In our paper, Investor Horizons and Corporate Policies, forthcoming in the Journal of Financial and Quantitative Analysis, we study the effect of investor horizons on corporate behavior. Institutional ownership of U.S. firms has increased dramatically during the last fifty years, and institutional investors today own the great majority of U.S. firms. However, institutional investors are far from homogenous. One of the dimensions along which they differ is the horizon of their investments. Their investment horizons can differ because the maturities of their liabilities differ. For example, pension funds have long-term liabilities and thus long investment horizons, whereas mutual funds are subject to large short-term redemptions and thus their investment horizons are also short-term. Investors also differ in their investment strategies: some, like Stevie Cohen, turn their portfolios over with lightning speed while others, like Warren Buffett, hold their portfolios forever. Surprisingly, however, there is little research on the effect of investor horizons on corporate policies. This paper aims to fill this void.
In perfect capital markets, a firm’s stock price always equals its fundamental value and the investment horizon of its investors does not matter for corporate policies. Managers’ investment decisions maximize the firm’s fundamental value. These decisions are fully reflected in the firm’s stock price and investors can meet their liquidity needs by selling their shares before the firm’s investments pay off. Mispricing of the firm’s stock, however, creates tension between investors with different investment horizons. This tension arises because mispricing does not matter for long-term investors who are able to wait until the mispricing is corrected, but it does matter for short-term investors who might have to sell their shares when the firm is still mispriced. We argue that long-term investors attenuate the effects of mispricing on corporate policies.
In our tests, we regress various corporate policy variables on the interaction between misvaluation and the fraction of the firm’s shares held by long-term investors and control for other determinants of corporate policies. To measure the investment horizon of a firm’s investors, we follow Gaspar, Massa, and Matos (2005) among others, and we measure the investment horizons of investors based on their portfolio turnover and the investor horizons of firms based on the ownership of their long-term investors. To measure mispricing, we follow the literature on the real effects of misvaluation. We use three residual book-to-market variables as our first three proxies for misvaluation and we use raw book-to-market as our fourth proxy. As our fifth and sixth proxies, we use future excess returns and mutual fund flows.
Our results support our argument that investor horizons affect corporate policies when the firm is mispriced. We find that, for undervalued firms, investment and equity financing are increasing in investor horizons and payouts are decreasing in investor horizons. Our results are economically and statistically significant. For example, a one-standard deviation increase in both long-term investor ownership and undervaluation increases capital expenditures and equity issuance by about 0.3% and 0.4% of total assets, respectively.
Our paper contributes to the market timing literature by disentangling two views of why firms time the market. Papers in this literature typically assume that firms aim to please one of two groups of investors: short-term or long-term. According to the “capital structure arbitrage” view, firms exploit temporary misvaluation of their stock to transfer value to long-term investors. By contrast, the “catering” view holds that firms pursue whatever investment, financing, and payout policies cater to the time-varying tastes of short-term investors. For instance, the literature provides evidence that firms that are overvalued issue more equity,but the interpretation of this finding differs according to the two views. According to the capital structure arbitrage view, overvalued firms transfer value to long-term investors by issuing equity and retaining rather than investing the proceeds. The catering view holds that overvalued firms issue equity and invest the proceeds in order to please short-term investors who overvalue the firm’s investment opportunities.In summary, both views are consistent with the evidence that firms time the market, but the capital structure arbitrage view holds that they do so to transfer value to long-term investors whereas the catering view holds that they do so to cater to short- term investors. Our paper uses investor horizons to disentangle these two views and finds support for the catering view over the capital structure arbitrage view.
We also contribute to the emerging literature on investor horizons. This literature revolves around the idea that short-term investors influence managers to pursue corporate policies that destroy firm value (Stein (1996)). Our paper exploits the fact that investor horizons matter mostly when the firm is mispriced. Therefore, our corporate policy effects are not identified by investor horizons on their own but by the interaction between investor horizons and mispricing.
The full paper is available for download here.