Does the Stock Market Harm Investment Incentives?

In the paper, Does the Stock Market Harm Investment Incentives? which was recently made publicly available on SSRN, my co-authors, John Asker and Joan Farre-Mensa, and I examine whether the stock market harms investment incentives. The theory literature in economics and finance has long argued that the separation of ownership and control following a stock market listing can lead to agency problems between managers and dispersed stock market investors and hence to suboptimal investment decisions. The literature is divided on whether overinvestment (i.e., empire building) or underinvestment (due to rational short-termism) will result, or indeed whether effective corporate governance mechanisms can be devised to ensure investment does not suffer (Tirole (2001), Shleifer and Vishny (1997)).

We embed Stein’s (1989) short-termism problem and the empire-building problem of Baumol (1959), Stulz (1990), and Stein (2003) in a nested model to derive testable predictions that allow us to empirically distinguish between the two. In order to test the model, we need a proxy for “optimal” investment decisions, that is, for the investment decisions managers would have made absent agency problems. We obtain such a proxy from a rich new data source on private (i.e., unlisted) U.S. firms provided by Sageworks Inc. Our maintained hypothesis is that the agency problems that public firms are subject to are less prevalent, or even absent, among private ones, which, however, face a higher cost of capital.

Matching Sageworks to standard Compustat data on stock-market listed companies by size and industry, we identify matched panels of (small) public and (large) private firms and then estimate standard investment equations. Using several distinct sources of identification, our results show that compared to private firms, public companies invest both less and in a manner that is significantly less responsive to changes in investment opportunities, especially in industries in which stock prices are particularly sensitive to current profits. These findings are consistent with short-termism and contrary to what one would expect if empire-building were the dominant agency problem in the stock market.

We also show that public companies tend to smooth their earnings growth and dividends and are reluctant to report negative earnings. One interpretation for these patterns is that public firms treat investment spending as the residual after having paid dividends out of their cash flows, whereas private firms treat dividends as the residual after paying for their investment out of cash flows.

Overall, at least for our fast-growing sample firms, the benefit of cheaper funding via the stock market appears to be somewhat diminished by distortions in investment behavior, which are consistent with short-termism on the part of managers driven by the agency costs associated with the separation of ownership and control.

The full paper is available for download here.