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Access to Equity Markets, Corporate Investments and Stock Returns: International Evidence

Access to Equity Markets, Corporate Investments and Stock Returns: International Evidence. By Sheridan Titman: UT-Austin K.C. John Wei: HKUST Feixue Xie: UT-El Paso. Introduction. Capital investment or asset growth anomaly More investment -> lower subsequent stock returns

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Access to Equity Markets, Corporate Investments and Stock Returns: International Evidence

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  1. Access to Equity Markets, Corporate Investments and Stock Returns: International Evidence By Sheridan Titman: UT-Austin K.C. John Wei: HKUST Feixue Xie: UT-El Paso

  2. Introduction • Capital investment or asset growth anomaly • More investment ->lower subsequent stock returns • Cannot be explained by CAPM or Fama-French factor models • Baker, Stein, and Wurgler (2003), • Titman, Wei, and Xie (2004), • Anderson and Garcia-Feijoo (2006), • Fama and French (2008), • Cooper, Gulen, and Schill (2008), • Polk and Sapienza (2009), etc. • Exception: Japan (Titman, Wei, and Xie (2009))

  3. Behavioral Explanations: Overinvestment • Titman, Wei, and Xie (2004): Agency-based explanation • Management empire building tendency (expropriation, compensation, ego) • Jensen’s (1986) agency cost of free cash flow: Too much free cash flow  too much CAPX  overinvest • Market mis-reaction to overinvestment: initially underreacts, subsequently corrects its reaction to negative information on overinvestment, resulting in lower stock returns

  4. Behavioral Explanations Agency-based overinvestment explanation Empirical evidence: the investment effect is more pronounced for firms with greater investment discretion Implications: factors that affect corporate overinvestment should also influence the asset growth effect If firms find it somewhat easier to overinvest in countries with easier access to equity markets, there may be a stronger asset growth effect in countries with better developed capital markets Empirical evidence: Titman, Wei, and Xie (2009) find no investment effect in Japan 9/11/2014 4

  5. Behavioral Explanations Overconfidence explanation Heaton (2002): managers overestimate return on investment -> overinvestment Implication: cultures that promote overconfidence are likely to exhibit a stronger asset growth effect Corporate governance Good corporate governance may mitigate overinvestment 9/11/2014 5

  6. Behavioral Explanations • Equity mispricing-based explanation • The catering theory of investment • Stein (1996) and Baker, Stein, and Wurgler (2003) • Firms overvalued or undervalued from time to time and firms tend to invest more when overvalued and less when undervalued. • Empirical support: Polk and Sapienza (2009) • mispricing proxy: discretionary accruals (DAC) • negatively associated with future stock returns. • higher DAC firms  invest more

  7. Rational explanations • The q-theory explanation • Cochrane (1991, 1996), Li, Livdan, Zhang (2009), Liu, Whited, and Zhang (2009), and others • Rrequired rate of returns are time-varying and firms investment more when their required rates of return (expected returns) are lower (assuming that firms invest optimally): ROIC = CoC • The extended q-theory with investment friction (Li and Zhang (2010)): the investment effect is stronger when frictions associated with increasing investment are stronger. • Implication: the asset growth effect is expected to be higher in countries with higher investment frictions

  8. Rational explanations • Option-theory explanation • Berk, Green, and Naik (1999): after growth options are exercised (increased investment), risk is reduced, -> expected returns are lower

  9. Main objectives Overinvestment can be caused by the agency cost of free cash flow, managerial overconfidence, or equity overvaluation Empirical evidence is inconclusive on which explanation (including the rational one) best explains the investment/asset growth effect in the United States Objectives: To examine the asset growth effect in an international setting To examine the extent to which the cross-country variation in the asset growth effect is generated by cross-country differences incountry characteristics such as the development of local equity markets, managerial overconfidence, and legal protection 9/11/2014 9

  10. Main Findings Using data from over 13,300 firms across 40 countries during 1981-2005, there exists the investment effect outside the United States With a few exceptions, most countries exhibit a negative relation between asset growth and subsequent stock returns As a whole, the asset growth effect is highly significant among developed countries, but is very weak and insignificant among developing countries The asset growth effect in developed markets is very persistent and lasts for at least five years after portfolio formation 9/11/2014 10

  11. Main Findings Among developed countries, the difference in the asset growth effect can be explained by the cross-country difference in the ease of access to equity markets or equity market development the asset growth effect is 0.58% per month (or about 7% per year) higher in countries in the top 30% than in the bottom 30% of all developed countries in the access-to-equity market index The asset growth effect is stronger in countries with higher corporate asset growth and more overconfidence, but insignificant for legal protection The inclusion of these country variables does not materially affect the significant influence of the access to equity markets on the asset growth effect 9/11/2014 11

  12. Hypotheses 1. Countries with easy access to equity markets should show a stronger asset growth effect Firms in countries with more developed capital markets may be more likely to invest more due to the easiness of their access to external markets Evidence: Titman, Wei, and Xie (2004, 2009a) 2. Countries with high individualistic cultures should exhibit a stronger asset growth effect People in countries with high individualist cultures tend to be more overconfident and more optimistic than their counterparts with low individualistic cultures Evidence: Chui, Titman, and Wei (2010) 9/11/2014 12

  13. Hypotheses 3. Country-level corporate governance may have a negative impact on the asset growth effect Strong corporate governance -> low agency problem -> less likely to overinvest -> a weak investment effect 4. Countries with higher investment frictions should have a stronger asset growth effect a given change in required rates of return produces a smaller change in investment when investment frictions are higher-> a stronger investment/asset growth effect 9/11/2014 13

  14. Data: Country-level variables The ease of access to external markets the index of access-to-equity market: Global Competitiveness Report from 1999 to 2006 surveyed by World Economic Forum the ratio of stock market capitalization to gross domestic product (GDP) scaled by the fraction of stock market held by outside investors Both are used by La Porta, Lopez-de-Silanes, and Shleifer (2006) Overconfidence The individualism index: from Hofstede (1980, 2001) Used by Chui, Titman, and Wei (2010) 9/11/2014 14

  15. Data: Country-level variables Corporate governance (Legal protection of investors) the anti-self-dealing index It is from Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2008) Firm-level data: Financial and market data The US: CRSP and Compustat Other countries: Datastream 9/11/2014 15

  16. Measurement of firm-level variables Total asset growth rate (TAG) TAGit = (TAit – TAit-1)/TAit-1 Alternative measures Capx divided by net fixed assets and its variants Firm size (SZ): market equity in U.S. dollars at the end of June of year t Book-to-market ratio (BM): ratio of a firm’s book value of equity to its market value of equity at fiscal year-end of year t-1 Momentum (MOM) at month m: the U.S.-dollar buy and hold return over the last six months that skips most recent month (i.e., from m-7 to m-1) 9/11/2014 16

  17. Measurement of firm-level variables Equity issuance (Issue) at month m: the change in the number of shares outstanding adjusted for distribution events over the past year (from m-12 to m) 9/11/2014 17

  18. Test Design Portfolio Analysis Sorting on TAG into quintiles and an TAG-hedge portfolio for each country Aggregating each country into the world TAG-sorted quintile portfolios and TAG-hedge portfolios (global investment effect) Return measures: in US dollars Raw returns SZ and B/M adjusted returns Regression analysis OLS with clustering by country and time and WLS The Fama-MacBeth procedure with and without weights 9/11/2014 18

  19. Test Design Cross-country difference: Regression analysis HedgeR is the SZ and BM adjusted monthly returns on a country’s TAG-hedge portfolio F is a vector of country-specific explanatory variables: easiness of raising external funds, legal protection of investors, and overconfidence MdBM and MdTAG are the median book-to-market equity and the median asset growth in a country OLS with clustering by country The Fama-MacBeth procedure 9/11/2014 19

  20. Test Design Cross-country difference: Portfolio analysis Double sort First sort on country-level (1) easiness of raising external funds, (2) legal protection of investors, and (3) overconfidence into 3 groups (top 30%, middle 40%, and bottom 30%) In each group, calculate time-series averages of returns on country-average TAG1, TAG5, and TAG-hedge portfolios, and examine the average investment effect for a given degree of access to equity markets, corporate governance, or overconfidence Compare the investment effect between the top and bottom groups 9/11/2014 20

  21. Preliminary Results: Country by country • Table 1: The country-by-country asset growth effects • Among developed countries, only 2 countries exhibit a reversed asset growth effect (Israel and New Zealand) and both are insignificant • 14 out of the 26 developed countries have a significant asset growth effect • The asset growth effect is very weak in developing countries • Only 3 out of the 14 developing countries have a significant asset growth effect • a considerable variation in the investment effect across countries • the developed countries as a whole show a strong and significant global investment effect, but not among developing countries

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  24. Preliminary Results: Persistence Table 2: The persistence of the investment effect Raw returns There exists a persistent asset growth effect for all economies as a whole, but the persistence mainly comes from the developed economies. The asset growth effect is persistent up to 5 years after portfolio formation for developed countries ranging from 0.32% to 0.53% per month for the whole sample and 0.32% to 0.53% for the developed countries. No asset growth effect in any of the 5 years after portfolio formation for the developing countries BM and SZ adjusted returns The same return patterns are observed but are weaker than those based on raw returns. 9/11/2014 24

  25. Persistence analysis 9/11/2014 25

  26. Preliminary Results: Regression analysis Table 3: Regression analysis from both regression models: total asset growth has a strong and negative effect on subsequent stock returns for all sample economies or the developed economies No asset growth effect for the developing economies Share issuance also has a negative effect on stock returns for the whole sample and developed countries. But the inclusion of share issuance does not damper the effect of asset growth on stock returns: Rule out the explanation of the catering theory of investment 9/11/2014 26

  27. Preliminary Results: Regression analysis Implications from Tables 1 and 3: The results appear to be consistent with the overinvestment explanation suggested by TWX (2004) inconsistent with the prediction of the q-theory with investment frictions put forth by Li and Zhang (2010) 9/11/2014 27

  28. Preliminary Results: Regression analysis 9/11/2014 28

  29. Explanations for cross-country differences in the asset growth effect Table 4: Summary statistics The developed countries have a higher average access-to-market index than the developing countries with a value of 5.76 versus 4.78 a higher average market cap to GDP ratio with a value of 0.59 versus 0.30. a higher average individualism index with a value of 60 versus 35. a higher average BM and SZ adjusted TAG-hedge returns with a value of 0.27% versus 0.08% per month. 9/11/2014 29

  30. Explanations for cross-country differences in the asset growth effect Table 4: Summary statistics there are more significant correlations in the developed economies than in the developing economies. The correlations between the TAG-hedge returns and most other variables are significant in the developed economies, but not in the developing economies. 9/11/2014 30

  31. Explanations for cross-country differences in the asset growth effect 9/11/2014 31

  32. Explanations for cross-country differences in the asset growth effect: Regression analysis Table 5: Regression analysis (Access to equity markets) The asset growth effect is stronger in countries with easy access to capital markets than in countries with limited access to capital markets as measured by the access to equity market index (Panel A) or the market ca to GDP ratio (Panel B) Implications: consistent with the overinvestment explanation and inconsistent with the prediction of the q-theory with investment frictions There is no difference in the asset growth effect between the high and low individualism countries (Panel C) or between the strong and weak investor protection countries (Panel D) 9/11/2014 32

  33. Explanations for cross-country differences in the asset growth effect: Regression analysis 9/11/2014 33

  34. Explanations for cross-country differences in the asset growth effect: Regression analysis 9/11/2014 34

  35. Explanations for cross-country differences in the asset growth effect: Portfolio analysis Table 6: Portfolio analysis The asset growth effect is stronger in countries with easy access to capital markets than in countries with limited access to capital markets as measured by the access to equity market index (Panel A) or the market ca to GDP ratio (Panel B) in both developed and developing countries The asset growth effect is stronger in countries with higher individualism (Panel C) or in countries with stronger investor protection (Panel D) for both developed and developing countries but the difference is significant only for developed countries. 9/11/2014 35

  36. Access to markets and the TAG effect 9/11/2014 36

  37. Individualism, investor protection and the TAG effect 9/11/2014 37

  38. Explanations for cross-country differences in the asset growth effect: Regression analysis Table 7: Regression analysis (Univariate) The asset growth effect is stronger in developed countries with easy access to capital markets as measured by the access to equity market index (Model 1) or the market cap to GDP ratio (Model 2), but not in developing countries The asset growth effect is stronger in developed countries with high individualism (more overconfidence) (Model 3), but not in developing countries 9/11/2014 38

  39. Explanations for cross-country differences in the asset growth effect: Regression analysis Table 7: Regression analysis (Univariate) No influence of shareholder protection on the asset growth effect (Model 4) in both developed and developing countries TAG has a strong influence on the asset growth effect in both developed and developing countries 9/11/2014 39

  40. Explanations for cross-country differences in the asset growth effect: Regression analysis Table 7: Regression analysis (Multivariate) The inclusion of individualism, legal protection, country-level asset growth does not damper the influence of access to capital markets on the asset growth effect in developed markets TAG still has a strong influence on the asset growth effect in both developed and developing countries even including all variables of interest. Implications from Tables 6 and 7: confirm with previous results. Consistent with the overinvestment explanation and inconsistent with the prediction of the q-theory with investment frictions 9/11/2014 40

  41. The TAG effect: Univariate regression 9/11/2014 41

  42. The TAG effect: Multivariate regression 9/11/2014 42

  43. Conclusion There is the asset growth effect outside the United States. We find a strong asset growth effect among developed economies but not among developing economies. Developed countries with easy access to equity markets and more overconfidence cultures show a stronger asset growth effect, possibly through a propensity-to-overinvest channel. A country’s asset growth level is also found to be a strong indicator of the asset growth effect. But the inclusion of these country characteristics does not damper the effect of the ease of access to equity markets. 9/11/2014 43

  44. Conclusion Our results appear to be generally consistent with an overinvestment explanation by Titman, Wei, and Xie (2004) and to be inconsistent with the prediction by the q-theory with investment frictions suggested by Li and Zhang (2010). Our results complement the findings by McLean, Pontiff, and Watanabe (2009), who find that the share issuance effect is more profound in countries with higher share issuance activities, more developed stock markets, and stronger investor protection 9/11/2014 44

  45. Conclusion In sum, we provide evidence that cross-country differences in access to equity markets and cultures can affect cross-country differences in the asset growth effect. Our results provide a challenge to market efficient hypothesis and behavioral as well as the traditional risk-based theories. Risk-based: Why asset growth portfolios are risky in developed countries but not in developing markets? Behavior based: why managers have a tendency to overinvest and at the same time investors tend to underreact to the negative information contained in overinvestment in developed markets, but it is in developing markets? 9/11/2014 45

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