The real impact of stock market mispricing — Evidence from Australia

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Abstract

Using a large panel of Australian firms, we investigate if mispricing in the stock market has an impact on firm-level investment. A significantly positive relation is documented between investment and the proxies for mispricing, suggesting that overpriced (underpriced) firms tend to overinvest (underinvest). Furthermore, we find that equity-dependent firms display a more pronounced sensitivity of investment to stock misvaluation than do nonequity-dependent firms. Taken together, our findings evidence that mispricing in Australian capital markets may have significant influence on the real economy, and the influence works though an equity-financing channel.

Introduction

It is a well-established finding that a firm's market valuation is positively related to its capital investment. A traditional description of this relationship is “Q” theory. Tobin (1969) proposes that a firm will invest until Q = 1, where Q is defined as the market value of assets divided by their replacement costs. In most of the subsequent studies, researchers explain investment with Tobin's Q under the assumption of efficient capital markets, where stock price fully reflects a firm's fundamentals.1

However, recent events and research findings increasingly suggest that actual practices of investors and managers may depart from the efficient market paradigm.2 In particular, the stock market is found to be not only driven by news about fundamentals but also by nonfundamental elements such as investor sentiment. The interaction between investor sentiment and managers in such a world may cause corporate investment to deviate from the optimal level as predicted by “Q” theory.3 This issue is important because previous studies on IPO waves and merger waves suggest that investor sentiment can be market-wide rather than firm-specific.

Stein (1996) proposes an equity-financing channel through which stock market mispricing affects investment decisions. In his model, a firm is said to be equity-dependent if it has low cash holdings and debt capacity and therefore has to rely on external equity financing for its capital investment. It is shown that an equity-dependent firm will issue equity and invest if its stock price is above its fundamental value but it will pass up the investment if the stock price is below its fundamental value. The resulting effect is a positive relation between nonfundamental component of its stock price and the level of new investment. On the other hand, less equity-dependent firms can insulate their investment decisions from irrational gyrations in their stock prices because by definition, they can rely on internal financing or tap the debt market relatively easily.

Two recent studies support the above equity-financing channel hypothesis by Stein (1996). Baker et al. (2003) conduct a cross-sectional test on the hypothesis and find that Q, defined as the market-to-book ratio of assets, does have a strong influence on the investment of equity-dependent firms.4 Shleifer and Vishny (2003) argue that stock price overvaluations lead to more investment in the form of mergers because an overvalued firm may wish to acquire another firm by offering stock.

The above studies on this equity-financing channel focus on the U.S. market. This paper seeks to detect the existence of the equity-financing channel in an Australian context. Australia is similar to the U.S. in many aspects, including language, legal system and other institutional settings. However, we notice that there are some fundamental differences between the Australian and the U.S. markets. Australia is one of the major exporters of raw materials while the U.S. is a major consumer of raw materials and natural resources. The difference is also reflected in the composition of listed firms in the two stock markets. As opposed to the U.S. stock market, our set of Australian firms consists of a larger proportion of firms in the energy and materials sectors and fewer firms in the information technology and telecommunications sectors. Presumably, firms in the energy and raw materials sectors have more tangible assets, thereby are relatively more transparent and less subject to mispricing. Therefore, if stock market mispricing only plays a marginal role in affecting firms' investment, one should not expect to observe a significant relationship between investment and mispricing in Australia.

To detect the equity-financing channel in Australia, we partition firms according to four different proxies for equity dependence. First, we employ an index based on the work of Kaplan and Zingales (1997) (KZ hereafter). This KZ index has become increasingly prevalent in the recent literature.5 To ensure our findings are robust to different sample partitioning criteria, we employ three alternative classification schemes to divide our sample: (1) the adjusted KZ index (AKZ), obtained by adjusting the original KZ index for the sample characteristics; (2) firm size; and (3) the beginning-of-period financial constraint score (ZFC) computed using multiple discriminant analysis. Using these criteria separately, we test if the capital investment of firms that are classified as being relatively more equity-dependent is relatively more sensitive to stock market mispricing.

The challenging part of our analysis is to find a good proxy for stock mispricing, or equivalently, the nonfundamental component of stock prices. Following Baker et al. (2003), we start by using Q to measure mispricing. The investment-Q sensitivity is found to be positive on average and increasing with equity dependence. While this suggests the presence of an equity-financing channel in Australia, it also admits other interpretations. As Q contains both fundamental and nonfundamental components, the positive investment-Q relation may simply suggest corporate managers response rationally to the change in investment opportunities (the fundamentals) by adjusting the investment level. Instead of extracting the nonfundamental component from Tobin's Q which is ideal but difficult, we introduce to our empirical analysis two direct proxies for stock mispricing — discretionary accruals (DACCR) and composite share issuance (CSI). These two variables are chosen because previous studies (e.g. Polk and Sapienza (2004)) suggest that they are good predictors of subsequent stock returns, and thus can be used as proxies for stock mispricing.6

Using various measures of equity dependence and different proxies for stock mispricing, we consistently document a significantly positive relationship between stock mispricing and subsequent investment. Furthermore, we find that this relationship is more pronounced for equity-dependent firms. Overall, our findings support the idea that mispricing in Australian capital markets has significant influence on the real economy, and that the influence works though an equity-financing channel.

Apart from documenting the presence of an equity-financing channel in Australia, our results contribute to the literature in two ways. First, prior studies on investment-mispricing sensitivities only control for cash flow in their empirical models. We augment the investment equation by including financial leverage, cash holdings and net sales that have been shown to influence firm-level investment decisions in the literature. Our consistent results across different empirical model specifications mitigate the concern that the evidence of equity-financing channel is merely a result of model misspecification or omitted variable problems. Second, Baker et al. (2003) show that the KZ index, which was originally developed from a small sample of American manufacturing firms, can be applied to a larger sample of firms as the index nominates several variables that are “indicative of equity dependence”. Our findings provide further support for the use of the KZ index as a proxy for equity dependence outside the U.S. The KZ indices, together with two other measures of equity dependence, provide investment-mispricing sensitivities of Australian firms consistent with those of Baker et al. (2003). In all, our results indicate that the KZ index is a rather appropriate, if not perfect, measure of equity dependence even for companies outside the U.S.

The remainder of the paper is organized as follows. Section 2 briefly reviews the previous literature and elaborates on our empirical methodology. Section 3 describes the data. Section 4 presents the empirical results and Section 5 concludes.

Section snippets

Empirical methodology

Motivated by prior literature, we hypothesize that the influence of market inefficiencies on real investment works through an equity-financing channel. We empirically test the cross-sectional implication of this hypothesis by comparing sensitivities of investment to stock mispricing across firms with different degrees of equity dependence.

This section presents our empirical methodology. We first discuss our empirical models of investment-Q sensitivity, followed by the definitions of two direct

Sample characteristics

We consider the universe of firms listed on the Australian Stock Exchange over the 1990–2003 period with financial data available from Aspect Fin Analysis on total assets, market capitalization, and capital expenditure, and plant, property and equipment (capital stock). Industry (GICS) codes and stock price data are obtained from IRESS.19

Investment-Q sensitivity

We begin with a simple test of the equity-financing channel. If stock market mispricing affects investment via an equity-financing channel and Q contains a component of mispricing, the investment of equity-dependent (ED) firms should be more sensitive to Q than that of nonequity-dependent (NED) firms. In other words, investment-Q sensitivity increases in equity dependence.

Table 3 presents the results obtained from the estimation of our baseline regression model (Eq. (1)) of investment-Q

Conclusion

The effect of investor sentiment on real economic activities is an important issue in corporate finance studies. It is particularly important when investor sentiment is market- or industry-wide rather than firm-specific, as documented in previous studies on IPO waves or merge waves. Stein (1996) predicts that more equity-dependent companies will have capital investment more sensitive to market prices of their stocks than nonequity-dependent firms. Heavy reliance on equity financing causes a

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    We thank an anonymous referee, Rob Brown, and Kalok Chan (the editor) for helpful suggestions. Xin Chang acknowledges funding provided under the Faculty Research Grant scheme of the Faculty of Economics and Commerce, The University of Melbourne. Tek Jun Tan acknowledges financial support of Kinsmen Award.

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