How Stock Price Volatility in Closely Held Firms Distorts Capital Allocation

Firms with concentrated ownership fear stock price fragility and conserve cash at the expense of capital investments and R&D, a new study finds.

Closely held companies worry about volatility in their share prices, tend to conserve cash, and consequently cut back on new investments and R&D outlays, according to a new research paper by experts at Wharton and elsewhere titled “Corporate Responses to Stock Price Fragility.”

Such companies accumulate cash because they are apprehensive that “stock price fragility,” or volatility of their share prices, could hinder their ability to raise fresh capital in the public markets, according to Wharton finance professor Itay Goldstein. His co-authors are Stockholm School of Economics professor Richard Friberg and University of Kentucky finance professor Kristine W. Hankins.

“When companies think that their ownership base has changed in a way that their stock prices can be subject to volatility, they will take precautionary measures to avoid the potential for downside risk,” said Goldstein. “If such firms do not have sufficient cash for their future investments, they conserve cash in anticipation of a drop in their share price.” Such stock price fragility has a negative impact on capital expenditures, R&D, repurchases, and short-term debt, the paper stated.

The paper covers new ground in exploring whether firms change their financial behavior when they anticipate that their exposure to non-fundamental price movements, such as their stock price fragility, has increased. This can happen when firms’ ownership base changes in a way that makes large flows and price fluctuations more likely.

Closely-held firms are exposed to a variety of shocks to their share prices, such as rapid unwinding of positions by large institutional investors, or “meme stock” trading fueled by social media, the paper stated. Against that backdrop, the authors contended that their paper is “the first to provide evidence that managers identify increasing stock fragility — and the resulting potential exposure to non-fundamental shocks — as a salient risk.”

How the Volatility of a Stock Drives Capital Allocation

The paper’s authors have developed a model that illustrates the economic mechanism of stock price fragility; they tested that model in two different empirical settings. One empirical setting is the long-sample evidence using a fragility measure fleshed out in a 2011 paper by Robin Greenwood and David Thesmar. The second setting is the merger of financial institutions, and particularly that of Blackrock and Barclays Global Investors (BGI) in 2009.

In the first setting, the paper analyzed quarterly corporate data from 2001 to 2017. It showed that companies exposed to stock price fragility decide on how much cash they must keep as a buffer for future financing needs. “While all firms face some risk that equity misvaluation increases their cost of raising capital in the future, changes in the degree of misvaluation risk should affect the benefit of precautionary cash holding. This implies that firms exposed to greater stock fragility will hold more cash and invest less in capital expenditure,” the paper stated.

In the second setting, the paper focused on the BlackRock-BGI merger, where the combined entity controlled $2.8 trillion worth of assets under management. The merger led to “a substantial change in ownership concentration” for many stocks in their portfolios. The study found  “a causal effect” between stock price fragility caused by ownership concentration and the capital investment and the R&D outlays of portfolio companies. The authors found similar patterns following other smaller financial institution mergers.

Capital Allocation, Interrupted

Goldstein summarized the main takeaways from the analysis in the two settings: “In the first one with long-sample evidence, we show how stock fragility affects firms’ financial policies. When the stock price fragility goes up, firms tend to take precautionary measures and hold more cash, which at the end of the day also affect their investments, R&D, and so on.

“In the second experiment of the BlackRock-BGI merger, we show that when firms see that their ownership concentration has gone up, they react by increasing their cash, and reducing their investment and R&D outlay. It interrupts the process of capital allocation.”

The paper pointed out that stock price fragility does not rely on any asymmetry between underpricing and overpricing. “A fragile stock price implies a higher probability of bigger overpricing just like it does for bigger underpricing,” the authors wrote. Overpricing does not impact a firm’s choice on how much cash it must have as a buffer, but the higher likelihood of underpricing will drive a firm to build its cash reserves.

Goldstein said the findings are significant especially because of the increase in stock ownership concentration, with more and more stock holdings moving from retail investors to institutional investors. Institutional investors account for 80% of the U.S. stock market capitalization, according to one report.

Investors who do not want to be exposed to the resulting stock price fragility may want to reduce their exposure to firms with concentrated ownership, Goldstein advised.

Regulators should also take into account the implications of ownership concentration of firms, he added. “The Securities and Exchange Commission, for instance, tries to regulate financial markets to allow for smooth allocation of capital. When stock ownership becomes too concentrated, the allocation of capital might be interrupted.”