Saturday, July 10, 2010

NYU Profs research findings : Does the Stock harm investment incentives ? Behavioral corporate finance research paper commentary #1

How this idea of academic paper commenting came to my mind 
Hi Everyone ! On 7th July, NYU Prof Alexander Ljungqvist came to NTU to publicize his research findings. I saw this flyer about this while at NTU on July 6th doing my registration procedure. But I was unable to come to NTU again for this because of my prior fixed work meeting with my non-academic mentor John. As a alternative, I got hold of this Prof's paper on SSRN and decided to make this as my first foray into research commentary. Looking at Prof Alex's profile on NYU, he certainly has a impressive record and looks pretty suave. He is said to be the youngest tenured track faculty member while he was at Oxford. The other 2 contributors are Assoc Prof John Asker and Phd Candidate Joan Farre Mensa (both from Econs Dept). Ok I am done with citation for courtesy's sake. By doing this, I hope to train myself to be more meticulous in my way of looking at issues. Eventually, I also hope to reach this high level of research standards. So this is to inspire and motivate me. Last but not least, I would like to share with people the knowledge I gathered.   

Introduction to this research study
This research study examines the differences between public and private companies in terms of investment behaviour. The sample is provided by Sageworks Inc which has a sizable database on U.S private companies. In this paper, empirical research is done to see if stock market listings harm investment incentives. The researchers did so by comparing the investment decisions of U.S. public companies to those of similar-sized private U.S. firms in the same industry. They found some evidence that public firms invest less compared to private firms and strong proof of public firms being less responsive to changes in investment opportunities. These results are most evident in industries in which stock prices are most sensitive to current profits. These behavioural patterns are more in tune with managerial myopia rather than empire-building. Public firms tend to smooth their earnings growth, maintain or increase their dividends and avoid  reporting negative earnings, unlike private firms. From a investment viewpoint at least, it seems that the agency costs of a stock market listed firm outweigh the benefits of a reduced cost of capital, at least for the fast-growing entrepreneurial firms in the sample.

Agency Problems - happens everywhere
Why Private firms have lesser agency problems ? An Agency problem is defined as an conflict of interest arising between creditors, shareholders, suppliers, employees and management due to opposing aims of the various parties. First, the fact that the shares of private firms cannot easily be traded means that managers do not need to worry about the short-term effect of investing in long-term projects on the current value of their stock. Second, private firms are typically owned by a small number of shareholders who either manage the firm themselves or supervise management closely. As a result, their shareholders tend to have the same information together with the management, making it easier to control any agency problems. In contrast, Public companies face problems that makes information flow more difficult between shareholders and managers. They restrict the information flow to the shareholders for fear of disclosing information that could be used by rivals (Bhattacharya and Chiesa (1995)) and also to follow the SEC’s Regulation Fair Disclosure, which prohibits selective disclosure of private information. Private firms are subject to no public reporting requirements, so very little is known about their investment behaviour.

My initial impression of this paper
This is a review of the pros and cons between the public and private firms which are clear to all. 
For a public listed firm, the advantages are having a lower borrowing cost, bigger recognition and having more room for growth. The disadvantages are having to deal with increasingly complicated corporate structures as the company grows bigger, risk of losing control by takeovers and additional public accountability standards (which can be exploited by rivals for information gathering).
For private firms, the advantages are a flatter corporate structure which make it more nimble for decision-making, no fear of being forced to come under another company's banner and the right to keep it's information away from rivals. The disadvantages are higher cost of borrowings, smaller recognition and limited room for growth. 

The paper has several equations to predict managers' behaviour whether short-termism (overly cautious, only after short term gains so as to maintain or brighten the quarterly earnings report) or empire-building (expansionary investments which needs huge capital outlays and long term commitment). I shall not disclose these equations for the sake of simplicity and not making laypeople confused. After all, I am just commenting because I had not reached the high level like these esteemed researchers yet. 

End of Sample size statistics
Public and private firms also differ systematically in their profitability, cash holdings, and use of debt. Private firms have significantly higher return on assets (ROA), defined as operating income before depreciation scaled by beginning-of-year total assets. In the matched sample, average ROA amounts to 0.084 for private firms versus -0.06 for public firms (median: 0.123 versus 0.051). At the same time, private firms hold significantly lower cash balances (beginning-of-year cash and short term investments) and have significantly higher leverage (beginning-of-year long-term and shortterm liabilities divided by beginning-of-year total assets). A greater reliance on borrowing is not
surprising considering that, by definition, private firms have no access to the stock market and so face a higher cost of raising equity capital.

Finally, note that matched-sample firms grow significantly faster than full-sample firms. For public firms, annual sales growth averages 18.3% in the full sample and 25.6% in the matched sample. For private firms, the corresponding numbers are 17.7% and 32.7%. This suggests that the empirical focus on small public and large private companies identifies fast-growing entrepreneurial firms where making optimal investment decisions is particularly important.

The aim of this paper is to examine whether the stock market harms investment incentives. It has long been argued that the separation of ownership and control following a stock market listing can lead to agency problems between managers and dispersed stock market investors and therefore suboptimal investment decisions. The debate is still divided on whether overinvestment (i.e., empire building) or underinvestment (due to rational shorttermism) will result on whether effective corporate governance mechanisms can be established to ensure investment does not suffer (Tirole (2001), Shleifer and Vishny (1997)). The researchers embed Stein’s (1989) short-termism problem and the empire-building problem of Baumol 30 (1959), Stulz (1990), and Stein (2003) in a nested model to derive testable predictions that allow to empirically distinguish between the two. In order to test the model, a proxy is needed for “optimal” investment decisions that is for the investment decisions managers would have made with the absence of agency problems. Such a proxy is taken from a rich new data source on private U.S. firms provided by Sageworks Inc. The hypothesis is proven to be correct. 

Matching Sageworks to standard Compustat data on stock-market listed companies by size and industry, identify matched panels of (small) public and (large) private firms and then estimate standard investment equations. Using several distinct sources of identification, the results show that compared to private firms, public companies invest both less and in a manner that is significantly less responsive to changes in investment opportunities, especially in industries in which stock prices are particularly sensitive to current profits. These findings are consistent with short-termism and opposite to expectations if empire-building were the dominant agency problem in the stock market. However, another similar research conducted in Europe in 2009 (Mortal and Reisel using the Amadeus European database of public and private firms) showed that public firms have greater investment sensitivities than private firms. Unlike the U.S.A, the main agency problem in Europe appears to be empire-building. Back to this research for the U.S.A firms, results showed that public companies tend to smooth their earnings growth and dividends and are reluctant to report negative earnings. One interpretation for these patterns is that public firms treat investment spending as the residual after having paid dividends out of their cash flows, whereas private firms treat dividends as the residual after paying for their investment out of cash flows.
Overall, at least for the  fast-growing sample firms, the benefit of cheaper funding via the stock market appears to be outweighed by the distortions that short-termism induces in the investment behaviour of public firms, due to the agency costs associated with separation of ownership and control. 

Closing Comments
This paper's research methods are very comprehensive. The sample size is more than sufficient to be convincing enough. Besides, the time periods are also long enough to be quantifiable. On average, it is 4.4 years of pre-IPO accounting data. Looking at this research working paper, I really understand that I still got a long way to go before reaching such a high level. To do a Phd, it is really not for everyone. First of all, the time cost is a big turn off, not to mention loss of potential higher income as what Sgt Kelvin said. Even I myself am still wondering if I really want to go all the way to it. It is gonna take more than just courage, luck and intellectual curiosity to complete the whole course from attending research seminars, finding your original research idea, oral and written examinations and finally writing the research thesis. Oh well, I shall see how it goes for me at the upcoming Msc course at NTU. Whatever it is, I find meaning in being a bridge between academia and industry in whatever I do as a aspiring intellectual researcher and consultant in my chosen life's calling.

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