Investment Decisions in Anticipation of Recessions and Outperformance of Pre-Acting Firms

ABSTRACT

We empirically examine whether firms make investment decisions in anticipation of recessions and subsequently perform better. Using a large quarterly dataset of fixed asset investments for U.S. firms during 1984–2012, we show that not all firms efficiently adjust their investment decisions in anticipation of a recession. However, we find that pre-acting firms that properly adjust their investment decisions (i.e., underinvest) before a recession outperform re-acting firms that fail to make proper investment decisions (i.e., overinvest) before a recession in subsequent returns on assets, returns on investments, and market-adjusted return measures.

KEY WORDS:

• Expansion
• investment decisions
• overinvestment
• recession
• underinvestment

Acknowledgments

We are grateful for insightful comments from three anonymous referees, seminar participants at Korea University and Research Forum of Korean Accounting Association. All remaining errors are our own.

Funding

This study is partially supported by Korea University Business School Research Grant.

Notes

1. The business cycle has two phases: recession and expansion. A recession (contraction) begins when the economy reaches a peak of activity and ends when the economy hits its trough. Between troughs and peaks, the economy is in an expansionary or contractionary period.

2. Certainly, two types of risks―an individual firm’s idiosyncratic and macroeconomic risks―have exerted confounding influence on its investment decision. However, our main focus in this study is the relationship between firm performance and a firm’s ex-post investment decision before the recession, rather than an attribute that drives firmsʼ investment decisions as such. Thus, we identify two types of firms that show different investment behaviors immediately before the recession and investigate whether they make investment decisions in anticipation of the recession and their relationship to firm performance.

3. If the under/overinvestment in the pre-recession period is related to the firms’ ability to predict the business cycle, it is natural to suppose that the pre-acting firms would overinvest before a boom initiates because they expect to secure much more market demand within a short period. However, owing to the nature of our dataset on the NBER recession date, the remaining periods except the recession are coded as expansion (boom) periods, which are not well identified in the dataset compared to recession periods. Thus, our analysis focuses on the recession periods to investigate a firm’s ability to predict the business cycle.

4. For further discussion on the definition and modeling of recessions, see Diebold and Rudebusch (1999).

5. This rule is consistent with the dispersion and duration requirements for a recession and with the average recessionary path of real GDP. However, two very small quarterly declines might not produce the depth required for a recession.

6. Given that adjustment costs are not linear, and thus, the relationship between investments and Tobin’s Q is a function of Tobin’s Q (Abel and Eberly 2002), Mcnichols and Stubben (2008) also include quartile information on Tobin’s Q in the investment model.

7. The sample contains observations from years 1984–2012 with accounting data from the Compustat Fundamental quarterly database and the stock return data from CRSP. Our original US firm data is available from the year 1981. However, our sample excludes the first three years of 1981–1983, which are identified as the recession period in the NBER recession date because we did not collect information on firm’s investment in pre-recession for that recession period.

8. One may argue that the book value of assets needs to be adjusted to reflect replacement costs for constructing a more precise Tobin’s Q. However, Perfect and Wiles (1994) suggest that this adjustment is not critical.

9. The reason why we consider cumulative returns is to document the differences in long-term performance between pre-acting and re-acting firms after the recession. We also observe non-cumulative performance measures and significant differences in accounting and market measures.

Additional information

Funding

This study is partially supported by Korea University Business School Research Grant.