The Stock Market and Corporate
Investment: A Test of Catering Theory
London School of Economics
Northwestern University, CEPR, and NBER
We test a catering theory describing how stock market mispricing might inﬂuence individual ﬁrms’ investment decisions. We use discretionary accruals as our proxy for mispricing. We ﬁnd a positive relation between abnormal investment and discretionary accruals; that abnormal investment is more sensitive to discretionary accruals for ﬁrms with higher R&D intensity (opaque ﬁrms) or share turnover (ﬁrms with shorter shareholder horizons); that ﬁrms with high abnormal investment subsequently have low stock returns; and that the larger the relative price premium, the stronger the abnormal return predictability. We show that patterns in abnormal returns are stronger for ﬁrms with higher R&D intensity or share turnover. (JEL G14, G31)
In this paper, we study whether mispricing in the stock market has consequences for ﬁrm investment policy. We test a “catering” channel, through which deviations from fundamentals may affect investment decisions directly. If the market misprices ﬁrms according to their level of investment, managers may try to boost short-run share prices by catering to current sentiment. Firms with ample cash or debt capacity may have an incentive to waste resources in negative NPV projects when their stock price is overpriced and to forgo positive investment opportunities when their stock price is undervalued. Managers with shorter shareholder horizons, and those whose assets are more difﬁcult to value, should cater more.
This paper previously circulated with the title “The Real Effects of Investor Sentiment.” We thank an anonymous referee, Andy Abel, Malcolm Baker, David Brown, David Chapman, Randy Cohen, Kent Daniel, Arvind Krishnamurthy, Terrance Odean, Owen Lamont, Patricia Ledesma, Vojislav Maksimovic, Bob McDonald, Mitchell Petersen, Fabio Schiantarelli, Andrei Shleifer, Jeremy Stein, Tuomo Vuolteenaho, Ivo Welch, Luigi Zingales, and seminar participants at Harvard Business School, Helsinki School of Economics, London Business School, McGill University, University of Chicago, University of Virginia, the AFA 2003 meeting, the NBER Behavioral Finance Program meeting, the Texas Finance Festival, the University of Illinois Bear Markets conference, the Yale School of Management, the WFA 2002 meeting, and the Zell Center Conference on “Risk Perceptions and Capital Markets.” We thank Sandra Sizer for editorial assistance. We acknowledge support from the Investment Analysts Society of Chicago Michael J. Borrelli CFA Research Grant Award. Polk acknowledges the support of the Searle Fund. The usual caveat applies. Send correspondence to Paola Sapienza, Finance Department, Kellogg School of Management, Northwestern University, 2001 Sheridan Rd., Evanston IL 60208; telephone: 1-847-491-7436; fax: 1-847-491-5719; E-mail: Paola-Sapienza@northwestern.edu. C The Author 2008. Published by Oxford University Press on behalf of the Society for Financial Studies. All rights reserved. For permissions, please e-mail: firstname.lastname@example.org. doi:10.1093/rfs/hhn030
Advance Access publication April 2, 2008
The Review of Financial Studies / v 22 n 1 2009
We rely on discretionary accruals, a measure of the extent to which the ﬁrm has abnormal noncash earnings, to identify mispricing. Firms with high discretionary accruals have relatively low stock returns in the future, suggesting that they are overpriced. We regress ﬁrm-level investment on discretionary accruals while controlling for investment opportunities, as measured by Tobin’s Q.
We ﬁnd a positive relation between discretionary accruals and ﬁrm investment. Our result is robust to several alternative speciﬁcations, as well as to corrections for measurement error in Tobin’s Q, our proxy for investment opportunities.
Exploiting the intuition of Stein’s (1996) short-horizons model,...
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