This study examines the market’s reaction to firms’ investment choices considering their opportunities, focusing on share price variations when firms overinvest without incentives or underinvest despite compelling reasons.
Using 1998–2023 data from 14 economies, we applied multiple linear regression with fixed effects. Robustness was ensured through sensitivity analyses, variable tests and alternative regressions, including Fama–MacBeth for serial autocorrelation.
Our research indicates that the market devalues firms that underinvest. Interestingly, companies that overinvest tend to receive higher market valuations. This consistency holds across the full dataset and when analyzing regions separately. These findings align with the adaptive markets hypothesis (AMH), suggesting that markets evolve and adapt based on firm behaviors and investment decisions.
While we discussed the reasons for the unexpectedly higher abnormal returns for firms that overinvest, we did not delve deeply into the underlying mechanisms. Future research could explore this area further, introducing new variables to the discourse. Another limitation is the inherent challenge of accurately measuring investment opportunities. We used Tobin’s Q as a proxy, but as Erickson and Whited (2002) highlighted, this is not without its imperfections. Additionally, our model might benefit from including variables representing corporate governance mechanisms. This could help mitigate hidden variable issues related to agency problems not captured by our underinvestment or overinvestment variables.
Our insights can guide managerial decisions, emphasizing factors influencing stock values. Boards can use our findings for informed resource allocation, weighing diverse investment opportunities. By understanding market reactions to underinvestment and overinvestment, corporate boards can develop more informed investment strategies that align with market expectations and enhance shareholder value.
Current literature on agency problems and investment opportunities offers limited insights into how the market reacts to firms’ investment behavior. Our research contributes three main advances. First, we introduce a unique model with two binary variables linking Tobin’s Q and company investments, categorizing over/underinvestment at both firm and sector levels. Second, unlike prior studies focused on individual firms, we compare firms with their industry peers. Third, our extensive timeframe and dataset spanning two decades provide a renewed global perspective. We also integrate the AMH to offer a dynamic perspective on market reactions, enhancing theoretical and practical implications.
