Abstract
An investment factor, long in low-investment stocks and short in high-investment stocks, helps explain the new issues puzzle. Adding the investment factor into standard factor regressions reduces the SEO underperformance by about 75%, the IPO underperformance by 80%, the underperformance following convertible debt offerings by 50%, and Daniel and Titman’s (2006) composite issuance effect by 40%. The reason is that issuers invest more than nonissuers, and the investment factor earns a significantly positive average return of 0.57% per month. Equity and debt issuers underperform matching nonissuers with similar characteristics in the post-issue years (e.g., Ritter, 1991; Loughran and Ritter, 1995; and Spiess and Affleck-Graves, 1995, 1999). We explore empirically the investment-based hypothesis of this underperformance. The q-theory of investment and the real options theory imply a negative relation between real investment and expected returns. If the proceeds from equity and debt issues are used to finance investment, then issuers should invest more and earn lower average returns than matching nonissuers.
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