Recent empirical research suggests that growth in the size of firms’ balance sheets, or in the size of various balance sheet components, predicts the cross-section of average returns. In particular, firms that experience high growth in total assets earn abnormal returns of -5.88 percent in the following year, and -4.85 percent in the second year. However the economic rationale for the subsequent drift in returns remains unresolved. We explore several hypotheses about the sources of the predictability: the long-run underperformance of acquirers after mergers; investors’ extrapolation of past growth; over-expansion by managers due to agency costs; and underperformance following equity market timing by managers. In line with the agency cost hypothesis, the adverse consequences of asset expansion are aggravated in cases where past profitability is low, or corporate governance is weak. Conversely when asset growth is primarily in the form of cash accumulation, the negative returns are mitigated.
|Original language||English (US)|
|State||Published - May 2008|