What Can We Learn from Stock Prices?

Prices convey information.  Hayek (1945) put it this way: Prices “coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan.”  Stock prices, in particular, matter a great deal in corporate and securities law.  Event studies, which measure statistically significant changes in stock prices, are widely used by investors and courts to infer the effect of an event on the value of a firm (Bhaghat & Romano, 2002b).

In my recent article, I ask a basic question: What can we learn from stock prices?  It is a tautology to say that price reflects value; after all, buyers will not pay more for an asset than what that asset is worth to them. But value does not imply cash flow: A buyer may happily pay $1 for an asset which never pays $1.  That is because assets which pay off when investors need money are more valuable to those investors than assets which pay off when they are wealthy.  Stock prices reflect not only the expected future cash flows of a firm but also the extent to which those cash flows serve as a kind of implicit insurance for investors, paying off precisely when they need money.  Put differently, investors especially value cash flows that smooth consumption by making hard times less painful.

I make a simple claim: The distinction between increasing expected cash flows and the insurance function that those cash flows serve matters for welfare.  A $1 increase in the price of a firm can have different welfare implications depending on what is driving it.  I outline two conditions under which this distinction matters.  The first is imperfect risk-sharing.  It is an axiom of finance theory that the price of an asset is its expected cash flows discounted at the risk-free rate and a discount for risk exposure.  This latter component is the covariance of the asset’s cash flows with the marginal utility of consumption, so-called “systematic risk” (Cochrane, 2005).  In an endowment economy with complete risk-sharing, shareholders are indifferent between a $1 increase in expected cash flows and a $1 reduction in risk exposure.   This is a consequence of the First Welfare Theorem (Leroy & Werner, 2014, p. 164).

But perfect risk-sharing is an unrealistic ideal.  There are all kinds of risks—especially those correlated with macroeconomic volatility like losing a job or customers in a downturn—that cannot be fully insured.  When risk-sharing is imperfect, investors are not indifferent between a $1 increase in the value of a firm driven by an increase in expected cash flows and a $1 increase in the value of the firm driven by a reduction in exposure to systematic risk.  In some cases, investors may prefer the latter to the former.  One reason, explored further in my article, is that prices are derived from marginal, not total, utilities.  An agent may be willing to pay the same price for a reduction in risk and an increase in expected cash flow, even though the former yields a higher total utility than the latter.

In short, price-equivalency does not imply welfare-equivalency.  Shareholders sometimes prefer a reduction in risk that yields a $1 increase in the value of the firm to an increase in expected cash flows that yields the same $1 increase.  The second half of my article shows that a similar result may obtain even when risk-sharing markets are complete.  I examine the classical setting where the firm is controlled by a manager who enjoys non-contractible private benefits of control (Jensen & Meckling, 1976).  The intuition is simple: Controlling and outside shareholders both prefer risk reduction, but they have opposite preferences as to the private benefits of control.  A reduction in risk that is price-equivalent to an increase in investor protection will thus always be preferred by the controlling shareholder, while outside shareholders are indifferent (after all, that is exactly what price equivalency implies in complete markets).

There are three ways that the divergence between price-equivalency and welfare-equivalency sheds light on methodological and substantive questions in corporate and securities law.

Event studies.  The first implication is methodological.  A large literature utilizes event studies to draw inferences as to the welfare effects of corporate events and policy changes. The standard interpretation is that “abnormally positive stock returns . . . suggest that . . . the market expects future cash flows to increase.” (Bhagat & Romano, 2002b, p. 410).  But a price increase can reflect either higher expected cash flows or lower systematic risk exposure.  And as this article has shown, welfare may be higher under one or the other for any given price increase, so separating “cash flow” news from “discount rate” news (Campbell & Vuolteenaho, 2004) can shed greater light on the welfare effects of a corporate event or policy change.

As such, it may be useful to measure the effect of an event on beta itself, i.e., the covariance of a firm’s returns with those of the market and other risk factors.  The asset pricing literature studies how beta varies over time, following theoretical work on the conditional capital asset pricing model (Jagannathan and Wang, 1996; Lettau & Ludvigson, 2001).  This can easily be done in an event study by interacting market beta with time windows or estimating alpha across calendar-time subsamples.

The latter approach is taken by Brav et al. (2015a), who consider the link between hedge fund activist interventions and time-varying systematic risk. They show that target exposure to the HML factor is statistically insignificant in the one to three years prior to the activist intervention, peaks in the first year after, and declines to a lower level in the following one to three years. They point out that this decline in expected returns — the “discount rate channel” — could explain some of the announcement- day returns to hedge-fund activism. And Brav et al. (2008b) show substantial variation in market beta when employing calendar-time regressions of abnormal returns surrounding hedge-fund activism announcements on Schedule 13-D. Table 3 of that paper shows a beta estimate for (-12 mo., 10 mo.) of 0.98, which drops to 0.39 in the (-1 mo., 1 mo.) window, only to rise again to 0.92 in the (7 mo., 9 mo.) window.

These findings raise the possibility that hedge fund activists may create value by reducing the covariance of a firm’s cash flows with systematic risk in addition to increasing expected cash flows.  Brav et al. (2015b) note that “[a] large fraction of [names of hedge fund activist] include words or phrases that connote value investing, such as ‘value,’ ‘contrarian,’ and ‘distressed’.”  To the extent that activists encourage a firm to pursue contrarian policies in particular, these hedge funds may create shareholder value by making a firm’s cash flows more idiosyncratic.  This is a slightly different conception of the role of activist investing than monitoring and reducing the consumption of private benefits of control (Kahan & Rock, 2006).

Principal costs and disagreement.  A second, more substantive, implication of this framework is that governance structures which allow for greater private benefits of control may provide offsetting benefits if they reduce systematic risk exposure.  A growing literature considers how instruments like dual-class stock, which can increase agency costs, also allow founders to pursue idiosyncratic vision and thereby reduce mistakes that might arise from dispersed ownership (Goshen & Hamdani, 2016).  More broadly, Goshen & Squire (2017) show a general tradeoff between agency costs and principal costs, such as incompetence and conflicts of interest between principals.  The separation of ownership and control may reduce the latter while increasing the former, so lowering agency costs is not always value-enhancing.

The principal-cost theory in Goshen & Squire (2017) is isomorphic to the framework in my article in the following sense: Idiosyncratic control facilitates a kind of contrarianism that gives rise to reduced correlation between cash flows.  Disagreement between outside shareholders and a controlling shareholder implies, by definition, that the latter will choose projects which pay off in states of the world that the former believe are less likely to occur.

For a trivial example, suppose outside shareholders think it will rain but the controlling shareholder is sure it will be sunny.  The controlling shareholder will choose a project that pays off when it is sunny (“sunny projects”).  Outside shareholders will invest in firms with projects that pay off when it rains (“rainy projects”).  This implies that the return on the controlling shareholder’s projects will be less correlated with outside shareholders’ portfolio returns.  Suppose, for simplicity, that sunny and rainy projects have the same expected cash flow.  Outside shareholders benefit when the controlling shareholder chooses sunny projects while they (in disagreement) invest in rainy projects.  After all, if they are wrong, the controlling shareholder’s sunny project pays off; if they are right, their portfolio of rainy projects pays off.

This example illustrates how mechanisms that allow founders to pursue an idiosyncratic vision that disagrees with outside shareholders can be value-enhancing by reducing the correlation of a firm’s cash flows with outside shareholders’ systematic risk exposure.  Of course, the key assumption in this story is that expected cash flows are identical in the two cases: The exercise of private benefits can easily reduce the value of the firm far beyond the benefits of additional diversification.  Thus, I am not suggesting that managerial entrenchment is presumptively value-enhancing, or even that it is value-enhancing a significant fraction of the time; rather, the claim is that it is possible that allowing founders to pursue idiosyncratic vision—even at the expense of some consumption of private benefits—may potentially benefit investors by exploiting the diversification benefits of disagreement.  The empirical evidence in Brav et al. (2015a) and Brav et al. (2008) suggests that hedge-fund activism may benefit firms either by enhancing cash flows or reducing risk exposure.

Governance and macroeconomic stability.  A large literature considers adjustment costs—frictions that impede adapting capital to more efficient uses (Hayashi, 1982).  Gordon (2018) argues that adjustment costs can lead large institutional investors to resist governance changes that would destabilize labor markets or bring about political instability.  Following Hansmann and Kraakman (2000), the question is, which shareholders enter into the objective function; that is, how much weight should be given to macroeconomic stability when maximizing firm value?

My article sheds light on this question by presenting the tradeoff between expected-value maximization and instability-reduction in price-equivalent terms.  By definition, an investor cannot diversify beta, the firm’s exposure to macroeconomic (systematic) risk.  Investors with high-beta portfolios might prefer a reduction in a firm’s risk exposure to an expected-value increase that has an equivalent effect on the price of the firm.  This can explain why, for example, large institutional investors might resist interventions that lead to cash-flow enhancing financial and operational change.  To the extent that these changes effectively make the firm more procyclical—e.g., by hiring and firing workers and thereby exposing the firm to the ups and downs of the labor market—the firm becomes more sensitive to macroeconomic risk and thus provides less of a diversification benefit to stability-minded investors.

Of course, taken to the extreme, stability can become stagnation.  Is it possible to strike a balance between the twin goals of increasing cash flow and reducing instability?  Price equivalency quantifies this tradeoff in terms of an observable metric (the stock price) that is routinely used to measure firm value.  One might wonder if large institutional investors prefer stability at the expense of lower portfolio alpha, but my paper shows why they might prefer stability, holding fixed the market value of the firm.  Put differently, if risk reduction yields a greater welfare increase than a price-equivalent change in expected cash flows, stability-minded corporate governance can be uniquely value-enhancing.

This post comes to us from Professor Joshua Mitts at Columbia University Law School. It is based on his recent paper, “What Can We Learn from Stock Prices? Cash Flow, Risk and Shareholder Welfare,” available here.