Do Long-Term Investors Improve Corporate Decision Making?

The following post comes to us from Jarrad Harford, Professor of Finance at the University of Washington; Ambrus Kecskés of the Schulich School of Business at York University; and Sattar Mansi, Professor of Finance at Virginia Polytechnic Institute & State University.

It is well established that managers of publicly traded firms, left to their own devices, tend to maximize their private benefits of control rather than the value of their shareholders’ stake in the firm. At the same time, imperfectly informed market participants can lead managers to make myopic investment decisions. One of the most important mechanisms that have been proposed to counter this mismanagement problem is longer investor horizons. By spreading both the costs and benefits of ownership over a long period of time, long-term investors can be very effective at monitoring corporate managers.

We explore this subject in our paper entitled Do Long-Term Investors Improve Corporate Decision Making? which was recently made publicly available on SSRN. We ask two questions. First, do long-term investors in publicly traded firms improve corporate behavior? Second, does their influence on managerial decision making improve returns to shareholders of the firm? To answer these questions, we study a wide swath of corporate behaviors.

According to theory, if long-term investors exert a positive influence on managers, we should observe a decline in corporate misbehavior and a rise in shareholder democracy. The predictions of theory are somewhat ambiguous about investment, financing, and payout decisions. Overinvestment, or “empire building”, is one possibility, but managers may instead underinvest, or “enjoy the quiet life”; in either case, shareholders lose. We view financing as being determined jointly with investment decisions. Payouts should follow the opposite pattern to financing if managers treat payouts as a residual. If instead they relentlessly accumulate corporate resources, then payouts should be higher given sufficient monitoring by investors. Finally, theory clearly predicts that greater monitoring should increase shareholder value.

We test these predictions using a large sample of publicly traded firms over nearly three decades. We measure investor horizons as the ownership in firms of those investors that trade very little, i.e., long-term investors. Additionally, we design our empirical analysis from the start to demonstrate causality. To this end, we exploit the fact that numerous investors index their portfolios. Long-term indexers have no control over the composition of their portfolio, but they are able to influence corporate managers, as the empirical evidence shows. We perform all of our tests not just with long-term investors as a whole but also with a plausibly quasi-random subset of them.

In our empirical analysis, we find that long-term investors reduce not only earnings management but also accounting misconduct, financial fraud, and option backdating. Underscoring the monitoring role of long-term investors, we find that they promote shareholder proposals and increase executive turnover. Next, we find that long-term investors reduce investment, both in tangible and intangible assets as well as through both organic and inorganic growth. Altogether, firms invest less, by about 2.0 percentage points of total assets. Long-term investors also reduce financing, by roughly 1.4 percentage points. Balance sheet and off balance sheet debt financing decrease, as does equity financing, which leaves firms more dependent on external financing and thus better disciplined. At the same time, long-term investors increase both dividends and share repurchases, by a total of approximately 0.6 percentage points.

We then examine the value implications of investor horizons on corporate behavior. In time-series regressions, a long-short portfolio formed based on longer-minus-shorter investor horizons earns positive abnormal returns of roughly 30 basis points per month. Excess returns from cross-sectional regressions are also higher, by approximately 100 basis points per year. Do these higher returns arise from greater profitability or lower risk? Our results indicate that realized earnings are significantly higher. Moreover, earnings volatility and stock return volatility are lower as are the rates of defaults and bankruptcies. Finally, we find that long-term investors lead to greater real diversification, along business, industry, and geographic lines as well as across customers and products.

In summary, our results indicate that long-term investors generate greater shareholder value by raising profitability and lowering risk. This is the case even for the plausibly exogenous component of investor horizons, which supports our causal interpretation. Our paper shows that long-term investors play an effective external governance role in firms. They affect corporate behavior by occupying the middle ground between voting with their feet and voicing their dissatisfaction with corporate management. Finally, they restrain a wide range of corporate behaviors in publicly traded firms, which ultimately benefits shareholders.

The full paper is available for download here.

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