Stein, Jeremy, “Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior,” The Quarterly Journal of Economics (1989), 655-669.
Claim: Managers will invest myopically, even when they care about stock price and even when markets behave rationally.
- Stock markets determine company valuation based on current earnings.
- Managers have an incentive to forgo profitable investments now in order to boost earnings (cash flow) now.
- Market are rational, so they will expect managers to do this.
- Managers who care about stock prices will be trapped into behaving myopically, since they will be penalized if they do not boost earnings now.
- In a steady-state “signal-jamming” model, managers will inflate earnings by “borrowing” from the future (i.e. not investing optimally), and markets will correctly estimate this borrowing.
- Capital market pressure determines the strength of this phenomenon, and may take one of the following forms:
- Threats of takeover (when a firm’s stock price is low)
- Lack of financial slack (the ability to undertake investments without issuing new stock)
- Distance between the firm and its creditors (creditors who are intimate with a firm will rely less on the stock price to appraise firm value)
- The degree to which current earnings are a good signal of future earnings.
- Myopic behavior, where managers underinvest to boost short-term earnings and market rationally expect this and adjust valuations accordingly, is a Nash equilibrium.
- This positive market reaction to announced investments is not evidence that managers do not underinvest, as argued by Jensen (1986).
- Underinvesting managers only undertake the best projects, so markets are pleased when myopic managers invest.
- Startups with high stock prices and high investments are not evidence that managers are not myopic.
- For startups, current earnings have little correlation with long-run success (most startups have negative earnings). The link between stock prices and underinvestment does not yet exist.
- Corporate divestitures and breakups are evidence supporting the signal-jamming model.
- Markets can better interpret the investments and future earnings of stand-alone companies than of conglomerates, so breakups reduce the signal-jamming inefficiencies