NBER WORKING PAPER SERIES CAPITAL INVESTMENTS AND STOCK RETURNS. Sheridan Titman K.C. John Wei Feixue Xie

NBER WORKING PAPER SERIES CAPITAL INVESTMENTS AND STOCK RETURNS Sheridan Timan K.C. John Wei Feixue Xie Working Paper 9951 hp://www.nber.org/papers/w9951 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachuses Avenue Cambridge, MA 02138 Sepember 2003 The auhors appreciae he helpful commens of he seminar paricipans a Peking Universiy, he Hong Kong Universiy of Science and Technology, Naional Cenral Universiy, Naional Chengchi Universiy, Universiy of Arizona, and he Ninh SFM Conference held in Kaoshiung, Taiwan. The auhors also hank Andres Almazan, Paul Malaesa (he edior), and wo anonymous referees for insighful commens and Dr. Virginia Unkefer for ediorial assisance. Sheridan Timan and John Wei acknowledge he financial suppor from an RGC Compeiive Earmarked Research Gran of he Hong Kong Special Adminisraion Region, China (HKUST6014/99H). The views expressed herein are hose of he auhors and no necessarily hose of he Naional Bureau of Economic Research. 2003 by Sheridan Timan, K.C. John We and Feixue Xie. All righs reserved. Shor secions of ex, no o exceed wo paragraphs, may be quoed wihou explici permission provided ha full cred including noice, is given o he source.

Capial Invesmens and Sock Reurns Sheridan Timan, K.C. John We and Feixue Xie NBER Working Paper No. 9951 Sepember 2003 JEL No. G1, G3 ABSTRACT Firms ha subsanially increase capial invesmens subsequenly achieve negaive benchmarkadjused reurns. The negaive abnormal capial invesmen/reurn relaion is shown o be sronger for firms ha have greaer invesmen discreion, i.e., firms wih higher cash flows and lower deb raios, and is shown o be significan only in ime periods when hosile akeovers were less prevalen. These observaions are consisen wih he hypohesis ha invesors end o underreac o he empire building implicaions of increased invesmen expendiures. Alhough firms ha increase capial invesmens end o have high pas reurns and ofen issue equiy, he negaive abnormal capial invesmen/reurn relaion is independen of he previously documened long-erm reurn reversal and secondary equiy issue anomalies. Sheridan Timan Deparmen of Finance Universiy of Texas a Ausin Ausin, TX 78712-1179 and NBER iman@mail.uexas.edu K.C. John Wei Deparmen of Finance Hong Kong Universiy of Science and Technology Clearwaer Bay, Kowloon, Hong Kong johnwei@us.hk Feixue Xie Deparmen of Economics and Finance Souhern Connecicu Sae Universiy New Haven, CT 06515 xief1@souhernc.edu

Capial Invesmens and Sock Reurns I. Inroducion There is now a subsanial lieraure ha examines corporae capial expendiures. For example, alhough firms end o inves more following increases in heir sock prices, cash flows end o be he bes predicor of a firm s invesmen expendiures (see, for example, Fazzar Hubbard and Peerson (1988) and Morck, Shleifer and Vishny (1990)). 1 I is also he case ha sock prices end o respond favorably o announcemens of major capial invesmen. 2 However, financing choices ha are associaed wih increased invesmen, such as equiy issuances, generally resul in negaive sock reurns (see for example, Loughran and Rier (1995) and ohers), while hose choices associaed wih decreased invesmen, such as repurchases, generally resul in posiive reurns (see, for example, Ikenberry, Lakonishok, and Vermaelen (1995) and ohers). There are a number of reasons why increased invesmen expendiures should be viewed favorably. Firs, higher invesmen expendiures are likely o be associaed wih greaer invesmen opporuniies. Second, higher invesmen expendiures may also indicae ha he capial markes, which provide financing for he invesmens, have greaer confidence in he firm and is managemen. The above-cied even sudies provide evidence ha is consisen wih hese views, and our own evidence also indicaes ha sock prices do quie well in hose years in which capial expendiures increase. However, i is difficul o inerpre eiher he even sudies or he evidence of higher sock reurns in years in which firms increase capial expendiures. Firs, here is likely o be a endency for firms o publicly announce only hose invesmen 1 See Hubbard (1998) for an excellen review of his lieraure. 2 McConnell and Muscarella (1985) indicae ha announcemens of increases in planned capial invesmens are generally associaed wih significanly posiive excess sock reurns. In follow-up sudies, Blose and Shieh (1997) 1

expendiures ha are likely o be viewed favorably. Second, higher sock prices may make i easier for firms o increase invesmen expendiures, so ha higher sock prices in years where invesmen expendiures are higher need no indicae ha he marke views he invesmen expendiures favorably. There are also reasons why increased invesmen expendiures may resul in negaive sock reurns. For example, managers have an incenive o pu he bes possible spin on boh heir new opporuniies as well heir overall business when heir invesmen expendiures are especially high because of heir need o raise capial as well as o jusify heir expendiures. If invesors fail o appreciae managemens incenive o oversell heir firms in hese siuaions, sock reurns subsequen o an increase in invesmen expendiures are likely o be negaive. This effec is likely o be especially imporan for managers who are empire builders, and inves for heir own benefis raher han he benefis of he firm s shareholders (see Jensen (1986)). The evidence provided in his paper is consisen wih he idea ha invesors end o underreac o he empire building implicaions of increased invesmen expendiures. Specifically, we find ha firms ha increase heir invesmen expendiures he mos end o underperform heir benchmarks over he following five years. A significan amoun of his abnormal performance occurs around earnings announcemens, providing addiional evidence ha our findings are generaed because invesors incorrecly assess he empire building endencies of managers raher han because of benchmark errors. Moreover, his negaive relaion beween increased capial expendiures and subsequen reurns ends o be sronger for firms wih greaer invesmen discreion, i.e., firms wih less deb or more cash flows. In and Vog (1997) find a significan posiive relaion beween he magniude of he sock marke reacion o capial invesmen announcemens and he level of new invesmen. 2

addiion, he relaion beween reurns and abnormal capial expendiures fails o exis in he 1984 o 1989 period in which he empire-builders were subjec o hosile akeovers. Our evidence is poenially relaed o he DeBond and Thaler (1985) reurn reversal evidence as well as o he Loughran and Rier (1995) evidence ha equiy issuers end o exhibi negaive long-run reurns. As we menioned a he ouse, firms ha increase invesmen expendiures are likely o have enjoyed posiive sock reurns and are also more likely o have issued equiy in he pas. Hence, he previously documened anomalies may be generaing he negaive abnormal capial expendiure/reurn relaion ha we documen. However, we find ha his is no he case. Indeed, we find he negaive abnormal capial expendiure/reurn relaion is independen of he long-erm reurn reversal and secondary equiy issue anomalies. The remainder of he paper is organized as follows. Secion II briefly discusses he experimenal design of he ess and daa requiremens and Secion III oulines he mehodology. The findings on he relaionship beween abnormal capial invesmens and expeced reurns are presened in Secion IV. Secion V examines he agency cos explanaion for he negaive abnormal invesmen/reurn relaion. In paricular, we examine wheher he negaive relaion beween abnormal capial invesmens and subsequen sock reurns behave differenly beween firms wih invesmen discreion and hose wihou discreion. Secion VI repors he robusness ess on he relaion and finally, Secion VII concludes he paper. II. Experimenal Design and Daa Descripion To es he relaion beween abnormal capial invesmens and subsequen sock reurns we examine he reurns on porfolios formed on he basis of abnormal levels of capial invesmen. More specifically, we es wheher reurns on porfolios wih low abnormal capial invesmens 3

are significanly higher han hose wih high abnormal capial invesmens. Once he negaive relaion beween abnormal capial invesmens and subsequen sock reurns is esablished, we invesigae possible explanaions for his negaive relaion by separaing firms ino wo groups based on heir invesmen discreion as measured by cash flows or leverage. We hen examine wheher he magniude of he negaive relaion beween abnormal capial invesmen and subsequen sock reurns is subsanially differen beween hese wo groups of firms. To carry ou hese ess, we consider all domesic, primary socks lised on he New York Sock Exchange (NYSE), American Sock Exchange (Amex), and Nasdaq sock markes. Following Fama and French (1992, 1993), we exclude closed-end funds, russ, ADRs, REITs, unis of beneficial ineres, and oher financial insiuions. The monhly daa on sock reurns, sock prices, and number of shares ousanding are obained from he Cener for Research in Securiy Prices (CRSP). The U.S. one-monh Treasury bill raes are used as risk-free raes. Financial saemen daa, such as book equiy, cash flows, long-erm deb, and sales are obained from he COMPUSTAT apes. While he sample period for financial daa covers from 1969 o 1995, he es period or he sample period for sock reurns covers from July 1973 o June 1996. To be included in he ess, a firm mus mee he following crieria. Firs, i should have he CRSP sock prices for December of year -1 and June of year and he COMPUSTAT book equiy for year -1. Second, is annual oal ne sales should be no less han US$10 million o exclude firms a heir early sage of developmen. Third, i should no have negaive book equiy for he fiscal year ending in calendar year -1. Moreover, following Fama and French (1992, 1993), firms are no included unil hey have appeared in COMPUSTAT for wo years o avoid he poenial survival/selecion bias inheren in he way COMPUSTAT adds firms o is apes (Banz and Breen (1986)). 4

A firm s marke equiy (ME) is defined as is price muliplied by he number of shares ousanding, and is marke size (SZ) is measured as he ME a he end of June of year. The book-o-marke equiy raio (BM) is compued as he raio of he book equiy (BE) of a firm for he fiscal year ending in calendar year -1 o he firm s ME a he end of December of -1. As in Fama and French (1993), we define book equiy as he COMPUSTAT book value of sockholders equiy, plus balance shee deferred axes and invesmen ax credis (if available), minus he book value of he preferred sock. Depending on availabiliy, he redempion, liquidaion, or par value (in ha order) is used o esimae he value of he preferred sock. In he resuls repored in his paper, he measure of abnormal capial invesmen (CI -1 ) in he formaion year, is calculaed as follows: CE 1 CI 1 = 1, (1) ( CE + CE + CE 4 ) / 3 2 where CE -1 is a firm s capial expendiures (COMPUSTAT daa iem 128) scaled by is sales in year -1. We use he las hree-year average capial expendiures o projec he firm s formaion year s benchmark invesmen, and inerpre firms wih high CI as high invesors. The formaion year is he year when he year -1 CI is measured and he CI porfolios are formed (i.e, he reurns from July of year o June of year +1 are mached agains wih CI -1 ). Using sales as he deflaor, we implicily assume ha he benchmark level of capial expendiures will grow proporionaely wih sales. By his definiion, a CI value equal o (greaer han, less han) zero indicaes ha he formaion year s capial invesmen is he same as (greaer han, less han) he prior hree years average. Our definiion of CI can acually be viewed as a measure of abnormal 3 invesmen. To see how he resuls are sensiive o he measure of CI, we also use CE -1 (CE -2 + CE -3 + CE -4 )/3, CE -1 alone, replacing he las hree-year average wih he las five-year 5

average capial expendiures in equaion (1), and he CI measure wihou deflaing o measure CI -1. In addiion, we also use oal asses o replace sales as he deflaor in all CI measures. The resuls (no repored here) are basically insensiive o alernaive measures of CI. To ensure ha accouning informaion is known before we use i o explain he sock reurns, following Fama and French (1992), we mach sock reurns for he period beween July of year o June of year +1 (which is referred o as he es period or he year 1 reurns afer formaion year ) o he accouning daa (including CI) of a firm for he fiscal year ending in calendar year -1. Firms wih one or more missing monhly reurns are excluded from he sample for ha paricular year. Our iniial sample includes 58,880 indusrial firm-years (an average of 2,560 firms a year) ha are available in CRSP and COMPUSTAT for a leas 2 years. The sample is reduced o an average of 1,902 firms a year, since we require a firm o have a leas four years of daa o firs compue is abnormal capial invesmen and hen o mach wih he subsequen sock reurns. The sample size is furher reduced o an average of 1,725 firms a year, when we exclude firms wih missing sock reurns in he esing period. Finally, by excluding firms ha do no mee daa requiremens on sales and book equiy, we obain a final sample ha has an average of 1,635 firms a year. III. Mehodology We use hree differen approaches for evaluaing he reurns of he various invesmen sraegies ha we consider. The firs approach measures excess reurns relaive o benchmarks ha are consruced o have very similar firm characerisics (i.e., size, book o marke, and momenum) as he evaluaed porfolio. The second approach applies Carhar s (1997) adapaion of he Fama and French (1993) mehod of calculaing excess reurns. And finally, we follow 6

Chopra, Lakonishok, and Rier (1992) o examine reurns around a shor window surrounding he firms earnings announcemen daes. A. Characerisic-based Benchmark Porfolios Firms wih differen levels of invesmen expendiures are likely o be subjec o differen ypes of risk. One migh expec ha firms ha inves he mos are he riskies, since a greaer fracion of heir value consiss of growh opions. Alernaively, since he leas risky firms have he lowes cos of capial, hey may inves he mos. In any even, when one compares he reurns of firms ha inves high and low amouns, i is criical ha appropriae benchmarks are chosen. Here we will be conrolling for firm characerisics as well as facor sensiiviies. Our procedure for calculaing benchmark-adjused reurns follows he mehodology oulined in he Daniel, Grinbla, Timan, and Wermers (1997) sudy ha developed benchmarks o evaluae muual fund performance. Specifically, we form 125 benchmark porfolios ha capure hree sock characerisics namely book-o-marke equiy, size, and momenum, which are significanly relaed o he cross-secional variaion in reurns. 3 These benchmark porfolios are formed as follows. Firs, saring wih July of year, he universe of common socks is sored ino five porfolios based on each firm s size (SZ) a he end of June of year according o he breakpoins for he NYSE firms. The breakpoins for size are obained by soring NYSE firms ino quiniles based on heir SZ measures a he end June of year in ascending order. The size of each firm in our sample is hen compared wih he breakpoins o decide which porfolio he firm belongs o. Firms in each SZ porfolio are furher equally sored ino quiniles based on heir book-o-marke raio (BM) a he end of year -1. Finally, he firms in each of he 25 SZ/BM 7

porfolios are equally sored ino quiniles based on heir prior-year reurn (PR1YR, calculaed hrough he end of May of year o reduce he bias from bid-ask bounces and monhly reurn reversals). The inercepion of he five SZ, he five BM, and he five PR1YR classificaions resuls in a oal of 125 benchmark porfolios. The value-weighed monhly reurns on benchmark porfolios are calculaed from July of year o June of year +1. All benchmark porfolios are rebalanced each year. Once we form hese 125 characerisic-based benchmark porfolios, calculaing he excess reurn is sraighforward. Each sock, in each year, is assigned o a benchmark porfolio according o is rank based on SZ, BM, and PR1YR. Excess monhly reurns of a paricular sock are hen calculaed by subracing he sock s corresponding benchmark porfolio s reurns from he sock s reurns. Specifically, he characerisics-adjused reurn is defined as: R CH i R R, (2) i CH i where R i and CH i R are he reurn on securiy i and he reurn on a SZ-BM-PR1YR mached porfolio in monh, respecively. The excess reurns on individual socks are hen used o calculae he value-weighed excess monhly reurns on es porfolios ha are formed based on he sorings of CI and oher variables. The excess reurns on es porfolios are someimes referred o as benchmark-adjused porfolio reurns. B. The Carhar Four-Facor Model To conrol for facor risk, he value-weighed excess reurns on es porfolios are regressed on he Fama-French hree facors and he Carhar momenum facor: 3 See Fama and French (1992, 1993), Jegadeesh and Timan (1993, 2001), Daniel and Timan (1997), and Daniel, Timan, and Wei (2001). 8

AR p, = p + β HML, prhml, + βsmb, prsmb, + βmk, p RMk, R f ) α ( + β R + ε Pr1yr, p Pr1yr, p,. (3) In equaion (3), AR p, is he benchmark-adjused reurn on CI ranked porfolio p; R f is he riskfree rae; R HML,, R SMB,, and R Mk, are he hree facors suggesed by Fama and French (1993, 1996); and R Pr1yr, is he momenum facor. More specifically, R HML is he book-o-marke facor and is he difference beween he reurn on a porfolio of high (he op 30%) book-o-marke socks and he reurn on a porfolio of low (he boom 30%) book-o-marke socks (HML, High Minus Low). R SMB is he size facor and is he difference beween he reurn on a porfolio of small (he boom 50%) socks and he reurn on a porfolio of large (he op 50%) socks (SMB, Small Minus Big). R Mk is he marke facor and is he reurn on he marke porfolio. R Pr1yr, is he difference beween he reurn on a porfolio of socks wih high (he op 50%) prior-year reurns and he reurn on a porfolio of socks wih low (he boom 50%) prior-year reurns (PR1YR, high minus low prior-year reurn, skipping he reurn in he formaion monh). The momenum facor suggesed by Carhar (1997) capures he Jegadeesh and Timan (1993, 2001) one-year momenum in sock reurns. The esimaed inercep from his regression capures he riskadjused reurns on our CI-sored porfolios. We refer o his model as he Carhar four-facor model. C. Excess Reurns Surrounding Earnings Announcemens Alhough our ess adjus reurns wih a characerisic-benchmark as well as wih a facor model, i is sill plausible ha he abnormal reurns we observe reflec risk facors ha are no accouned for by our benchmarks. To address his possibiliy, we provide an addiional es in his secion ha is based on sock reurns of pas high and low CI firms around earnings 9

announcemen daes. If significan excess reurns are generaed because of benchmark errors, we expec hem o accrue relaively smoohly over he year, since sysemaic risk is no likely o change a lo from day o day. However, if invesors fail o appreciae he negaive effecs of overinvesmen, hey are likely o be unpleasanly surprised when he firms announce heir earnings, implying ha a significan porion of he abnormal performance for low CI firms over high CI firms will occur around he earnings announcemens. 4 This mehodology, which was iniially proposed by Chopra, Lakonishok, and Rier (1992) o sudy overreacion, has been applied in several sudies o es for he possibiliy ha invesors have biased expecaions. For example, Jegadeesh and Timan (1993) apply his approach o invesigae he deerminans of momenum profis and La Pora, Lakonishok, Shleifer, and Vishny (1997) apply his approach o examine he value/growh premium. IV. Empirical Resuls A. Disribuional Characerisics of Reurns on Porfolios Formed on Capial Invesmens We firs form five capial invesmen (CI) porfolios and hen examine he relaion beween abnormal capial expendiures and subsequen sock reurns on he CI porfolios. Saring wih July of year, we sor all socks ino quiniles based on heir year -1 capial invesmen measures in ascending order. The firms remain in hese porfolios from July of year o June of year +1. Based on hese porfolios, we form a CI-spread porfolio ha has a one-dollar long posiion in he wo lowes CI porfolios (he 1 s and he 2 nd ) and a one-dollar shor posiion in he wo highes CI porfolios (he 4 h and 5 h ). The porfolios are rebalanced each year. 4 An alernaive approach for deermining wheher invesors have biased expecaions is o look a changes in analys earnings esimaes (see, for example, Teoh and Wong (2002) and ohers). Specifically, one could examine wheher here are biases in earnings esimaes ha are sysemaically relaed o capial invesmen expendiures. 10

The disribuional characerisics of he benchmark-adjused reurns on he CI porfolios are repored in Panel A of Table 1. I is revealed ha excep for he lowes CI quinile, he benchmark-adjused mean reurn decreases monoonically wih abnormal capial invesmens. A furher inspecion shows ha firms wih high abnormal invesmens are penalized wih negaive benchmark-adjused reurns, while firms wih low abnormal invesmens are rewarded wih posiive benchmark-adjused reurns in more han half of he ime during he sample period. The saisics on he CI-spread porfolio shows ha he mean excess reurn (0.168% per monh) is above he median (0.119% per monh) and is significanly differen from zero wih a p-value of less han 0.01. The saisics in Panel A of Table 1 indicae ha he beer performance of low invesors over high invesors is no due o ouliers. [Pu Table 1 here] B. The Year-o-Year Performance of he CI-Spread Sraegy To examine he riskiness of he CI-spread sraegy and he persisence of he negaive relaion beween abnormal capial invesmens and sock reurns, we examine he year-o-year reurns of he sraegy. Panel B of Table 1 presens he year-o-year performance (from July 1973 o June 1996) of he zero-cos benchmark-adjused CI-spread porfolio. I repors he performance of he CI-spread porfolio in he firs hrough he fifh year following he formaion year as well as he five-year cumulaive reurns. The performance is measured by annual reurns, which are compued by compounding he welve monhly reurns from July of year o June of year +1. The resuls presened in he las row of Panel B in Table 1 sugges ha he sock reurns of firms ha inves he leas end o ouperform he sock reurns of firms ha inves he mos for a While his would also be a good approach, daa on analys forecass are no available for he early par of our 11

leas 5 years. The reurns in year 2 (2.26%), year 3 (1.91%), year 4 (1.85%), and year 5 (1.64%) are all saisically indisinguishable from he year 1 reurns and are all reliably differen han zero. However, he average reurn on CI-spread in year 6 afer porfolio formaion (no repored in he Table) is 1.05% and is saisically insignifican. A close look a he year-o-year reurn on he CI-spread sraegy reveals ha low abnormal invesmen socks ouperform high abnormal invesmen socks in abou wo-hirds of he years (column 2 of Panel B in Table 1); he year-oyear reurns are srongly posiive in each year beween 1974 and 1980, hey are negaive in 1981 and each year beween 1984-1989, and are posiive again in all subsequen years. This reurn paern is very unlikely o occur purely by chance, which is suppored by a formal -es on he null hypohesis ha he chances of having a posiive or a negaive annual reurn on CI-spread are 50-50. Specifically, he CI-spreads are posiive in 15 ou of 17 years during he sample period ha excludes he hosile akeover years from 1984-1990 (o be discussed below). The es saisic on he null hypohesis is 4.75 for his sample period and srongly rejecs he null a he 0.005 significance level. For years beween 1984 and 1989, all CI-spreads are negaive, which again srongly rejec he null hypohesis ha he chance is 50-50 in any given year. The observed ime-series reurn paern coincides, however, wih he wave of he hosile akeover and merge aciviy, and is consisen wih our empire builder explanaion. In a paper ha discusses he rise and fall of hosile akeovers since he 1980s, Holmsrom and Kaplan (2001) finds ha he number of leverage buyous (LBOs) and hosile akeovers increased subsanially in he 1984 o1990 period. Our evidence suggess ha he CI-spread reurns were very high in he 70s when lax corporae governance and a weak akeover marke allowed firms o overinves. However, afer 1984, many of he firms wih a endency o overinves were sample and here are no daa on earnings esimaes for mos of he smaller firms in our sample. 12

subjec o eiher hosile akeovers, or were forced o make value-improving changes o preemp hese akeovers. In eiher case, he empire builders would be expeced o exhibi posiive abnormal reurns in his subperiod. However, because of various impedimens o akeovers inroduced in he lae 1980s, he relaion beween abnormal invesmens and reurns may have again reversed in he laer period. We herefore define he hosile akeover period as from 1984 o 1989 ha corresponds wih he monhly reurn period from July of 1984 o June of 1990. C. The Relaion beween Capial Invesmens and Sock Reurns The saisical ess of he benchmark-adjused reurns on he CI porfolios are presened in Table 2. Since empire builders were subjec o hosile akeovers in he 1984 o 1989 period as evidenced in Panel B of Table 1, in addiion o reporing resuls in all years, we also repor resuls in non-hosile akeover years and in hosile akeover years separaely. The resuls for benchmark-adjused reurns from all years (Column 2) demonsrae ha one of he wo low invesors is saisically significanly posiive a he five percen level, while boh of he wo high invesors are significanly negaive a he five percen level. In addiion, he mean reurns differ reliably from each oher across he five CI porfolios as evidenced by he Wilks Lambda saisics (F-value = 2.08 wih a p-value of 0.026). Furhermore, he mean reurn on he CIspread porfolio is significanly posiive wih a value of 0.168% (-value = 2.91) per monh or 2.02% (12 0.168%) per year, indicaing ha firms ha inves more realize lower sock reurns han firms ha inves less afer conrolling for size, book-o-marke equiy, and momenum effecs. A furher inspecion on he mean excess reurns indicaes ha he underperformance from high invesors and he ouperformance from low invesors are no symmeric. High invesors underperform he characerisic benchmarks by 0.105% (=(0.083+0.127)/2) per monh, 13

while low invesors ouperform he characerisic benchmarks by only 0.062% (= (0.042+ 0.083)/2) per monh. [Pu Table 2 here] Alhough our benchmarks conrol for reurn differences ha arise because of differences in firm characerisics, he benchmarks do no necessarily conrol for facor risk. In order o conrol for facor risk, we regress benchmark-adjused CI porfolio reurns on he Carhar four facors. The resuls repored in Column 3 of Table 2 show ha hree ou of five esimaed inerceps are reliably differen from zero and all of he five esimaed inerceps are significanly differen from each oher across he five CI porfolios (F-value of Wilks Lambda = 4.68 wih a p-value of 0.001). Wih he excepion of he firs quinile, he risk-adjused reurns monoonically decrease wih abnormal capial invesmens. In addiion, he esimaed inercep for he zero-cos CIspread porfolio is significanly posiive, indicaing ha he low reurn for high invesors is no due o risks associaed wih he Carhar four facors. Afer adjusing for sock characerisics and aking ino accoun he Carhar four facors, low CI firms sill earn, on average, a reurn of abou 0.192% (-value = 3.25) per monh or 2.3% per year more han do high CI firms. In oher words, he Daniel, Grinbla, Timan, and Wermers (1997) hree-characerisic-based model and he Carhar four-facor model fail o explain he underperformance of high invesors. Furhermore, evidence of underperformance of high invesors and superior performance of low invesors is sronger when excess reurns are based on he facor model. To check he robusness of he obained resuls, we apply nonparameric ess on medians. The medians of he excess reurn series and he Fama-French inercep series are repored in square brackes [ ]. The Fama-French inercep series are obained by adding back residuals o he esimaed alphas. The es on medians confirms our finding ha high invesors generally 14

underperform low invesors. In addiion, he nonparameric Krushal-Wallis ess sugges ha he medians differ reliably from each oher across he five CI porfolios for boh he benchmarkadjused reurns and he Fama-French inerceps. When he sample is divided ino non-hosile akeover and hosile akeover years, i is obvious ha he underperformance for high invesors over low invesors mainly comes from he nonhosile akeover period. In fac, low invesors ouperform high invesors more in non-hosile akeover years han in all years. For insance, he risk-adjused reurn for he CI-spread porfolio increases from 0.192% per monh in all years o 0.312% (-value = 4.42) in non-hosile akeover years. Moreover, for he CI-spread porfolio, boh he mean excess reurn and he Fama-French inercep are significanly posiive for he non-hosile akeover period bu no for he hosile akeover period. In addiion, during he hosile akeover period, high invesors acually perform beer hough no significanly beer han low invesors. In fac, boh he difference in he excess reurns and he difference in he esimaed Fama-French inerceps for he CI-spread porfolio beween non-hosile akeover and hosile akeover periods differ reliably from zero, as repored in he las column of Table 2. The significan differences are also confirmed by he nonparameric Wilcoxon Z-saisics (repored in braces { }) for he es of medians o be equal across he wo periods. D. Sock Reurns Around Earnings Announcemen Daes This secion examines sock reurns around earnings announcemen daes and provides furher evidence ha he excess reurns presened in he previous subsecions are generaed by errors in invesor expecaions raher han benchmark errors. Specifically, we examine he marke-adjused reurns (raw reurns minus he reurns on he marke porfolio) over a 3-day 15

window cenered around quarerly earnings announcemen daes in each of he five years afer porfolio formaion. 5 The earnings announcemen daes are obained from he COMPUSTAT quarerly indusrial daabase. If he previously documened excess reurns arise because invesors have sysemaically biased expecaions, hen we expec ha he excess reurns will be subsanially higher around earnings announcemen daes when new informaion is realized. For each quarer, he 3-day marke-adjused reurns are equally weighed across all socks in a given CI porfolio o compue he porfolio s average even-dae marke-adjused reurn. These quarerly earnings announcemen dae marke-adjused reurns are hen aggregaed ino annual inervals by summing up he four quarerly earnings announcemen dae marke-adjused reurns in each of he five pos-formaion years. For comparison purposes we also calculae annual buyand-hold marke-adjused reurns on a given CI porfolio by equally weighing he individual sock s annual marke-adjused reurns across all socks in he porfolio. The individual sock s annual marke-adjused reurn is compued by compounding he welve monhly marke-adjused reurns on he sock. Table 3 presens annual earnings announcemen dae marke-adjused reurns (even reurns) as well as annual buy-and-hold marke-adjused reurns for he five CI porfolios in each of he five years afer porfolio formaion for he whole sample period. I also presens he average marke-adjused reurns on he CI-spread porfolio for he hree differen sudy periods. The able reveals a paern of announcemen dae marke-adjused reurns ha is consisen wih he paern repored in Table 2. In paricular, Panel A of Table 3 shows ha in he firs year 5 We use daily marke-adjused reurns insead of daily benchmark-adjused reurns o compue he abnormal reurns around he earnings announcemen daes, since he daily benchmark-adjused reurns are no readily available. However, by inspecion of he monhly reurn behavior on he five CI porfolios based on boh benchmark-adjused reurns and marke-adjused reurns, we find ha he monhly reurn paerns are virually idenical beween hese wo measures of reurns. However, he magniudes are higher for he marke-adjused reurns han for he benchmark-adjused reurns, which suggess ha he repored resuls may be conservaive. 16

following he formaion dae he cumulaive earnings announcemen dae marke-adjused reurns decrease monoonically wih CI. The even-dae marke-adjused reurn of he CI-spread porfolio over hese 12 rading days is 0.79% which represens abou 24% of he 3.33% oal difference in he firs-year reurns beween low CI firms and high CI firms, as summarized in Panels B and C. 6 The able also reveals ha he subsanially posiive announcemen dae marke-adjused reurns on he CI-spread porfolio are saisically significan in he firs hree years afer he formaion dae. As one migh expec, he magniude of he excess reurns decreases as he ime elapsed from he formaion dae increases. [Pu Table 3 here]. The evidence in Panel C of Table 3 and es resuls no repored in he able indicae ha earnings announcemen dae marke-adjused reurns are subsanially differen from each oher across he non-hosile akeover and hosile akeover periods. The observed paern of announcemen dae marke-adjused reurns mainly comes from he non-akeover period. In paricular, he CI-spread announcemen dae marke-adjused reurns are significanly posiive in all five years afer he formaion during he non-hosile akeover years, while hey are all negaive and saisically indifferen from zero during he akeover years. Our evidence suggess ha earnings announcemen reurns conribue a good porion of reurn differenial beween he low and he high abnormal invesmens, suggesing ha he reurn differenial is no likely o be generaed by benchmark measuremen errors. 6 For comparison, La Pora, Lakonishok, Shleifer, and Vishny (1997) find ha a significan porion of he reurn difference beween value and glamour socks is aribuable o earnings surprises. Specifically, hey find ha earnings announcemen reurn differences accoun for approximaely 25-30 percen of he annual reurn differences beween value and glamour socks in he firs hree years afer porfolio formaion and approximaely 15-20 percen of he reurn differences over years four and five afer formaion. 17

V. The Cross-Secional Deerminans of he CI-Reurn Relaionship The resuls in he previous secion indicae ha in he pre- and pos-hosile akeover years, here is a srong negaive relaion beween abnormal invesmen expendiures and reurns, whereas in he hosile akeover years, he relaion becomes posiive hough no significan. In his secion, we examine he cross-secional deerminans of his CI-reurn relaion. Specifically, we explore how his CI-reurn relaion is influenced by variables such as cash flows and deb raios ha are likely o be relaed o empire building endencies. Given ha he relaions beween CI and reurns appear o be differen beween non-hosile akeover years and hosile akeover years, we examine hose years separaely. Jensen (1986) argues ha hose firms wih he highes cash flows and he lowes leverage raios are more likely o overinves han less levered firms wih low cash flows. If his is rue, one migh expec o observe a sronger negaive CI-reurn relaionship among firms wih eiher high cash flows or low leverage. In he nex hree subsecions, we es he Jensen hypohesis based on cash flows, leverage raios, and he combined effecs. A. The Relaion beween Cash Flows and he Abnormal Capial Invesmen-Reurn Relaion To es wheher or no cash flows have any effec on he negaive CI-reurn relaionship, we firs form en es porfolios based on cash flows (CFs) and CIs as follows. Saring wih July of year, we place all socks ino wo groups according o heir year -1 s cash flows. Cash flow, which is scaled by oal asses, is measured as operaing income before depreciaion minus ineres expenses, axes, preferred dividends, and common dividends. If a firm s CF is below he median CF of he year, i is designaed as par of he low CF group; oherwise i is placed in he high CF group. Wihin each CF group, socks are equally sored ino quiniles based on heir 18

year -1 s CIs in an ascending order. As a resul, we have a oal of en porfolios based on he CF and CI classificaions. The reurns of a paricular sock are adjused for is corresponding characerisic-based benchmark porfolio reurns. We hen calculae each porfolio s valueweighed monhly excess reurns from July of year o June of year +1, and hen rebalance he porfolios in June of year +1. We furher form wo CI-spread porfolios, one for he low CF group and he oher for he high CF group. In addiion, we form one H-L (High minus Low) CF CI-spread porfolio. The CIspread porfolio denoes a zero-invesmen porfolio ha has a one-dollar long posiion in he lowes wo CI porfolios and a one-dollar shor posiion in he highes wo CI porfolios for a given CF group. The H-L CF CI-spread porfolio is he one ha has a long posiion in he high CF CI-spread porfolio and a shor posiion in he low CF CI-spread porfolio. Forming porfolios in his way allows us o deermine wheher here is a differenial paern in he CIreurn relaion beween low CF firms and high CF firms afer conrolling for he firm characerisics. We also regress CI porfolio reurns on he Carhar four facors o conrol for risk. The Jensen agency argumen suggess ha he reurn on he H-L CF CI-spread porfolio will be posiive. The resuls repored in Table 4 are consisen wih his agency explanaion. Table 4 presens he monhly mean excess reurns, he regression resuls on he en characerisic-adjused CF/CI porfolios and he CI-spread porfolios in each of he hree sudy periods, and he difference beween non-hosile akeover and hosile akeover periods. The median values and he Z- saisics of he nonparameric Wilcoxon es for he CI-spreads are repored in square brackes [ ] and braces { }, respecively. The las hree rows in Table 4 provide he F-values of he Wilks Lambda saisic for he es of wheher means are equal across he CI porfolios. 19

[Pu Table 4 here] The resuls from he all-years sample indicae ha he mean excess reurns for high CF firms monoonically decrease wih abnormal capial invesmens. This is no, however, he case for firms wih low cash flows. Indeed, in he low CF subsample, he lowes CI porfolio experiences a significan negaive reurn. In addiion, he posiive CI-spread is significan only for he high CF group (he CI-spread is 0.227% per monh for he high CF group while i is only 0.078% for he low CF group). However, he difference in reurns beween he high and he low CF CIspreads (0.149% per monh) is no saisically significan, as is also evidenced by he es resul of Wilks Lambda saisic on he mean reurns of he CI-spread porfolios across he wo cash flow groups. These resuls ge somewha sronger when we conrol for risk using he Carhar four-facor model. The Wilks Lambda es resul suggess ha he esimaed Fama-French inerceps are significanly differen from each oher across he five CI porfolios for boh cash flow groups. The risk-adjused reurn is significan only for he CI-spread porfolio of he high CF group wih a value of 0.256% per monh, and is insignifican for he low CF group wih a value of 0.059% per monh. This suggess ha among firms wih a high level of free cash flows, high CI firms end o underperform low CI firms subsanially, whereas he underperformance is much weaker among firms wih a low level of free cash flows. A formal es on he H-L CF CI-spread porfolio indicaes ha a reurn difference of 0.197% per monh in he CI- spreads beween he high and he low CF firms is marginally significan a he en percen level. I suggess ha afer accouning for he characerisics and risk facors, he negaive CI-reurn relaionship is sronger among firms wih higher levels of cash flows han among firms wih lower levels of cash flows, which suppors he managerial agency/overinvesmen explanaion suggesed by Jensen (1986). 20

The resuls from non-akeover years versus akeover years clearly sugges ha he above CIreurn paern mainly comes from non-akeover years raher han from akeover years. Specifically, he esimaed Fama-French inerceps differ reliably from each oher across he five CI porfolios for boh CF groups for he non-hosile akeover period, bu i is no he case for he hosile akeover period. Moreover, boh he difference in he mean excess reurns and he difference in he Fama-French inerceps of he high CF CI-spread beween he non-akeover and akeover periods are reliably differen from zero. The evidence of he nonparameric es of medians (no repored here) also suppors his conclusion. B. The Relaion beween Deb Raios and he Abnormal Capial Invesmen-Reurn Relaion This same procedure described above is also used o deermine wheher a firm s deb raio affecs he CI-reurn relaion. We form en porfolios based on he deb-o-asses raio (DA) and he capial invesmen (CI) classificaions and hen form wo CI-spread porfolios and one H-L DA CI-spread porfolio. The deb-o-asses raio is defined as he raio of long-erm deb over he sum of long-erm deb plus he marke value of firm s equiy. If a firm s deb-o-asses raio is below he median deb-o-asses raio of he year, he firm is assigned o he low deb group; oherwise i is assigned o he high deb group. The Jensen agency argumen suggess ha he H- L DA CI-spread should be negaive. Table 5 repors he average reurns on benchmark-adjused DA/CI porfolios, he regression resuls on he Carhar four facors, and he across periods ess on he mean reurns and he Fama-French inerceps. The resuls from all years show ha he characerisics-adjused reurns monoonically decrease wih he CI measures for he low DA sample bu no for he high DA sample. In addiion, he characerisics-adjused reurns on he CI-spread porfolios are 21

significanly posiive for he low DA sample (0.225% per monh) bu no for he high DA sample (0.099% per monh). The difference in reurns beween he high DA and he low DA CI-spreads (H-L DA CI-spread = 0.126% per monh) is no saisically significan, bu becomes marginally significan a he en percen level when we conrol for risks using he Carhar four-facor model. The es resuls also sugges ha he risk-adjused reurns are significanly differen from each oher across he five CI porfolios for boh DA groups. In addiion, boh he difference in excess reurns and he difference in he esimaed Fama-French inerceps beween he non-hosile akeover and hosile akeover periods are significanly differen from zero, for boh he high DA and he low DA CI-spreads. Again, his evidence and he evidence from he nonparameric es of medians are driven by he non-akeover years and are consisen wih he agency explanaion. [Pu Table 5 here] C. The Combined Effec of Cash Flow and Deb Raio on he Abnormal Capial Invesmen- Reurn Relaion In his secion we examine he combined effecs of cash flows and deb by using a Fama- MacBeh (1973) approach. Specifically, we esimae he following Fama-MacBeh regression models: Model 1: R i Model 2 : R Model 3 : R i i = λ 0, = λ = λ 0, 0, + λ CI 1, + λ CI 1, + λ CI 1, 1 1 1 + λ CI 2, + λ CI 3, + λ CI 2, 1 1 1 DCF DDA DCF 1 1 1 + ε, + ε, + λ CI 3, = 1,..., T, = 1,..., T, 1 DDA 1 + ε, = 1,..., T, (4) where R i is he benchmark-adjused value-weighed reurn on individual sock i in monh. I is weighed by he firm s marke value relaive o he oal marke value for a given CI rank i belongs o in a given year, which is basically wha we have done in Tables 4 and 5. CI -1 is he abnormal capial invesmen measure for firm i. To be consisen wih our resuls repored in 22

Tables 4 and 5, we use dummy variables DCF and DDA o assign a firm s cash flow (CF) and deb o asses raio (DA). If a firm s CF is above he median CF of he year, hen DCF equals one and zero oherwise. DDA is defined in he same way. In addiion, o reduce he impac from he exreme ouliers, he op and boom 1.5% of he observaions (based on characerisicsadjused reurns) are excluded from he sample. The Jensen (1986) managerial agency/overinvesmen explanaion predics ha λ 1 < 0, λ 2 < 0, and λ 3 > 0. The es resuls are presened in Table 6. The resuls from Model 1 and Model 2 are basically consisen wih hose repored in Tables 4 and 5. More specifically, he resuls from all years indicae ha he regression coefficiens on boh CI and CI DCF are significanly negaive. The resuls sugges ha he CI-reurn relaionship is negaive and ha his negaive relaionship is significanly sronger for high CF firms, consisen wih our findings in Table 4. We also find ha he regression coefficien on CI is significanly negaive a he five percen level whereas he regression coefficien on CI DDA is significanly posiive a he en percen level. The resuls indicae ha he CI-reurn relaionship is srongly negaive and ha his negaive relaionship is marginally sronger for low DA firms, consisen wih our findings in Table 5. When boh CI DCF and CI DDA are simulaneously considered in he regression, he coefficiens on CI and CI DCF are sill significanly negaive, he coefficien on CI DDA remains posiive bu i becomes insignifican. 7 [Pu Table 6 here] 7 Noice ha he independen variable in Equaion (4) is characerisics-adjused reurns wihou aking ino accoun he facor risks. Using he characerisics-adjused reurns, he reurns on he H-L CF CI-spread porfolio and on he H-L DA CI-spread porfolio are no saisically significan in Tables 4 and 5, respecively. If we exclude he op and he boom 2.0% of he observaions based on characerisics-adjused reurns, all slope coefficiens are saisically significan for boh he all-years sample and he non-hosile akeover years sample wih prediced signs. 23

The resuls from he non-hosile akeover period versus he hosile akeover period sugges ha he impac of cash flow and deb raio on he negaive CI-reurn relaionship primarily comes from he non-hosile akeover period. In sum, he Fama-MacBeh regression resuls confirm our findings in he previous subsecions ha he ouperformance of low CI firms over high CI firms is sronger for hose firms wih he leas financial consrains and ha hese resuls exis only in he non-hosile akeover period. VI. Robusness of he CI-Reurn Relaion A. The Conrarian Effec The firms in our sample wih high abnormal capial expendiures end o have experienced above average sock reurns in he preceding years. For insance, he pas five-year raw reurns on he five CI porfolios ranked from he lowes CI o he highes CI are 81.53%, 114.50%, 132.85%, 145.64%, and 153.77%, respecively. Hence, i is possible ha he capial invesmen effec ha we have documened is driven by he conrarian effec ha was previously documened by De Bond and Thaler (1985). To examine his more closely, we independenly sor firms ino quiniles deermined by boh he pas 5-year reurns of heir socks (PR) and he level of heir abnormal capial expendiures (CI). We also form five CI-spread porfolios and five PR-spread porfolios. 8 The reurns on he resuling porfolios are repored in Table 7. The resuls indicae ha here is clearly an abnormal capial expendiure effec (i.e. low CI firms ouperform high CI firms) ha is independen of he conrarian effec in all years and in non-hosile akeover years. For insance, he CI-spread is generally posiive for a given PR rank as shown in boh Panel A and Panel B of Table 7; and he 8 Refer o Table 7 for he deailed descripion of porfolio consrucion. 24

average CI-spread is saisically significan wih a value of 0.285% per monh as shown in Panel B. In addiion, our unrepored es show ha he average CI-spread differs reliably across he non-akeover and akeover periods while he average PR-spread does no. The evidence here suggess ha afer conrolling for firm characerisics and he conrarian effec, he CI effec remains srong, especially for he non-hosile akeover period. However, our resuls also reveal a conrarian effec, which is weak and saisically insignifican afer conrolling for he CI effec. 9 In addiion, as shown in Panel C of Table 7, he conrarian effec is negaive in he hosile akeover years when he CI effec is negaive. Indeed, uncondiionally (ha is, when we do no sor on CI) our unrepored resul indicaes ha he conrarian effec is negaive in he hosile akeover years. Hence, our evidence suggess ha i is more likely ha he conrarian effec is caused by he capial invesmen effec han vice versa. [Pu Table 7 here] B. The Effec of New Equiy Offerings Pas research documens ha companies ha issue new equiy, eiher iniial public offerings (IPOs) or seasoned equiy offerings (SEOs), subsequenly realize poor long-run sock price performance (Loughran and Rier (1995), Cai and Wei (1997) and ohers). Firms ha issue new equiy generally have higher levels of capial expendiures (relaive o oal asses) han nonissuing firms (Loughran and Rier (1997)). Our own evidence also indicaes ha firms ha issue equiy in he previous year inves more han hose ha do no have new equiy issues. Specifically, he value-weighed average and he simple average of CI measures for firms in our 9 To check he robusness of our resuls, (1) we also rank he socks based on he pas 3-year reurns insead of he pas 5-year reurns, and (2) we sor he socks firs based on he pas reurns and hen he CI-measures or he reverse. The unrepored resuls indicae ha he reurn paerns are almos idenical o hose repored in Table 7. More specifically, here exiss a capial invesmen effec ha is independen of he conrarian effec. 25

sample ha have no issued new equiy in previous year are 0.014 and 0.091, respecively, while hose averages for firms ha have issued new equiy in previous years are 0.071 and 0.170, respecively. Adverse selecion models, like Myers and Majluf (1984), sugges ha he negaive sock reurns associaed wih high capial invesmens should be concenraed in hose firms ha fund heir capial expendiures wih SEOs. To examine wheher he observed negaive abnormal invesmen/reurn relaion is aribuable o hese new equiy offering firms, we reexamine he benchmark-adjused reurn differences beween high and low invesors ha have no issued sock in any year from year 5 o year 1. The es resuls are repored in Table 8. The underperformance of high invesors relaive o low invesors remains he same. Specifically, he benchmark-adjused reurn on he CI-spread porfolio in he all-years period is 0.186% per monh (2.23% per year) wih a -value of 3.34. The corresponding risk-adjused reurn is 0.208% per monh (2.50% per year) wih a -value of 3.43. Again, he CI effec is significan in non-akeover years bu i reverses and is insignifican in akeover years. This evidence suggess ha he observed negaive CI-reurn relaion is no driven by he SEO effec and is also suppored by evidence from es on medians. 10 [Pu Table 8 here]. VII. Conclusion This paper documens a negaive relaion beween abnormal capial invesmens and fuure sock reurns. Firms ha increase heir level of capial invesmen he mos end o achieve lower 10 The unrepored resuls indicae ha he benchmark-adjused reurn paern on he CI-spread porfolio ha excludes firms ha have issued new equiy in any of he pas five years also persiss for a leas five years. Specifically, he reurns are 2.49% (=3.23) for year 1, 2.67% (=3.11) for year 2, 2.15% (=2.67) for year 3, 2.26% (=2.47) for year 4, and 1.71% (=1.98) for year 5 and he five-year cumulaive benchmark-adjused reurn is 9.91% 26