C&B Notes

Short-Sightedness & Compounding Capital

According to a recently updated working paper, public companies underinvest in their businesses compared to similar private companies.  The study is not definitive, but it suggests a condition that we have experienced anecdotally: public shareholders’ concerns about next quarter’s earnings and many compensation programs encourage management teams to underinvest now in order to meet short-term expectations.  This frequently comes at the expense of larger future cash flows.  We prize businesses with management who makes optimal long-term reinvestment decisions.

In my view, though, the professors’ thesis is the correct one.  I suspect that: a) Outside investors are indeed myopic, thereby b) leading to suboptimal investment decisions by companies, and c) stock prices do not fully adjust for these suboptimal decisions.  That is, I suspect that the public companies that invest fully and properly in their businesses and that therefore post relatively lower quarterly earnings have undervalued stocks.

The investor myopia is amply supported by behavioral literature.  As the professors’ paper notes, a 1995 study found that public-company managers preferred investment projects with shorter time horizons because the managers believed that the stock market did not fully value longer-term projects.  More strikingly, a 2005 survey found that most corporate respondents would not initiate a project that had a forecasted positive net present value, or NPV, if taking on the project meant that the company would fail to meet its consensus quarter-earnings estimate.  The motivation to underinvest is present.  As are the presumed penalties for those who do not.

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Paper’s Abstract: We document sizeable and surprising differences in investment behavior between stock market listed and privately held firms in the U.S. using a rich new data source on private firms.  Listed firms invest substantially less and are less responsive to changes in investment opportunities compared to matched private firms, even during the recent financial crisis.  These differences do not reflect observable economic differences between public and private firms (such as lifecycle differences) and instead appear to be driven by a propensity for public firms to suffer greater agency costs.  Evidence showing that investment behavior diverges most strongly in industries in which stock prices are particularly sensitive to current earnings suggests public firms may suffer from managerial myopia.