There’s an ongoing academic debate on the impact that institutional investors have on listed companies. On one hand, the indirect pressure of having lots of large investors scouring earnings reports could drive earnings management; on the other hand, institutions tend to be better informed than individuals (having better resources and access to more sophisticated financial data) and their judgment should be less susceptible to earnings management.
There’s nothing inherently underhanded in all this. “Within certain restrictions, company management has the flexibility to manage accruals through account receivables and payables, inventory, deferred revenue, and prepaid expenses etc. Managing accruals can shift the nature of current and future earnings performance,” explains a February 14 Deutsche Bank report on institutional investors.
As a way of taking the Thomson Reuters Share Ownership dataset out for a test run, the Deutsche Bank report tries to determine whether the concentration of institutional ownership of a given stock, what they call intensity, makes it more or less likely for a company to make use of earnings management. Since no company is going to admit to fiddling with the numbers a bit to keep investors happy, a number of likely proxies are tested instead.
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Accruals as a proxy for earnings management
The first proxy is the absolute level of accruals per share. Since accruals are one of the easier numbers to fudge without actually violating accounting standards, it’s often assumed that a high level of accruals means there is a greater likelihood of earnings management. Some analysts prefer to look at net accruals (accruals less cash flow) instead of absolute accruals, arguing that for two companies with equally high accruals during a quarter the one with weaker cash flow has a greater incentive to manage earnings. Nonetheless, there is a clear, if weak, correlation between accruals and institutional ownership.
“The difference between the absolute accruals within the top and bottom levels of institution ownership concentration is fairly small at 0.05,” says the report. “Nevertheless, this rudimentary analysis shows some relationship between earnings management and the level on institutional share ownership concentration.”
Institutional ownership and price transparency
Next the report attempts to check whether institutional ownership increases or decreases the amount of transparency in a company’s stock price using the performance of momentum portfolios and the average amount of coverage. As proxies, analyst coverage is intuitive (if more people are researching and reporting on a company, then new information should be priced in more quickly), but momentum performance is less obvious.
“The time duration it takes investors to ingest and understand news flow can potentially lead to trending in stocks prices,” explains the Deutsche Bank report. “We would expect that momentum anomaly would perform well in stocks with poor information diffusion.”
In other words, momentum strategies should underperform when there is greater transparency because there is less of a time lag between news being made public and the market’s reaction. In both instances, there is a clear (if noisy) correlation showing that increased institutional ownership promotes price transparency.