The implications of capital investment for future profitability and stock returns: An over-investment perspective

In this dissertation, I investigate whether over-investment can partially explain the negative association between capital investments (change in long-term asset accruals), future profitability, and stock returns. Capital investments have a robust negative association with future profitability ratios. Consistent with Jensen (1986), the negative association is stronger when firms have greater investment discretion, i.e., for those firms with higher free cash flow and lower leverage. More importantly, the negative association between investment, future profitability and stock returns is almost exclusively driven by the sample of positive-discretionary-investment stocks, where over-investment is more likely to occur, rather than by the sample of negative-discretionary-investment stocks, where over-investment is much less likely. Financial markets do not seem to fully understand the implications of capital investment for future profitability. A hedge strategy based on firms' investment levels can generate persistent abnormal one-year-ahead stock returns even after controlling for firm risks and other potentially confounding variables. Further tests show the hedge returns are more pronounced in stocks with higher arbitrage risk. Sell-side analysts seem to be more optimistic in forecasting future earnings for firms with high capital investments. Evidence in this study provides an underlying explanation for Titman, Wei and Me (2003)'s notion that managers' empire-building behavior is responsible for the negative association between capital investment and future stock returns. In addition, to the extent that change in long-term asset accruals captures investment intensity, the results here may also provide an alternative interpretation of the long-term asset accrual anomaly.