The Signaling Role of Seemingly Myopic Investment Behavior

This paper analytically and empirically investigates managerial investment responses to negative shocks in firm value. In the model, managers are privately informed about the shocks' persistence, and those facing transitory shocks strategically underinvest to boost earnings and signal financial strength to investors. The model also predicts counter-signaling: firms with strong fundamentals do not need to cut investment to convey strength. We exploit the 2003 mutual fund trading scandal as a plausibly exogenous source of price pressure. Consistent with signaling, we find that firms with greater tainted-fund ownership are more likely to meet or narrowly beat analyst forecasts by cutting R&D, and that this behavior is associated with more favorable earnings announcement returns and better long-run performance. Consistent with counter-signaling, these firms are less likely to cut R&D when they beat analyst forecasts by a wide margin. Cross-sectional tests also support the model's comparative statics.