Blockholder Trading, Market Efficiency, and Managerial Myopia

In my paper Blockholder Trading, Market Efficiency, and Managerial Myopia which was recently accepted for publication in the Journal of Finance, I analyze how outside blockholders can induce managers to undertake efficient real investment through their informed trading of the firm’s shares.

The model developed in this paper addresses two broad issues. First, it shows that blockholders can mitigate managerial myopia. Small shareholders base their decisions on freely-available short-term earnings. By contrast, a blockholder’s large stake gives her strong incentives to gather costly information about the firm’s fundamental value, i.e., to learn whether weak earnings result from low firm quality or desirable long-term investment. By trading on this information, she causes prices to more closely reflect fundamental value rather than short-term earnings. This increased market efficiency improves real efficiency: the manager is willing to undertake investments that boost fundamental value even if they depress short-term earnings.

This beneficial effect of liquid trading on investment contrasts with conventional wisdom. In the 1980s and 1990s, many commentators feared that the U.S.’s liquid markets would lead to it being overtaken by Japan in international competition, because short-term trading by shareholders causes managers to focus excessively on short-term earnings. They argued that reducing liquidity would make “exit” more difficult upon short-term losses, and force a shareholder to exhibit “loyalty”. My model shows that the mutual exclusivity of loyalty and exit paradoxically leads to complementarities between them. If a blockholder has retained her stake despite low earnings, this is a particularly positive indicator of fundamental value if she could have easily sold instead. In short, the power of loyalty relies on the threat of exit. Far from exacerbating myopia, the liquidity of the U.S. capital allocation system may be a strength, because liquid trading causes prices to more closely reflect fundamental value.

The second issue that the model demonstrates is that shareholders can exert governance even if they cannot intervene directly in a firm’s operations. Most existing theories assume that blockholders govern through “voice” – firing a shirking manager or overturning a pet project. However, intervention is uncommon in the U.S., because blockholders are typically small and face significant legal and institutional barriers. Existing models therefore have difficulty in explaining the role that small blockholders with few control rights play in corporate governance, and thus why they are so prevalent. This paper shows that blockholders can still add significant value even if they lack control.

The paper closes with empirical implications. One set concerns stock-price effects, and is unique to a model where blockholders trade rather than intervene. While block size does not matter in standard microstructure theories, here it is positively correlated with an investor’s private information, trading profits and price efficiency. More generally, the model suggests a different way of thinking about blockholders that can give rise to new directions for empirical research. Previous studies have been primarily motivated by perceptions of blockholders as controlling entities, but new research questions may be motivated by conceptualizing them as informed traders. A second set relates to real effects: blockholders should increase firm investment and deter earnings manipulation.

The full paper is available for download here.

In another paper, co-written with Gustavo Manso, I extend the analysis to consider the role of multiple blockholders, which we observe frequently in practice. We find that splitting a block can be beneficial for corporate governance. While splitting a block weakens “voice”, by creating free-rider problems in intervention, it strengthens “exit” because multiple blockholders trade aggressively, impounding more information into prices. The paper entitled Governance Through Exit and Voice: A Theory of Multiple Blockholders is available for download here.