The Puzzle of Frequent and Large Issues of Debt and Equity
Rongbing Huang and Jay R. Ritter
Coles Working Paper Series, SPRING18-05, March 2018
Overview Nobel laureate in Economics Eugene Fama and his frequent co-author Kenneth French identify five important factors that describe stock return variations: the market factor and return spreads based on the firm’s size, growth status, profitability, and investment spending. We found that more frequent and larger external debt or equity financings in the prior three years were followed by lower stock returns in the subsequent year. Specifically, after controlling for the five factors, a value-weighted portfolio of firms with at least three large external financings underperformed other firms by 0.64% per month. To understand the magnitude of the underperformance, assume $1,000 invested in the market portfolio yields 1% per month, returns over the subsequent year and the next ten years would be $127 and $2,300, respectively. If $1,000 is invested in a portfolio of firms with at least three large external financings that yields 0.36% per month, returns would be only $44 and $539, respectively. A Fama-MacBeth regression that controls for several firm characteristics shows that firms with three external debt financings underperformed firms with no external financing by 0.62% per month, and firms with three external equity financings underperformed by 1.25%. Investors were disappointed at the earnings announcements following frequent external financings, especially equity financings. These patterns indicate that firms successfully raised external capital when their stocks were overvalued.
26 | Working Papers
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