Firm-Level Investor Favoritism and the External Financing and Capital Expenditure Anomalies

Abstract

Prior literature documents a positive (negative) relation between past (future) stock returns and both external financing and capital expenditures. In this study, we examine whether managers’ financing and capital expenditure decisions are associated with firm-level investor favoritism (neglect) and, therefore, whether managers exploit investor mispricing by issuing more (less) capital and investing more (less) in capital expenditures when firm-level investor sentiment is high (low), which leads to more negative future stock returns. We employ both a stock’s extreme return momentum and extreme trading volume to capture firm-level investor favoritism (neglect), which reflects firm-level investor overpricing (underpricing) due to investor sentiment. We find that both external financing and capital expenditure decisions are positively (negatively) associated with favoritism (neglect) and that the previously documented negative association between future stock returns and external financing is more pronounced in periods of favoritism. However, we find no association between future stock returns and capital expenditures after controlling for external financing. These findings suggest that managers’ financing and capital expenditure decisions are associated with firm-level investor favoritism/neglect, and that managers exploit investor mispricing in making financing decisions, resulting in lower future stock returns.

Keywords: External financing, capital expenditures, mispricing, favoritism, optimism, sentiment

JEL Classification: D24, G31, M41