External Financing, Access to Debt Markets, and Stock Returns

This paper offers a novel understanding of the cause of the external financing anomaly, a well established observation that net overall external financing activities and future stock returns are negatively related. Recent studies argue that the external financing anomaly is driven by earnings management and/or investment growth. However, we find that about half of the anomaly remains unexplained by these interpretations. The remaining predictability is not due to exposures to conventional risks and firm characteristics, the accrual factor, the asset growth factor, the wealth transfer hypothesis, or the issuer risk hypothesis, and is not driven by performance delistings or delistings associated with negative returns or unknown risks. Instead, it is attributed to the overvalued young and small unprofitable firms that lack internal funds and have limited access to public debt markets rely heavily on equity and modestly on private debt external financing to pursue their ambitious growth strategies through heavily investing in research and development.