The Nonlinearity of Working Capital and Cross-Sectional Stock Returns: Does Financial Constraints Matter?

Abstract

This study is the first to examine the impacts of working capital (WC) and financial constraints on cross-sectional stock returns in Taiwan. The findings indicate a non-linear relationship between WC and stock returns. Moreover, the nonlinearity between WC and cross-sectional stock returns is robust after controlling for financial constraints, risk, and growth factors, before the Covid-19 pandemic. In contrast, there is no evidence of nonlinearity between WC and stock returns throughout the Covid-19 outbreak. In addition, the study shows that any deviations from the minimum WC level enhance the stock returns cross-sectionally. It is found that a positive Deviation effect exists in the Taiwan stock exchange before the Covid-19 pandemic by employing portfolio sorting methodologies. The return difference of the long buying highest Deviation and short selling lowest Deviation portfolios earn from 0.6% to 0.9% per month after controlling for financial constraints, risks, and growth factors. Interestingly, it is determined that the deviation effect becomes negative for small stocks during the Covid-19 pandemic, implying that investors prefer small stocks to maintain minimum working capital. The results support the trade-off theory and liquidity preference theory. Finally, the study provides insights into working capital management for managers, and investment strategies for investors during the pandemic.