with abnormally high or low returns, and stocks with news announcements.
They find that the individual investors in their sample are more likely, on the
following day, to be purchasers of these high-attention stocks than sellers.
- Application: Corporate Finance
8.1. Security Issuance, Capital Structure and Investment
An important strand of research in behavioral finance asks whether irra-
tional investors such as those discussed in earlier sections affect the financ-
ing and investment decisions of firms.
We first address this question theoretically, and ask how a rational
manager interested in maximizing true firm value—in other words, the
stock price that will prevail once any mispricing has worked its way out
of valuations—should act in the face of irrational investors. Stein (1996)
provides a useful framework for thinking about this, as well as about other
issues that arise in this section. He shows that when a firm’s stock price is
too high, the rational manager should issue more shares so as to take advan-
tage of investor exuberance. Conversely, when the price is too low, the man-
ager should repurchase shares. We refer to this model of security issuance as
the “market timing” view.
What evidence there is to date on security issuance appears remarkably
consistent with this framework. First, at the aggregate level, the share of
new equity issues among total new issues—the “equity share”—is higher
when the overall stock market is more highly valued. In fact, Baker and
Wurgler (2000) show that the equity share is a reliable predictor of future
stock returns: a high share predicts low, and sometimes negative, stock re-
turns. This is consistent with managers timing the market, issuing more
equity at its peaks, just before it sinks back to more realistic valuation
levels.
At the individual firm level, a number of papers have shown that the B/M
ratio of a firm is a good cross-sectional predictor of new equity issuance
(see Korajczyk, Lucas, and McDonald 1991; Jung, Kim, and Stulz 1996;
Loughran, Ritter, and Rydqvist 1994; Pagano, Panetta, and Zingales 1998;
Baker and Wurgler 2002a). Firms with high valuations issue more equity
while those with low valuations repurchase their shares. Moreover long-
term stock returns after an IPO or SEO are low (Loughran and Ritter
1995), while long-term returns after the announcement of a repurchase are
high (Ikenberry, Lakonishok, and Vermaelen 1995). Once again, this evi-
dence is consistent with managers timing the market in their own securities.
More support for the market-timing view comes from survey evidence.
Graham and Harvey (2001) report that 67 percent of surveyed CFOs said
that “the amount by which our stock is undervalued or overvalued” was an
important consideration when issuing common stock.
56 BARBERIS AND THALER