Does Equity Research Suppress Investment?


The Financial Times recently ran an article on the mysterious decline of U.S. investment despite record corporate profits.  The culprit may be stock research’s intense focus on short-term earnings.  Recent academic studies are suggesting that equity research has a perverse effect on innovation and investment.

According to Jeremy Grantham’s GMO, profits and overall net investment in the US tracked each other closely until the late 1980s, with both about 9 per cent of gross domestic product. Then the relationship began to break down. After the recession, from 2009, it went haywire. Pre-tax corporate profits are now at record highs – more than 12 per cent of GDP – while net investment is barely 4 per cent of output.

“We have this strange thing that the return on capital really does seem to be high, the cost of equity capital is low, and yet we’re getting a lot of share buybacks and not much investment,” says Ben Inker, co-head of asset allocation at GMO. “It just feels a bit weird.”

There are a variety of potential explanations.  The financial crisis created overcapacity and poor growth prospects which dampen the incentives to invest.  But it doesn’t explain why profits have reached record highs nor why their relationship with investment has changed so much over the past 25 years.

Increasing regulation is another argument, but it doesn’t explain why investment would start declining in the 80’s and 90’s during periods of deregulation.  The increasing use of computers may understate investment since computing power is cheaper than building new assembly lines.  However, investment should increase with higher profits as companies plough money into computing power.

Perhaps the problem is that economic statistics aren’t accurately reflecting investment since the cost of computing has been declining.  According to Carol Corrado of The Conference Board, intangible investment has doubled as a share of GDP over the past 40 years.  There are doubts whether intangibles truly qualify as legitimate investment, particularly since the largest intangibles are created through acquisitions.

Recent academic research is pointing the finger at a different cause.  A recent New York Fed paper finds that executive pay contracts may have “dramatic, adverse business cycle consequences”.  In “Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts”, economists John Donaldson, Natalia Gershun and Marc Giannoni conclude compensation induces executives to ignore external factors such as the opportunities associated with investment.

We recently reported on an academic paper finding that firms covered by a larger number of analysts generate less patents, suggesting that innovation declines with the pressures associated with public ownership.

But perhaps the most remarkable result comes from newly available data on private companies studied by Alexander Ljungqvist and colleagues at Harvard and New York University. They find that, keeping company size and industry constant, private US companies invest nearly twice as much as those listed on the stock market: 6.8 per cent of total assets versus just 3.7 per cent.

In their paper, “Corporate Investment and Stock Market Listing: A Puzzle?”, private companies are four times more responsive to new investment opportunities and, when a private company goes public, it changes its behavior.   Ljungqvist told the FT that, given the size of the S&P 500, investment might be percentage points of GDP higher if its component companies invested like private companies.

Stimulating investment is a major policy goal for the U.S.  If equity research is a contributor to under-investment, what should policy makers do?  Encourage bank lending and fixed income capital formation?  Incent more companies to go private?  Try to shift capital formation from public to private placement? Or the most likely outcome: do nothing and let the equity capital markets continue to downsize.


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