Short-Termism – Corporate Investment and Stock Market Listing: A Puzzle?
New York University – Leonard N. School of Business – Department of Economics
Harvard Business School
Alexander Ljungqvist
New York University (NYU) – Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Research Institute of Industrial Economics (IFN)
Abstract:
We investigate whether short-termism distorts the investment decisions of stock market listed firms. To do so, we compare the investment behavior of observably similar public and private firms using a new data source on private U.S. firms, assuming for identification that closely held private firms are subject to fewer short-termist pressures. Our results show that compared to private firms, public firms invest substantially less and are less responsive to changes in investment opportunities, especially in industries in which stock prices are most sensitive to earnings news. These findings are consistent with the notion that short-termist pressures distort their investment decisions.
Corporate Investment and Stock Market Listing – Introduction
Economists have long worried that a stock market listing can induce short-termist pressures that distort the investment decisions of public firms. Narayanan (1985), for example, expresses the concern that “American managers tend to make decisions that yield short-term gains at the expense of the long-term interests of the shareholders.” More recently, a growing number of commentators blame the sluggish performance of the U.S. economy since the 2008-2009 financial crisis on short-termism.
Yet systematic empirical evidence of widespread short-termism has proved elusive, largely because identifying its effects is challenging. A chief challenge is the difficulty of finding a plausible counterfactual for how firms would invest absent short-termist pressures. We address this difficulty by comparing the investment behavior of stock market listed firms to that of comparable privately held firms, using a novel panel dataset of private U.S. firms covering more than 400,000 firm-years over the period 2001-2011. Building on prior work such as Jensen and Meckling (1976) and Jensen (1989), our key identification assumption is that, on average, private firms suffer from fewer agency problems and, in particular, are subject to fewer short-termist pressures than their listed counterparts. This assumption is motivated by the fact that private firms are often owner-managed and even when not, are both illiquid and typically have highly concentrated ownership. These features encourage their owners to monitor management more closely to ensure long-term value is maximized (Bhide (1993)).
As Holmström (1982), Narayanan (1985), Miller and Rock (1985), Stein (1989), Shleifer and Vishny (1990), and von Thadden (1995) have argued, a focus on a firm’s short-term profits or its current share price will distort investment decisions from the first-best if investors have incomplete information about how much the firm should invest to maximize its long-term value. Foregoing positive NPV projects boosts current earnings, and thereby today’s share price, by reducing “depreciation charges to earnings or other start-up charges” (Graham, Harvey, and Rajgopal (2005)). We extend Holmström’s (1982) model to show that short-termism induces public-firm managers not only to choose inefficiently low investment levels but also to be less sensitive to changes in investment opportunities than their private counterparts. As in Grenadier and Wang (2005), this occurs even though investors can perfectly observe a firm’s actual investment.
Our empirical results are consistent with these two predictions. We first show that private firms invest substantially more than public ones on average, holding firm size, industry, and investment opportunities constant. This pattern is surprising in light of the fact that a stock market listing gives firms access to cheaper investment capital. Second, we show that private firms’ investment decisions are around four times more responsive to changes in investment opportunities than are those of public firms, based on standard investment regressions in the tradition of tests of the Q theory of investment (see Hayashi (1982) or, more recently, Cummins, Hassett, and Oliner (2006) and Bloom, Bond, and van Reenen (2007)). This is true even during the recent financial crisis.
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