The Stock Market and Corporate Investment: a Test of Catering Theory

We test a catering theory describing how stock market mispricing might influence individual firms' investment decisions. We use discretionary accruals as our proxy for mispricing. We find a positive relation between abnormal investment and discretionary accruals; that abnormal investment is more sensitive to discretionary accruals for firms with higher R&D intensity (opaque firms) or share turnover (firms with shorter shareholder horizons); that firms with relatively high abnormal investment subsequently have relatively low (high) stock returns; and that the larger the relative price premium, the stronger the abnormal return predictability. We show that patterns in abnormal returns are stronger for firms with higher R&D intensity or higher share turnover.