Technological shocks, import competition, and shifts in regulatory policies lead with increasing frequency to major industry shakeouts and radical change in economic environments. Whether firms succumb or thrive depends on the extent to which they restructure and reinvent their business models. Therefore, it is crucial to understand which factors help spur prompt and successful restructuring of firms affected by permanent negative shocks and, at the macroeconomic level, of stagnating economies.
Our recent working paper aims to understand how a firm’s ownership structure affects its response to permanent negative shocks. Existing literature implies that in firms with short-horizon investors, management fears the consequences of short-term underperformance to a larger extent than in other firms. Short-term investors are more likely to sell after observing negative short-term results not only because of their trading strategies (Cella, Ellul and Giannetti, 2013), but also because long-term investors typically follow an index or hold large positions and are unable to sell. Since managers would rather avoid selloffs of their firms’ stocks, short-horizon investors’ threat to exit may discipline managers even absent actual selloffs (Fos and Kahn, 2015).
While the behavior of short-horizon investors is believed to create a handicap for firms in ordinary circumstances (Stein, 1989), we propose that the pressure created by the mere presence of short-horizon investors spurs firms to rapidly adjust after shocks that require major strategy overhauls. This may be true because firms that are forced to focus on short-term performance learn to be quick in adjusting their corporate policies.
To explore how ownership structure affects firms’ adjustment to changing economic environments, we study firms’ reactions to large and permanent negative shocks. We base most of the empirical investigation on the effects of large drops in industry-level import tariffs. Since weakening trade barriers increases the competitive pressure that foreign rivals exert on domestic manufacturing firms, substantial reductions in import tariffs are considered to be large, plausibly exogenous, shocks, to which firms may have to react by reinventing their business models. We test whether firms with disproportionately more short-horizon investors are more successful in adjusting to these shocks and, consequently, achieve better long-term performance than other similarly affected firms.
We find that, following the above-mentioned shocks, firms with disproportionately more short-term investors have smaller drops in sales and employment in comparison with other (domestic) firms in their industry that have been similarly affected by the shocks. These effects appear to be associated with greater investment and more acquisitions that diversify a company. In particular, firms appear to spend more in advertising, and differentiate their products from those of competitors to a greater extent, arguably to limit the effects of intensified competition. Firms with more short-term institutional investors also have higher executive turnover following the shocks. Importantly, these changes translate into long-term improvements in profitability and firm value. Thus, firms with more short-term investors appear to be better at adapting to new environments: They reinvent their business models and choose the industries in which to operate and the skills of mangers to create comparative advantage.
Besides providing a wide-range of robustness tests aiming to rule out alternative explanations and to show that results are not driven by endogeneity problems, we extend the analysis to major changes in regulation. Industry deregulation provides a source of exogenous variation in the extent of product market competition. Also in this context, we find that, as an industry deregulates and competition increases, firms with a higher proportion of short-horizon investors adjust faster to the new environment, achieving higher growth of sales, fixed assets, and employment and performing better than competitors.
Our work contributes to a growing literature exploring the effects of institutional ownership on firm performance and corporate policies (e.g., Aghion, Van Reenen and Zingales, 2013). A strand of this literature shows that investor horizon affects corporate policies. For instance, Bushee (1998), Bushee and Noe (2000) and Bushee (2001) show that short-term investment may be valued more in firms whose shareholders have short horizons. Consistent with the above evidence, many managers admit that they are willing to sacrifice projects that are profitable in the long run in order to meet short-term earnings targets (Graham, Harvey and Rajgopal, 2005). By contrast, long-term institutional investors appear to improve corporate governance by limiting over-investment (Harford, Kecskes and Mansi, 2014).
All these papers provide evidence that long-term investors influence managers to pursue corporate policies that enhance firm value when the economic environment is static. Theoretically, however, ownership structures with higher tolerance for failure in the short-term (fewer selloffs in our context) may lead to inefficient long-termism (Ferreira, Manso and Silva, 2012). Investor short-termism could ameliorate managerial incentives and limit extraction of private benefits or managerial preference for a quiet life (e.g., Fos and Kahn, 2015; Thakor, 2015). Trading on long-term information not yet incorporated in prices, short-term investors may also provide stronger governance through their threat to exit (Admati and Pfleiderer, 2009; Edmans, 2009; Edmans and Manso, 2011).
To the best of our knowledge, ours is the first empirical paper to highlight a benefit of short-term investors and to document a case of inefficient long-termism. We are agnostic on the effect of short-term ownership during normal times or when shocks are temporary (which our empirical strategy is not designed to identify). However, we note that our results can be fully consistent with existing literature documenting the negative effects of short-term ownership, because the benefits we highlight are conditioned on permanent negative shocks that require restructuring.
Our results suggest that following radical change, firms and economies with disproportionately more short-term investors are more dynamic and avoid stagnation, indicating that short-horizon investors perform an important function in the economy. More generally, our work suggests that institutional investors with different characteristics perform complementary roles in an economy and that their actions contribute to the improvement of firm performance in various countries.
Admati, A. R. and P. Pfleiderer. 2009. The “Wall Street Walk” and Shareholder Activism: Exit as a Form of Voice. Review of Financial Studies 22: 2645–2685.
Aghion, P., J. Van Reenen, and L. Zingales. 2013. Innovation and Institutional Ownership. American Economic Review 103: 277–304.
Bushee, B. J. 1998. The influence of institutional investors on myopic R&D investment behavior. Accounting Review 73: 305–333.
Bushee, B. J. and C. F. Noe. 2000. Corporate Disclosure Practices, Institutional Investors, and Stock Return Volatility. Journal of Accounting Research 38: 171–202.
Bushee, B. J. 2001. Do Institutional Investors Prefer Near-Term Earnings over Long-Run Value? Contemporary Accounting Research 18: 207–246.
Cella, C., A. Ellul, and M. Giannetti. 2013. Investors’ Horizons and the Amplification of Market Shocks. Review of Financial Studies 26: 1607–1648.
Edmans, A. 2009. Blockholder Trading, Market Efficiency, and Managerial Myopia. Journal of Finance 64: 2481–2513.
Edmans, A. and G. Manso. 2011. Governance Through Trading and Intervention: a Theory of Multiple Blockholders. Review of Financial Studies 24, 2395–2428.
Fos, V. and C. Kahn. 2015. Governance through Threats of Intervention and Exit. Working Paper, Boston College.
Giannetti, Mariassunta and Yu, Xiaoyun, Adapting to Radical Change: The Benefits of Short-Horizon Investors (April 18, 2017). European Corporate Governance Institute (ECGI) – Finance Working Paper No. 467/2016. Available at SSRN: https://ssrn.com/abstract=2723357
Graham, J. R., C. R. Harvey, and S. Rajgopal. 2005. The Economic Implications of Corporate Financial Reporting. Journal of Accounting and Economics 40: 3–73.
Harford, J., A. Kecskes, and S. Mansi. 2014. Do Long-Term Investors Improve Corporate Decision Making? Working Paper, University of Washington.
Stein, J. C. 1989. Efficient capital markets, inefficient firms: A model of myopic corporate behavior. Quarterly Journal of Economics 104: 655–669.
This post comes to us from google, a professor at the Stockholm School of Economics, a research affiliate at the Centre for Economic Policy Research, and a research associate with the European Corporate Governance Institute, and from Professor Xiaoyun Yu at Indiana University’s Kelley School of Business. It is based on their recent paper, “Adapting to Radical Change: The Benefits of Short-Horizon Investors,” available here.