Print
E-MailRichard Friberg is the Jacob Wallenberg Professor of Economics at the Stockholm School of Economics, Itay Goldstein is the Joel S. Ehrenkranz Family Professor of Finance at the Wharton School of the University of Pennsylvania, and Kristine Hankins is the William E. Seale Professor of Finance at the University of Kentucky. This post is based on their article forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes Stock Investors’ Returns are Exaggerated (discussed on the Forum here) by Charles Wang, Jesse M. Fried, and Paul Ma.
Meme stock trading and consolidation in the asset management industry seem like unrelated topics but both can contribute to non-fundamental stock price movement. That is, they increase stock fragility – the risk of future misvaluation.
Does this matter for firms? How do executives react?
Our recently accepted Journal of Financial Economics paper “Corporate Responses to Stock Price Fragility” provides novel evidence that firms respond to price fragility stemming from changes in the composition of investors. Specifically, firms increase cash and decrease investment in response to the risk of future misvaluation.
While existing research often investigates the impact of non-fundamental mispricing shocks on corporate finance outcomes such as investments and takeovers, we document firms alter their financial behavior when anticipating increased stock price fragility. This offers new insights into the link between financial market shocks and corporate decisions.
The paper presents a simple model to illustrate the mechanism. Firms decide on the amount of cash buffer to keep in the business, balancing the cost of forgone returns on illiquid investment opportunities against the risk of having to raise external funds at a time when the firm is undervalued. While all firms face some risk that the cost of raising capital in the future will be impacted by misvaluation, the degree of misvaluation risk should affect the benefit of precautionary cash. As such, the level of fragility should affect both cash holdings and current capital expenditure. Our model offers a novel take on understanding the implications of mispricing by modeling the ex-ante precautionary response.
Empirically, we document a strong relationship between changing stock price fragility and corporate cash holdings. Moreover, we find this precautionary response is stronger for firms where the cost of future misvaluation is larger. More financially constrained firms and those facing higher uncertainty respond more to changes in fragility.
As managerial expectations about future misvaluation are central to our channel, we investigate the role of managerial biases. Here we find the response to fragility is attenuated when managers are more optimistic and, thus, less concerned with the risk of future misvaluation.
We also explore corporate decisions beyond cash holdings and find stock price fragility has a negative impact on capital expenditures, R&D, repurchases, and short-term debt. The range of these precautionary responses highlights the importance of understanding the real effects of the financial markets and how changes in ownership composition affect corporations.
To address potential endogeneity concerns, we examine responses to the natural experiments provided by the 2009 merger between BlackRock and Barclays Global Investors as well as two small mergers. These mergers generate exogenous shocks in ownership concentration and stock price fragility and, like our earlier evidence, show that firms respond in a precautionary manner to increased fragility.
The paper connects to the broader literature on uncertainty and investment by identifying a novel financing risk. This not only improves our comprehension of the factors influencing precautionary corporate behavior but also emphasizes the significance of understanding consolidation within the asset management industry. Further, it contributes to research on precautionary cash holding and financial flexibility, providing evidence that the risk of misvaluation influences corporate cash decisions. Importantly, the effect of stock fragility on cash holding is economically significant relative to the effect of key variables identified in this literature in the past, speaking to the important role of stock market fluctuations in the policies of modern corporations.
More broadly, the paper provides a new angle to understanding the real effect of financial markets. The question of whether the secondary stock market affects firms has been a central one in the literature connecting asset pricing and corporate finance. Previous papers have looked at the effect of price changes after they are realized. We show that the effect extends beyond that. As firms actively engage in precautionary behavior to protect themselves against the anticipated risk of misvaluation, expected fluctuations in stock prices, which are generated by changes in ownership composition, will have a real effect. Hence, keeping track of the ownership base of the firm is critical for understanding corporate policies, even if shareholders do not directly engage with the firm.
