Info Market Failure

Unless project gains can be very clearly proven to analysts, or perhaps so small and numerous to allow averaging over them, public firms are basically incapable of taking a loss on earnings this quarter in order to make gains several years later. … CEOs are strongly tempted to instead please analysts by grabbing higher short-term quarterly earnings. …

Private firms are 3.5 times more responsive to changes in investment opportunities than are public firms. … IPO firms are significantly more sensitive to investment opportunities in the five years before they go public than after. (more)

A month ago I said that these results imply that we need wealth inequality, to ensure we make the discretionary investments on which all our future wealth depends.

Today I want to admit that these results also imply that even thick speculative markets, full of lots of people trading lots of money, often have big info failures. While I am a big fan of using speculative markets to aggregate info, I must admit that they quite often fail to aggregate all relevant info, even when a lot of money can be won there.

CEOs at private firms choose investments based on private info on likely rates of return. If the same firm were to be made public, however, the above evidence suggests that CEOs would make less than 25% of those investments. In the other 75+% of cases, the CEO would estimate that market speculators would not credit the stock price for the value of those promising investments, but would instead punish the firm for lower short term earnings. It seems that market speculators cannot distinguish these investments from other less promising ones that CEOs would undertake if speculators were to credit these. CEOs typically know crucial investment details not available to speculators.

Now I can see ways to improve existing stock markets, so that they could aggregate more investment info. We could allow and even encourage “insider” stock trading by firm insiders like the CEO. And we could create decision markets, trading the stock value conditional on specific investment decisions. But while these changes should raise that <25% figure, i.e., the fraction of investments by private firms that would also be made by a public firm, they might not raise it by much.

Speculative markets can work info aggregation wonders, at least compared to common methods like surveys or committee meetings. But if you really want as much info as possible on big investments, we still know of nothing better than rich private investors with a lot on the line.

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  • Stephen R Diamond

    Bad link at the first “more.”

  • Salem

    Why do you assume the failure is in the public firms? It could be that the private firms are too sensitive to changes in investment opportunities – liquidity constraints, perhaps.

    • Vaniver

      Because the requirements of public firms look far too short-sighted. Not pursuing an investment that has a payback time of 2 years suggests a discount rate that is way too high.

      • Salem

        Yes, they “look” too short-sighted, but looks can be deceiving. Human intuition is frequently too confident about uncertain matters, of which long-term investments are a classic example. Private firms are run more at the whim of individuals, so perhaps they display this risk-seeking bias more, whereas public firms are appropriately conservative. Or perhaps not. The point is, you can’t just assume where the failure lies. What is the fact of the matter?

        Metrics that might shed light:
        1. Overall return on capital in public vs private firms (this favours public firms)
        2. Survivorship rate in public vs private firms (this favours public firms)
        3. Cross-national comparison of growth rates and return on capital compared with % of the economy in public firms (I don’t know what this would look like)

  • David E

    I think the main issue is that speculative markets work well in the short term (say 6 months), but not in the longer term. At the margin, stocks are purchased based on whether the buyer thinks they will go up in the next few months, not the next few years.

  • Michael Vassar

    I appreciate this sort of balance to your usual perspective Robin. Thanks.

  • Brendan

    This finding is surprising to me.

    There is lots of research showing that firms w/ ample liquidity invest way too much in R&D and CAPEX. For example:

    Also, the general driver of so many cross-sectional return anomalies is that CEO’s are overly aggressive- acquisitions, equity issuance, debt issuance, asset growth, capex are all associated with abnormally poor subsequent long-term returns.

    And why wouldn’t a simple quant strategy of investing in firms w/ high/increasing relative R&D/CAPEX eliminate this?

    • Robin Hanson

      If you aren’t spending your own money, you can easily build your empire via lots of bad investments. It takes a lot of work to identify the good ones.