Does Stock market harm investment incentives?

A fascinating article on Harvard's Governance Blog today. A MUST read for class.

Does the Stock Market Harm Investment Incentives? by Asker, Farre-Mensa, and Ljungqvist.

"The theory literature in economics and finance has long 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 hence to suboptimal investment decisions. The literature is divided on whether overinvestment (i.e., empire building) or underinvestment (due to rational short-termism) will result, or indeed whether effective corporate governance mechanisms can be devised to ensure investment does not suffer. "

and later:

"We also show 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. "

From The paper's abstract:

"Theory suggests that agency problems resulting from separation of ownership and control can cause stock market listed firms to invest suboptimally... Listed firms invest less and are less responsive to changes in investment opportunities compared to observably similar private firms, especially in industries in which stock prices are particularly sensitive to current profits. Listed firms also tend to smooth earnings growth and dividends and avoid reporting losses. These patterns are consistent with models of managerial myopia and do not appear to be due to firms endogenously choosing to be public or private: Firms that go public for reasons other than to fund investment invest like private firms pre-IPO and like public firms post-IPO. Nor do the results appear to be driven by measurement error, tax effects, or firm life-cycle effects. Our evidence suggests that the stock market distorts investment, at least for the fast-growing companies in our sample."

Cite: Asker, John William, Farre-Mensa, Joan and Ljungqvist, Alexander, Does the Stock Market Distort Investment Incentives? (March 13, 2011). ECGI - Finance Working Paper No. 282/2010. Available at SSRN: http://ssrn.com/abstract=1603484

Definitely I^3=Interesting, Informative, and Important!