Volatility, Investment Efficiency and Firm Performance

• In Event: Earnings Management and Market Reaction

Abstract

This study seeks to explain the relationship between cash volatility, investment efficiency and market returns. A number of studies in the Accounting literature, starting with the seminal work of Sloan (1996), describe the negative relationship between accounting accruals (the non-cash component of earnings) and subsequent stock returns, otherwise known as the accruals anomaly. In explaining the root cause of this anomaly, some researchers including Fairfield et al. (2003) and Zhang (2007) highlight the investment information role of accruals, as captured by growth in assets. A recent study by Li (2012), however, shows that this long-assumed negative relation between growth in assets and firm performance reverses in the mid-1990s. My work attempts to further understand this reversal. I hypothesize that the increase in cash volatility observed during this period serves as a mitigating mechanism for overinvestment among firms with high cash holdings. I study whether firms with high cash holding and high volatility invest more efficiently than firms with high cash holding and low volatility. I predict and find that (1) these firms tend to invest less on average, and (2) the investments made are more efficient on average. Since the investments that are made are more efficient, this would explain the positive market reaction to an increase in investments. This study may be relevant for academic researchers, practitioners and policy makers. While an extensive academic body of literature exists on the accrual anomaly, this study is one of the first to document the reversal in the anomaly and to my knowledge the first to provide an explanation for the reversal in the anomaly. Practitioners in the financial sector may find trading on these strategies profitable. And policy makers may find the implication from the study useful, particularly when deciding whether to provide firms with additional line of credit to stimulate investment during financial economic downturns.

Author

• Shira Cohen, Columbia University