Firms Making Payouts to Shareholders Outperform Peers
Capital investment rather than investor behavior or managerial market timing accounts for the lower expected returns of companies that raise equity.
ANN ARBOR, Mich.—Economists who study the relation between corporate financing decisions and average subsequent returns frequently disagree on what drives the seemingly incongruous outcomes they observe.
Some theorize, for example, that the underreaction by investors to overinvestment and market timing by corporate managers accounts for the fact that firms raising capital earn lower average returns while firms distributing capital earn higher average returns over the long term.
A new study by Lu Zhang, associate professor of finance at the Ross School of Business, and colleagues Erica X. N. Li of the University of Rochester and Dmitry Livdan of Texas A&M University offers an alternative economic explanation.
They contend that capital investment rather than behavioral market timing is the major determinant in the cross section of expected returns, and that optimal investment drives the external financing anomalies. Their theoretical approach uses the so-called “q-theory” to better understand the negative relation between capital investment and average returns from the perspective of firms. The researchers also crunch numbers in a simulated model to quantify their theoretical effects.
“Our main point is that optimal investment is likely to be the more fundamental driving force behind the external financing anomalies than the current leading explanations,” Zhang said.
Firms use capital to generate operating profits (revenue minus costs). Taking the operating profits as given, firms choose optimal investment to maximize their market value. Historically, smaller firms and more profitable firms (growth firms) issue more equity than bigger firms and less profitable firms (value firms). Smaller firms tend to distribute little or no cash back to shareholders, whereas big firms distribute more cash. Moreover, firms with high productivity distribute more than firms with low productivity.
Through a series of computational experiments using 100 simulated datasets representing thousands of firms, the researchers calculate that firms with low capital investment earn average returns which are as much as 10.6 percent higher than those with high capital investment. The outperformance is stronger in firms with higher cash flows than in firms with lower cash flows.
More important, Zhang and colleague interpret other anomalies through their lens of investment decisions, demonstrating for example that the amount and frequency of equity issuance are procyclical; that the new equity share is a significantly negative predictor of aggregate stock-market returns; and that the operating performance of equity issuing firms substantially improves prior to the stock offerings, but then deteriorates. They also confirm that, relative to industry peers, firms announcing share repurchases exhibit superior operating performance, which subsequently declines following the announcements.
“The q-theory is a good start to understand the return-related evidence often interpreted as behavioral underreaction to managerial overinvestment and market timing,” Zhang said.
Written by Claudia Capos
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