Do Public Companies Underinvest?

Yet, per the professors' research, this is not so. When compared with similar private companies, public companies hesitate to spend. Perhaps this is because sceptical MBA graduates from the 1980s and 1990s, who were taught about the evils of CEO spending, are now the institutional investors who (largely) set stock market prices. Perhaps, instead, it is that the managements of private companies are more optimistic about their companies' future prospects.

Or, perhaps, there's something else going on. The professors would argue a third possibility: This behaviour can be explained by a stable, ongoing model. For logical reasons, shareholders in publicly traded companies are more focused on quarterly results than are the holders of private companies. This preference by shareholders encourages the managers of publicly traded companies to grasp the bird at hand than chase the two birds in the bush. Managements' actions are forced by near-sighted investors who suffer from "myopic distortions."

Farre-Mensa emailed me with the explanation of how public investors can have a short-term mind-set and yet be rational. (This explanation is not found explicitly in the paper.) "Investors cannot observe what would be the optimal investment given the firm's investment opportunities. ... Investors cannot observe a firm's projects (particularly, those that not initiated). Therefore, they cannot observe if the firm is underinvesting, even if they know the firm's capex from its 10-K." (For UK-based readers, the 10-K is an annual report required by the US regulator on a company’s performance.)

It's a form of game theory. The idea is that investors cannot tell from the outside which companies invest properly and which underinvest. Because those companies that underinvest enjoy slightly better quarterly performance (as their earnings rise by the amount of the foregone investments), and investors can see earnings but not the correct level of investment, the result is that the cheaters prosper. Companies that stint on investing are rewarded in the marketplace for their superior near-term results. Those that do not, are not.

That makes sense. However, these game-theory models inevitably have a whiff of Vizzini. If the structure of public-company reporting nudges companies toward suboptimal behaviour by highlighting positive current results (that is, quarterly earnings) but not illuminating negative future results (that is, foregone investment opportunities), then presumably rational market participants would recognise that this distortion occurs and would respond by penalising the stocks of companies that have low investment rates. I don't see why the professors' model stops where it does.

However, the model is a very useful framework. The next logical step is to see how this has played out. The paper doesn't prove that public companies with higher reinvestment rates have better future outcomes than those with lower rates. It doesn't show that private companies grow the value of their franchises faster than do public companies. (We might assume that from their higher growth rates, but that would be only an assumption.) It may well be that public companies are the ones that get reinvestment right and that private companies are wasteful. 

Also, despite the professors' best efforts to control for multiple variables, including not only the aforementioned size and industry but also age, tax treatment, accounting choices and the treatment of intangibles, they might have missed something. There may be an untested factor that explains the difference in investment behaviour between the two groups of companies. 

So, it's far from proven that public companies underinvest. It's clear that they invest less than private companies but unclear that this lower investment is a bad thing.

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 behavioural 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.

(Morningstar's Haywood Kelly, senior vice president of equity and credit research, puts the matter directly: "Managers who want to avoid short-term pressures don't do conference calls, analyst meetings, earnings guidance, etc.--they try to act private even though they're public.")

If investors are indeed myopic, then point b) follows logically from a). Companies are investing suboptimally. Per point c), have the markets adjusted? I doubt it. There are thousands of mutual funds that pick stocks at least partially based on their quarterly results. Earnings momentum and earnings acceleration have long been core strategies for growth-stock managers. More recently, near-term stock-price momentum has become fashionable. So, there are many people paying close attention to small changes in the quarterly results. Fewer surely make their primary investment decision on a company's long-term growth prospects, with an eye towards capital expenditures. Tellingly, when I asked Morningstar's fund analysts to name funds with managers who sought companies that had high rates of internal reinvestment, they drew a collective blank.

Perhaps we will see such funds in the future. In the interim, one could put the professors' ideas to work by looking at companies that have unusually high reinvestment rates (along with good profitability--there's not much point in a company putting a lot of money into a poor business). Perhaps research and development costs should added to the professors' list of capex and M&A. 

Read John Rekenthaler's previous articles here.