So there’s this fight over what Apple should do with its money and I think it boils down to:
- Lots of people think that Apple is undervalued,
- Some of those people say: “so, since the market undervalues you, a dollar in your hands is valued less than a dollar in shareholders’ hands, and since you have Just. So. Many. Dollars. in your hands, why not give some back to shareholders, like in the form of colossal dividends, or even more amusingly in the form of tens or hundreds of billions of dollars of preferred stock?”
- Others say: “no, the market’s valuation is irrelevant, you should stealthily keep investing your zillions of dollars into building wrist computers or whatever, and one day your stock will catch up.”
If these arguments sound familiar that’s because they are; you can pretty much always find an activist who thinks that a company should return cash to shareholders feuding with a management who thinks they should be investing that cash in growing the business. And they’re endless because they’re tough to adjudicate: everyone is sort of talking their own book. There is a pile of money, and some people say “we should have the money,” and others say “no we should have the money,” and, y’know, duh they’d say that. Are return-the-cash activist shareholders just greedy short-termers destroying long-term value? Are managers who prefer to invest the cash just blinkered empire-builders who don’t care about the welfare of the people actually funding their wrist-computer adventures?
I dunno. Here are some hypotheses:
Assume that the manager maximizes the mean of shareholders’ valuations of the firm, i.e., he chooses the investment policy that is optimal from the perspective of the average shareholder. In this case, the greater is the ownership of short-term shareholders compared to long-term shareholders, the less the manager invests. We summarize this intuition in the following hypothesis:
H1: For undervalued firms, investment is increasing in investor horizons.
… When the firm is undervalued, short-term investors want to minimize cash flowing from shareholders to the firm for investment and instead want to maximize cash flowing from the firm to shareholders, i.e., dividends and share repurchases. Thus our third hypothesis is:
H3: For undervalued firms, payouts to shareholders are decreasing in investor horizons.
Those hypotheses are from this paper, forthcoming in the Journal of Financial and Quantitative Analysis, and they turn out to be true, more or less. The authors looked at “undervalued” public companies,1 and found that undervalued firms with a higher percentage of long-term owners (life insurers, pensions, index funds, Warren Buffetts) tended to have higher capex and less capital return than undervalued firms with more short-term owners (hedge funds,2 high-turnover mutual funds). Not that impressively – “a one-standard deviation increase in both long-term investor ownership and undervaluation increases capital expenditures and equity issuance by about 0.3% and 0.4% of total assets, respectively” – but, it’s something. (The intuition is that long-term holders value an expected $1.01 (present value) of future corporate value higher than $1 of cash in hand right now, because they’ll be around to receive it; a short-term holder values cash now over a higher future corporate value.)
This does not really answer the question though: do undervalued firms with lots of long-term owners invest more because they correctly take the long view of shareholder value, or because they don’t have David Einhorns reminding them to keep their eye on the prize, the prize being free cash flow to shareholders? The paper comes to this question from sort of the opposite end, noting that long-term investor horizons tend to correlate with (1) more monitoring of management and (2) more concentration, which should also constrain management. You see the tension in Apple, where long-term governance-y activists like CalSTRS are opposing David Einhorn’s short-term activist-y activism. Nonetheless, controlling for governance and concentration yields similar results: more longer-term investors means more investment and less cash return, regardless of governance.
Also neat is that index funds get similar results to non-index long-term investors: index funds, like Warren Buffett, tend to have low turnover (since the index doesn’t change that much), but unlike Warren Buffett they’re not out looking for companies whose philosophy matches their long-term focus. They’re just looking for companies in the index. And yet companies they own do (weakly) tend to make more long-term investments when undervalued, suggesting that management is looking out for their shareholders’ preferences – maximizing future value rather than just handing out cash today – even when those shareholders can’t do much to look out for those preferences themselves. As indexing gives owners of capital a less direct say in allocating that capital, it’s nice to see management doing that allocating for them.
Maybe? The flip side of good governance – evidence of managers actually acting in the best interests of shareholders – is that shareholders sort of suck. If you worry, as some people do, about excessive trading and short-termism in markets, then this (weak?) evidence that management actually responds to shareholder time horizons shouldn’t make you all that happy. Shareholders are bad! Their horizons are too short! They want short-termism and cash return rather than investment in productive activities! What jerks.
Even if you think that, there’s some good news. Shareholder horizons are, I suppose, lengthening slightly: volumes are down since their crisis-era peaks though ticking up modestly in recent months. If you believe this paper’s evidence, that suggests that corporate investment horizons should be similarly lengthening. Which would be a good thing? Unless, of course, the short-term-focused shareholders have a point, and there really are no productive activities to invest in. That seems harder to measure, which means it will remain fun to argue about.
Apple checkmate: Another big investor backs company vs. Einhorn [NYP]
Apple’s Cook Calls Einhorn Lawsuit ‘Silly Sideshow’, Says Company’s Not Tight-Fisted [CNBC]
Derrien, Kecskés & Thesmar, Investor Horizons and Corporate Policies [SSRN via Harvard Law]
1. Feh, right? They have six proxies for undervaluation; four of them are book-to-value-ish measures (so debatable in that they would seem to treat correct market expectations about a dim future as “undervaluation”; one is a kooky technical-pressure-from-mutual-funds-with-extreme-inflows-and-outflows measure. One is “companies whose stock later goes up a lot were, sort of by definition, undervalued,” which is intuitive enough, though I guess it interacts strangely with predicting policies. Anyway that one is a bit less likely to be significant (LTIO x VP, i.e. interaction of undervaluation and long-term investors) on various tests. I dunno. You could disagree with the value stuff here if you wanted.
2. I enjoyed their list of “famous short-term investors” that includes “Stevie Cohen, John Paulson, and György Soros.” I feel like Steve Cohen doesn’t like going by Stevie? And George Soros … I dunno, but I’m calling him György from now on.