Corporate Investment and Equity Market Anomalies through the Lens of Stock Liquidity: Evidence from Pakistan

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Abstract

Using a sample of 100 non-financial firms listed in Pakistan Stock Exchange from 2004 until 2017, this study established a connection among corporate investment and capital market anomalies (momentum effect & short term reversal effect) by emphasizing its role in modeling liquidity of a stock. Panel data regression results indicate that investment significantly positively adds to stock liquidity. Moreover, contrary to the traditional finance perspective, evidence regarding the impact of corporate investment on anomalies is consistent with the behavioral explanation of limit to arbitrage theory, which indicates that corporate investment exhibits significant pricing anomalies. It argues that these findings are attributable to the idea when corporate investment ameliorates stock liquidity through the channel of noise traders (a significant limit to arbitrage) then instead of attenuation it significantly enhances the profitability of contrarian and momentum strategies. Overall, the evidence presented in this study does not validate the existence of market efficiency, which actually describes the different characteristics of emerging markets (like Pakistan). Taking behavioral finance into account this study complements the corporate finance, corporate investment, and market efficiency literature and also provides useful insights to investors seeking optimal portfolio allocation. Additionally, this study guides policy makers that by carefully devising corporate and investment policies they can enhance the stability of equity markets.