Overinvestment Versus Underinvestment

There are two basic forms of inefficient investment:underinvestment and overinvestment.Researchers endeavor to set up a general framework which takes both underinvestment and overinvestment into consideration.However,their empirical results are usually driven by the net effects of under-and overinvestment.Using a two-tier stochastic frontier model,this paper proposes direct measures of under-and overinvestment for each firm-year observation based on the data of U.S.Listed firms from 1975 to 2014.This paper examines the relation between investment efficiency and stock returns.Our empirical applications consist three parts.First,we validate the index we propose and evaluate various financial constraint sorting criteria with our underinvestment index.We find that firm size and WW index outperform KZ index,Cleary index and dividend payout dummy in measuring the degree of financial constraints.Then we explore different channels that affect the magnitude of inefficient investment.We find firms with higher accounting quality and better corporate governance tend to invest more efficiently.Firms are more likely to overinvest(underinvest)when their stock price is overpriced(underpriced)or when investor sentiment is high(low).Finally,the paper investigates the relation between investment inefficiency and stock returns both intertemporally and cross-sectionally.We find common variations in the stock returns of firms with under-or overinvestment.This result cannot be fully explained by Fama-French three factors and momentum factor.We find lower investment efficiency leads to lower excess returns.This paper contributes to the literature by proposing direct measures of under-as well as over-investment and providing empirical evidence on the variance of stock returns.