Introduction

This study examines how the variation in CEO managerial ability impacts firms’ investment efficiency. Specifically, I investigate whether higher managerial ability contributes to improved investment practices when firms operate in an environment where under-investment or over-investment is very likely. Existing literature (Jensen 1986; Shleifer and Vishny 1989; Morck et al. 1990; Bertrand and Schoar 2003) suggests that CEOs’ individual attributes influence corporate investment practices and outcomes. Bertrand and Schoar (2003), for instance, find that a significant part of the heterogeneity in firms’ investment practices can be explained by unobserved manager-fixed effects, supporting the upper echelons theory in Hambrick and Mason (1984).1 Managers with different abilities view future prospects differently (Trueman 1986), and their differing views affect their judgments, confidence, and risk preferences. Moreover, managers with different levels of ability possess various skill sets, which in turn affect their perceptions and evaluations of potential investment opportunities. Therefore, I first predict that more able and less able CEOs behave differently in their investment practices. Further, I examine whether more able CEOs make more efficient investment decisions. Higher ability CEOs are perceived to have better knowledge and judgment than their peers, which enables them to better anticipate future changes (Trueman 1986). As a result, they are more likely to identify favorable investment opportunities. Consistent with this argument, Jian and Lee (2011) provide empirical evidence that investment decisions made by more reputable CEOs lead to better post-investment performance. This study takes another angle by examining how more able CEOs respond to an operating environment with a preexisting high likelihood of over-investment or under-investment. Holding other things constant, if CEO managerial ability contributes to improved investment efficiency, more able CEOs are expected to be associated with a decreased propensity for under-investment and/or over-investment. Prior studies (e.g., Scharfstein and Stein 1990) suggest that less able CEOs may ignore their own private information about payoffs and copy the decisions of previous managers, because they are afraid that they may be punished for their investment decisions by shareholders and markets. Such ignorance and herd behavior can lead to firms’ underinvestment or over-investment. In addition, without sufficient knowledge and capability, less able CEOs may fail to accurately anticipate future changes and employ inappropriate strategic views and poor evaluation techniques that lead to inefficient investment decisions. In contrast, more able CEOs pinpoint potential investment opportunities and make investment decisions that best fit their firms’ operating characteristics and strategic plans (Copeland et al. 1994). Further, with their private information, superior knowledge about business operations (i.e., firms’ cost structures and revenue drivers), and other skill sets, high ability CEOs are likely to arrive at more accurate estimates and evaluations of investments. This discussion suggests that, ceteris paribus, more able CEOs are likely to make more efficient investment decisions, which leads to less over- and/or underinvestment. In this study, I utilize the CEO managerial ability measure developed by Demerjian et al. (2012) to examine the above predictions. A CEO’s ability can be indicated by the efficiency with which he or she operates a firm, i.e., the degree to which a CEO generates more outputs by consuming fewer resources (Demerjian et al. 2012).