Firm efficiency and stock returns: Australian evidence

We employ a stochastic frontier approach to estimate firm efficiency - the efficiency with which a firm converts its inputs into output. We find a negative relation between firm efficiency and the cross-section of stock returns (‘firm efficiency effect’) in the Australian stock market. The firm efficiency effect is robust after controlling for other firm characteristics and is more pronounced in stocks with high limits-to-arbitrage. However, we find no evidence that firm efficiency is a priced factor in the cross-section. Our findings suggest that investors misprice firm efficiency and arbitrage costs perpetuate its return predictability. •We find a negative relation between firm efficiency and the cross-section of stock returns in Australia.•Firm efficiency is not a priced factor in the cross-section.•Investors misprice firm efficiency and arbitrage costs perpetuate its return predictability.