The Stock Market and Corporate Investment: A Test of Catering Theory

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The Stock Market and Corporate
Investment: A Test of Catering Theory
Christopher Polk
London School of Economics
Paola Sapienza
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
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In other words, managers with shorter shareholder horizons, and those whose assets are more difficult to value, should cater more. To test these cross-sectional predictions, we analyze the relation between discretionary accruals and investment for firms that are more opaque (higher R&D intensity) and for firms that have short-term investors (higher firms’ share turnover). We find that firms with higher R&D intensity and share turnover have investment that is more sensitive to discretionary accruals.
Our results provide evidence that discretionary accruals and firm investment are positively correlated. However, they show only indirectly that firms that overinvest are overpriced. To address this point, we analyze the relation between investment and future stock returns. If firms are misallocating resources due to market misvaluation, then abnormal investment should predict risk-adjusted returns. We estimate cross-sectional regressions of future monthly stock returns on current investment, controlling for investment opportunities (Tobin’s Q) and financial slack. We find that firms with high (low) abnormal investment have low (high) stock returns on average. This finding is robust to controlling for other characteristics linked to return predictability. Consistent with the theory’s prediction, we find that this effect is stronger for firms with higher

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