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E-MailMartijn Cremers is Bernard J. Hank Professor of Finance at University of Notre Dame Mendoza College of Business; Ankur Pareek is Assistant Professor of Finance at University of Nevada, Las Vegas; and Zacharias Sautner is Professor of Finance at Frankfurt School of Finance & Management. This post is based on their recent article, forthcoming in Management Science.
Related research from the Program on Corporate Governance includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); The Uneasy Case for Favoring Long-Term Shareholders by Jesse Fried (discussed on the Forum here); and Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law by Leo E. Strine (discussed on the Forum here).
Survey evidence documents that many executives are willing to take short-term actions that are detrimental to long-term firm value, such as cutting long-term investment, in response to short-term pressures by investors. (See Graham, John R., Campbell R. Harvey, and Shiva Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40, 3-73.) In our article Short-Term Investors, Long-Term Investments, and Firm Value: Evidence from Russell 2000 Index Inclusions, forthcoming in Management Science, we empirically show that an increase in equity ownership by short-horizon investors is associated with cuts to the corporation’s long-term investments and increased short-term earnings. These higher earnings lead to temporary boosts in equity valuations, but we find that these reverse over time.
Our tests are motivated by the theory in Bolton, Scheinkman, and Xiong (2006), which predicts that short-horizon investors pressure CEOs to cut investment to increase earnings, which subsequently leads to temporary boosts in stock prices. (Bolton, Patrick, José Scheinkman, and Wei Xiong, 2006, Executive compensation and short-term behavior in speculative markets, Review of Economic Studies 73, 557-610.) The model argues that CEOs, incentivized by short-horizon investors through short-term pay, take actions that increase the short-term speculative component in stock prices, at the expense of long-term firm value. Bolton, Scheinkman, and Xiong (2006) use the case of R&D cuts that boost short-term earnings as a specific example of actions that temporarily inflate stock prices. Short-term investors benefit from this by selling stocks to other investors with more optimistic beliefs. Stock prices are then driven up to the valuations of the most optimistic investors, as short-sale constraints limit rational investors from eliminating any overvaluations. CEOs also benefits from temporary overvaluations as their short-term compensation is tied to short-term stock prices. Equity overvaluations reverse only gradually as it takes time for investors to understand that the higher earnings were due to R&D cuts that are detrimental to long-term firm value.
Our proxy for the presence of short-horizon investors is ownership by transient institutions. (Bushee, Brian, J., 1998, The influence of institutional investors on myopic R&D investment behavior, The Accounting Review 73, 305,333.) Transient institutions are characterized by having high portfolio turnover and diversified portfolios. We document a large and persistent increase in ownership by such institutions after a firm is added to the Russell 2000 from below: transient ownership is 1.9 percentage points higher after index inclusion, an increase by 22% relative to the pre-inclusion average of 8.5%. The increase in short-term ownership does not reverse over subsequent years. We identify the effects of short-term investors by estimating difference-in-differences regressions around a firm’s inclusion in the Russell 2000, comparing firms with large and small increases in transient ownership.
In a first step, we show that firms that experience a large transient-ownership increase reduce R&D rates by 1.3 percentage points after index inclusion, relative to firms that do not experience the same increase. This effect equals 11% of the R&D variable’s standard deviation, and remains robust when we control for changes in passive ownership or analyst coverage. The decline in R&D is persistent and not reversed in the years after index inclusion.
Short-term investors may pressure CEOs to cut R&D in order to report higher earnings. If temporarily inflated earnings are misinterpreted by some investors, this can temporarily boost stock prices. Thus, linking the presence of short-term investors to current earnings (and later to equity valuations) is an important element in testing for the effects of managerial myopia. We find that the earnings (EBIT over assets) of firms that experience a large increase in transient ownership rise by 4.7 percentage points after index inclusion, relative to those of firms that do not experience the surge. This effect equals 22% of the earnings variable’s standard deviation. The higher earnings also do not reverse over time.
In a second step, we explore short-term and long-term equity valuations around index inclusions, conditional on changes in R&D and transient ownership. If short-term investors pressure managers to behave myopically, then the equity valuation of firms that reduce R&D around index inclusion should rise temporarily relative to those of other firms. This effect should be strongest among firms with a large, recent increase in short-term ownership, as the decline in R&D at such firms should be most strongly attributable to the ownership change. Temporary boost in equity valuations would suggest that markets (initially) misinterpreted the higher earnings as a positive signal about firm fundamentals.
In the year of index inclusion, equity market-to-book ratios of firms that cut R&D are 1.5 units higher than those of other firm; this valuation difference corresponds to 39% of the equity valuation’s standard deviation. Importantly, the effect of R&D cuts on equity valuations is strongly concentrated among firms that experienced a large increase in transient ownership.
While this result is consistent with myopia, an alternative explanation is that short-term investors pressure CEOs to optimally reduce investment that had previously been too high. We distinguish between these competing explanations by examining the effect of R&D cuts on long-term valuations. If R&D cuts are indeed myopic, then valuations should decline over time as the costs of the reduced investment are gradually revealed. Conversely, if R&D cuts are efficient, then valuations should not decline in the long run.
We document that R&D cuts have significantly negative long-term effects on future valuation: market-to-book ratios of firms that cut R&D start to decline in first year after index inclusion and this effect accelerates in subsequent years. Again, the decline in valuation is strongest among R&D-cutting firms that also experienced a large increase in transient ownership around index inclusion. Overall, this reversal pattern is consistent with temporary price distortions caused by the effects of short-term investors on R&D.
In a last step, we explore whether firms with more short-term investors grant more short-term incentives to their CEOs. The channel in Bolton, Scheinkman, and Xiong (2006) holds that short-term investors incentivize CEOs to act myopically by providing them with short-term pay. This allows CEOs to personally benefit from temporary increases in equity valuation. Using data on ExecuComp firms for which we can link short-term ownership to short-term incentive pay, we find that firms with more transient investors grant their CEOs more options and restricted stock.
The complete article is available for download here.
