The Signaling Role of Seemingly Myopic Investment Behavior

We examine investment distortion as a signaling device under transitory price shocks. We first analyze a model where the market is uncertain about a negative shock’s effects on firms’ pre-investment earnings and investment productivity. Managers can influence market beliefs about firms' financial health through reported earnings. The model predicts that less impacted firms have greater incentives to underinvest relative to their no-signaling optimum, investment cuts convey information despite the market's imperfect inference, and signaling is stronger when managers face greater short-term price concerns and investment productivity is more uncertain, but weaker when earnings are more uncertain. Using the 2003 mutual fund trading scandal to capture plausibly exogenous price pressure, we find that firms with greater tainted-fund ownership are more likely to meet or narrowly beat analyst forecasts by cutting R&D. This signaling behavior is associated with more favorable announcement returns and higher long-term returns. Cross-sectional tests support the comparative statics.