We propose that stock market liquidity affects corporate investment and production. Illiquidity, which raises firms’ cost of capital, lowers investment in capital assets, R&D, and inventory. This effect holds after we control for endogeneity using exogenous liquidity events, the 2001 decimalization, and the 1997 Nasdaq reform and after employing instrumental variable estimation. Illiquidity affects investment regardless of firms’ financial constraints. Consequently, illiquidity induces firms to adopt less capital-intensive production processes. Illiquid firms have higher marginal productivity of capital, greater labor input increases for given increases in assets, and lower operating leverage, which means lower reliance on fixed costs.

Investors are reluctant to trade in the high-information-asymmetry days before earnings announcements. We show that the decrease in liquidity trading before announcements is asymmetric. We analyze buy and sell orders of investors with passive investment strategies, and find they do not reduce their sales as much as their purchases in the days before announcements. Investors needing liquidity sell stocks at a discount relative to the post-announcement price, and these preannouncement liquidity sales are a significant driver of the average positive returns, or return premium, known to characterize announcement days.