warranted multiple” for each firm, and identify peer firms as those having the closest warranted multiple. We test this approach by examining the efficacy of the selected comparable firms in...

We document several factors that help explain cross-sectional variations in the delayed price response to individual analyst forecast revisions. First, the market does not make a sufficient distinction between those analysts providing new information and others simply "herding" toward the consensus. Second, the market responds more completely to "c...

This study examines the usefulness of contextual fundamental analysis for the prediction of extreme stock returns. Specifically, we use a two-stage approach to predict firms that are about to experience an extreme (up or down) price movement in the next quarter. In the first stage, we define the context for analysis by identifying extreme performer...

In this study, we propose an alternative technique for estimating the cost of equity capital. Specifically, we use a discounted residual income model to generate a market implied cost-of-capital. We then examine firm characteristics that are systematically related to this estimate of cost-of-capital. We show that a firm's implied cost-of-capital is...

Much of capital market research in accounting over the past 20 years has assumed that the price adjustment process to information is instantaneous and/or trivial. This assumption has had an enormous influence on the way we select research topics, design empirical tests, and interpret research findings. In this discussion, I argue that price discove...

We investigate the relation between analyst stock recommendations and eight concurrently available variables that have predictive power for stock returns. We find that analysts generally pay little attention to the large sample predictive attributes of these variables. In seven out of eight cases, analysts' stock recommendations are directionally o...

We examine the effect of signal attributes and analyst identity on the price impact of an earnings forecast revision. We measure the price impact immediately upon the release of a forecast, as well as over the next twenty-four months. We find that an analyst's own prior forecast and the consensus forecast at the time of the release are both importa...

We use a unique dataset (TORQ) to calibrate several techniques commonly used to infer investor behavior from transactions data. Specifically, we evaluate the Lee–Ready (1991) Journal of Finance 46, 733–746) algorithm for distinguishing trade direction, and we examine the use of trade size as a proxy for trader identity. We find that, due to complex...

This study shows that past trading volume provides an important link between "momentum" and "value" strategies. Specifically, we find that firms with high (low) past turnover ratios exhibit many glamour (value) characteristics, earn lower (higher) future returns, and have consistently more negative (positive) earnings surprises over the next eight...

We use a bottom-up approach to estimate the intrinsic value of the 30 stocks in the Dow Jones Industrial Average. In recent years, traditional aggregate market multiples (e.g., book to price, earnings to price) have had little predictive power for overall market returns. We show that an aggregate value-to-price ratio, in which "value" is based on a...

We model the time-series relation between price and intrinsic value as a cointegrated system, so that price and value are long-term convergent. In this framework, we compare the performance of alternative estimates of intrinsic value for the Dow 30 stocks. During 1963-1996, traditional market multiples (e.g., B/P, E/P, and D/P ratios) have little p...

We use a discounted residual-income valuation model to compute an ex-ante cost-of-capital for a large sample of U.S. stocks that are covered by I/B/E/S analysts. We show that the ex ante cost-of-capital computed in this manner is correlated with a firm's degree of leverage, market liquidity, information environment, and earnings variability. Specif...

Accounting-based valuation theory suggests that a firm's value (V) is a combination of its book value (B) and market expectations of future earnings. We empirically evaluate the ability of this model to explain the book-to-market (B/P) effect. We find that our empirical proxies of V dominate B in cross-sectional correlations with price, and that th...

We explore a new accounting-based valuation model in an international context. An appealing feature of the model is that it produces a measure of firms' fundamental value, "V", that is immune to accounting differences across countries. We explain why this model has the potential to become a "universal translator," that is, a vehicle by which accoun...