• fundamental analysis;
  • stock valuation;
  • institutional investment

Abstract:  Previous research shows that fundamental signals (financial ratios) derived from publicly available financial statements can predict future abnormal stock returns. This paper examines whether institutional investors trade on these fundamental signals and the implications of institutional investors’ trading for stock valuation. We provide evidence that transient institutional investors (institutions who actively trade securities for short-term returns) trade on fundamental signals. We also show that the abnormal returns associated with fundamental signals increase with transaction costs and arbitrage risk, indicating the existence of limits to arbitrage for this investment strategy. We further document that transient institutional investors’ trades help reduce the returns related to fundamental signals. This paper provides evidence helping to explain the abnormal returns associated with fundamental signals and contributes to our understanding of institutional investors’ role in enhancing market efficiency.