Adapting to Radical Change: The Benefits of Short-Horizon Institutional Ownership

Technological shocks, import competition, and shifts in regulatory policies lead with increasing frequency to radical change in economic environment and major industry shakeouts. Whether firms succumb or thrive depends on the extent to which they restructure and reinvent their business model. Therefore, it is crucial to understand what factors help spur the prompt and successful restructuring of firms affected by permanent negative shocks and, at the macroeconomic level, of stagnating economies.

Our recent working paper takes up this challenge. The paper aims to understand how a firm’s ownership structure affects its response to permanent negative shocks. Existing literature implies that in firms with more 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 rather avoid actual interventions and sell outs of their firms’ stocks, short-horizon investors’ threat of selling or intervening may successfully discipline managers even if we do not observe actual interventions or sell offs (Fos and Kahn, 2015).

While the behavior of short-horizon investors is believed to create a handicap for firms when business is as usual (Stein, 1989), we conjecture that the pressure created by the presence of short-horizon investors may allow firms to rapidly adjust in the aftermath of shocks that require major strategy overhauls. This may be the case not only because short-horizon investors exercise pressure on boards (through exit or voice) following shocks, but also because firms that are forced to focus on short-term performance learn to be fast 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 softening 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 model. 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 to other (domestic) firms in their industry, which have been similarly affected by the shocks. These effects appear to be associated with more investment and diversifying acquisitions. In particular, firms appear to invest more in R&D and 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 environment: they reinvent their business models and choose the industries in which they operate and managerial skills, in order to create comparative advantage.

Besides providing a wide-range of robustness tests aiming 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.

In summary, 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.

References

Cella, C., A. Ellul, and M. Giannetti. 2013. Investors’ Horizons and the Amplification of Market Shocks. Review of Financial Studies 26: 1607–1648.

Fos, V. and C. Kahn. 2015. Governance through Threats of Intervention and Exit. Working Paper, Boston College.

Stein, J. C. 1989. Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior. Quarterly Journal of Economics 104: 655–669.

Mariassunta Giannetti is a Professor of Finance at the Stockholm School of Economics.

Xiaoyun Yu is a Professor of Finance and Arthur M. Weimer Faculty Fellow at the Kelley School of Business, Indiana University.