Working Paper: CEPR ID: DP3826
Authors: Christopher Polk; Paola Sapienza
Abstract: Does inefficiency of financial markets have real consequences? Or does it only result in transfers of wealth from noise traders to arbitrageurs? We study firm business investment to address this question. In our model, benevolent managers of overvalued companies invest in projects with negative net present value and managers of undervalued companies forego projects with positive net present value. Empirically, we find a positive relation between investment and a number of proxies for mispricing, controlling for investment opportunities and financial slack, suggesting that overpriced (underpriced) firms tend to over invest (under invest). Consistent with the predictions of our model, we find that investment is more sensitive to mispricing for firms with higher R&D intensity (suggesting longer periods of information asymmetry) or share turnover (suggesting that the firms' shareholders are short-term investors). We document similar patterns in the cross-section of average returns. Firms with relatively high (low) investment subsequently have relatively low (high) stock returns, after controlling for investment opportunities and other characteristics linked to return predictability. These patterns are stronger for firms with higher R&D intensity or higher share turnover.
Keywords: behavioral finance; investments
JEL Codes: E22; G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Overvalued firms (G32) | invest in projects with negative NPV (G31) |
| Undervalued firms (G32) | forego projects with positive NPV (G31) |
| Investment (G31) | proxies for mispricing (G19) |
| Investment decisions (G11) | future stock returns (G17) |
| Overvalued firms (G32) | low stock returns (G17) |
| Undervalued firms (G32) | high stock returns (G17) |