Zacharias Sautner
Professor of Finance, Head of Finance Department
Zacharias Sautner is Professor of Finance and Head of the Finance Department at Frankfurt School of ...

Do firms with short-term investors spend less on long-term investment?

January 25, 2016
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Recent survey evidence suggests that many executives are willing to take short-term actions that are detrimental to long-term firm value, such as cutting long-term investments. It is often argued that these myopic actions are taken in response to pressures by short-term investors. For example, Nobel laureate Edmund S. Phelps is concerned about the effects of short-horizon investors for long-term economic development, arguing that in “…established businesses, short-termism has become rampant.

In a new study, me and my coauthors Martijn Cremers and Ankur Pareek study the effects of short-term investors on long-term investment and firm valuations.  Our empirical proxy for the presence of short-term investors is a new measure of the stock holding duration of institutional investors. This measure, called Stock Duration, is calculated as the weighted-average length of time that institutional investors have held a stock in their portfolios.

We first study whether firms spend less on R&D, our proxy for long-term investments, and report higher earnings in the presence of short-term investors. We focus on R&D expenses, as these are investments whose benefits are likely manifested only in the long-run, while their expenditures depress current earnings. In particular, as R&D spending is expensed directly on a firm’s income statement, a reduction in these discretionary expenditures allows the firm to report higher current earnings. This can boost the firm’s stock price in the short term, if investors naïvely use earnings-based multiples to derive their estimate of firm value or misinterpret positive earnings surprises that result from R&D cuts. Therefore, any pressure from short-term investors may cause executives to reduce R&D to report higher earnings, and markets may not be able to immediately determine whether such R&D reductions are suboptimal due to asymmetric information.

Using our Stock Duration measure, we document that firms cut R&D spending, report higher earnings, and generate positive earnings surprises when short-term investors enter as shareholders. Furthermore, the increased presence of short-term investors tends to be temporary only and reverses after a few years. Consistent with this pattern, we find that both R&D expenses and reported earnings reverse when the inflow of short-term investors also reverses, confirming that the effects from temporary increases in short-term investors are only transitory.

We then show that these changes in the presence of short-term investors are related to firm valuations. As short-term investors move en masse into particular stocks, their equity market valuations increase substantially relative to fundamentals—but only temporarily. Contemporaneously, a standard-deviation decrease in Stock Duration (0.7 years) is associated with an increase in the market-to-book ratio of 13%. More importantly, this large valuation increase is followed by a predictable decline in the market-to-book ratio. Economically, a standard-deviation decrease in Stock Duration this year is associated with a decrease in next year’s market-to-book ratio of 9%. The market-to-book ratio then reverses to its initial level over the subsequent year. This predictable reversal is consistent with the previous valuation increase reflecting overvaluation.

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