Investment Horizons and Information

• Date: 01 July 2016
• Author: Kershen Huang,Alex Petkevich
• Published date: 01 July 2016
• DOI: http://doi.org/10.1111/jbfa.12205

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(7) & (8), 1017–1056, July/August 2016, 0306-686X

doi: 10.1111/jbfa.12205

Investment Horizons and Information

KERSHEN HUANG AND ALEX PETKEVICH∗

Abstract: We examine the relation between institutions’ investment horizons on firms’

financing and investment decisions. Firms with larger short-term institutional ownership use

less debt financing and invest more in corporate liquidity. In contrast, firms with larger long-

term institutional ownership use more internal funds, less external equity financing, and

preserve investments in long-term assets. These results are primarily driven by the variation

in informational preferences of different institutions. We argue that short-term (long-term)

institutions collect and use value-neutral (value-enhancing) information.

Keywords: institutions, investment horizons, corporate policies, information

1. INTRODUCTION

Institutional investment horizons may be associated with corporate policies in at least

two ways. On the one hand, different institutions may have different preferences for

firm characteristics. For example, Gompers and Metrick (2001) find that institutions’

demand for stocks is determined by firm size, liquidity, and past market performance.

On the other hand, institutions with different horizons may affect corporate policies

in different ways. As large shareholders, their focus on short-term or long-term

objectives can incentivize management in choosing strategies accordingly (Bushee,

1998; Chen et al., 2007).1Corporate policies may therefore reflect the information set

of institutions. In this paper, we examine the latter channel.

We view firm policies comprehensively as components of firm assets. The financing

components include (i) retained earnings, (ii) external debt, and (iii) external equity;

∗The first author is at McCallum School of Business, Bentley University, USA. The second author is

at the College of Business and Innovation, University of Toledo, USA. This paper has previously been

circulated under the title ‘Capital Structure, Information Collection, and Investment Horizons’. The

authors are grateful to Ronan Powell (the editor), an anonymous referee, Kee-Hong Bae, Nancy Beneda,

Colin Campbell, Daniel Chi, Doina Chichernea, Shan He, Tony Holder, Wendy Jeffus, Haim Kassa, Jim

Musumeci, Kartik Raman, Len Rosenthal, Kyle Tippens, the seminar participants at Bentley University, and

the conference participants at the 2014 Financial Management Association Annual Meeting in Nashville,

TN, the 2014 Northern Finance Association Annual Meeting in Ottawa, ON, CA, the 2013 Boston Area

Finance Symposium in Wellesley, MA, and the 2013 Southern Finance Association Annual Meeting in

Fajardo, PR for insightful comments and suggestions. Any remaining errors or omissions are the authors’

alone. (Paper received November 2014, revised revision accepted April 2016).

Address for correspondence: Kershen Huang, McCallum School of Business, Bentley University, Waltham,

MA 02452, USA. e-mail: khuang@bentley.edu

1 Since the 1980s, the growth of institutional investors has drawn much attention in the financial economics

literature. Viewing them as ‘large minority shareholders’, studies have shown evidence that they (at

least partially) solve the free rider problem. These developments in the literature justify the theoretical

foundations of Shleifer and Vishny (1986).

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the investment components include (iv) holdings in cash and cash equivalents and

(v) investments in long-term net property, plant, and equipment (PP&E). We use

portfolio turnovers as a proxy for investment horizons and categorize firm-level total

institutional ownership (TIO) into short-term (SIO) and long-term (LIO) institutional

ownerships (Gaspar et al., 2005; Yan and Zhang, 2009).2

Comparing firms with larger short-term institutional ownership (SIO firms) to

those with larger long-term institutional ownership (LIO firms), we find that the

former finance using less retained earnings, less debt financing, and more equity

financing. SIO firms also hold more cash and invest less in PP&E. In contrast,

LIO firms preserve long-term investments in real assets and rely more on internal

financing. Our findings are predominantly driven by differences in information used

by different types of institutional investors, rather than by the long-term demand

shock from their ownership growth. Further, the changes in asset components for

a given calendar quarter can be explained by changes in short-term and long-term

institutional ownerships of the previous calendar quarter in a similar fashion. We

interpret our results as institutions collect and use different types of information based

on their investment preferences.

As institutional investors align managerial incentives with those of their own, firm

policies reflect the type of information preferred by investors. The short-termism

of SIOs encourages managers to meet near-term earnings goals even at the cost of

forgoing long-term returns (Bushee, 1998; Chen et al., 2007).3Their focus on quick

profits relies on the ability to identify securities mispricing based on past managerial

actions.Conversely, LIOs are more likely to engage in relationship investing and to

care about the well-being of firms over the long run (Chidambaran and John, 1998;

Bhagat et al., 2004; An and Zhang, 2013). They are interested in seeing decisions and

improvements that potentially create value through fundamentals.

In sum, we argue that short-term (long-term) institutions use value-neutral (value-

enhancing) information (Holmstr¨

om and Tirole, 1993).4Value-neutral information is

used to evaluate managerial decisions that have already been made, and value-

enhancing information is used to provide the best possible set of corporate policies,

better decision-making, and, if necessary, changes in existing business strategies. Col-

lecting value-enhancing information is more costly as it involves thorough budgeting

analyses for many possibilities (as opposed to evaluating decisions that have already

been made). It can also be more subjective as different parties may have different

views. Goetzmann et al. (2004), for instance, discuss how the value of information

2 Our decomposition of firm assets is similar to that used by Cooper et al. (2008) in studying asset growth.

For simplicity, we will refer to short-term (long-term) institutional ownership and owners as ‘SIO (LIO)’

throughout the paper.The two terms may take plural forms (e.g., SIOs) where we deem appropriate and can

also be used as adjectives (as in SIO firms, referring to firms with larger short-term institutional ownership).

3 Graham et al. (2005) provide anecdotal evidence that firm managers are very often willing to meet short-

term earnings targets at the cost of economic value. We argue that this more (less) likely happens with

larger short-term (long-term) institutional ownership. Consistent with our view, Burns et al. (2010) show

that misreporting is more likely and more severe among SIO firms. More recent studies also suggest that,

while short-term investors more likely trade on fundamental signals (Xue and Zhang, 2011), long-term

investors respond to news beyond what financial reports show (Gietzmann and Isidro, 2013).

4 Holmstr¨

om and Tirole (1993) link monitoring (passive and active) to information (value-neutral and

value-enhancing). In their paper, the two types of information are also referred to as speculative and strategic.

Tirole (2006) uses the terms retrospective and prospective to describe value-neutral and value-enhancing

information, respectively.Studies such as Chen et al. (2007) have also used the terms traders (monitors/owners)

to describe short-term (long-term) institutional investors. These studies, along with ours, more or less echo

Hirschman’s (1970) earlier work on exit and voice.

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can be recognized differently. Further, the value of a firm’s long-term prospects (e.g.,

lower costs of capital, higher and less volatile earnings and cash flows, and easier

financing for future projects) may take time to be realized, and thus introduces a

tradeoff between commitment and liquidity (Aghion et al., 2004). These arguments

imply that when focusing on long-term performance, one may be less concerned about

the temporary mispricing of securities. Altogether, value-enhancing information is (i)

costlier, (ii) more user-specific, and (iii) less efficiently captured in security prices than

value-neutral information.

Our empirical findings regarding the relation between institutional investment

horizons and the financing and investment decisions of firms are consistent with

these arguments.5First, our finding that LIO firms use more retained earnings and

less external equity financing than SIO firms indicates the degree of information

asymmetry in capital markets for the two different types of investors (Akerlof, 1970).

If LIOs use value-enhancing information, they are more likely to perceive their equity

investments as underpriced and discourage the issuance of new shares. Further, since

a proposed action to enhance value is meaningful only if it can be executed, the

collection and use of value-enhancing information must be incentivized through

sufficient controlling power and less dilution of ownership (Aghion and Tirole, 1997).

As opposed to external financing, retained earnings prevent the issuance costs related

to new debt or equity, information asymmetry problems in financial markets, and the

dilution of ownership from a cash offer of new equity.6As such, LIO firms conform

more to the pecking order (Myers, 1984; Myers and Majluf, 1984).7

In contrast to LIO firms using less equity, SIO firms use less debt. This is again

consistent with value-neutral information being less user-specific and more efficiently

reflected in security prices: When external equity financing is subject to severe

information asymmetry problems (e.g., in an economy with only small investors;

(Grossman and Hart, 1980), debt is a valid solution due to its relative non-sensitivity

to private information as a pricing factor and its lower associated monitoring costs.8

When shareholders produce information, however, information asymmetry problems

are mitigated and debt is therefore no longer that essential. Between value-neutral

information and value-enhancing information, which one drives down the importance

of debt more? We argue that it is the former. This is due to the aforementioned

characteristics of value-neutral information – since value-neutral information can

more easily be shared among stakeholders and more efficiently priced by other

investors through SIOs’ actions, it drives down the importance of debt financing more

than value-enhancing information does.9

5 We discuss mainly comparisons between SIO and LIO firms. While we also provide discussions and

evidence on how firms with institutional ownership in general (SIO +LIO =TIO) compare to other non-IO

firms, that is not the focus of this study.

6 A rights offer does not dilute ownership. In the US, most seasoned equity offerings are cash offers.

7 One may argue that, with the presence of institutional investors signaling mitigation of information

asymmetry problems, firms with institutional ownership should be able to afford to use more external

financing than otherwise. While this is true, long-term institutions may not want to let other investors free

ride on their value-enhancing information, which is, as we argue, less efficiently priced than value-neutral

information. The case is similar to venture capitalists during the early stages of a start-up firm, where shares

are usually privately held and not marketable to anyone except for themselves.

8 A large part of debt pricing is determined by interest rates. In addition, debt bears less moral hazard

problems than equity.

9 Michaely and Vincent (2012) refer to this phenomenon as institutional ownership substituting debt. It is

also important to recognize that the higher turnover of SIOs leads to more frequent leakage of value-neutral

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