How "sleepy" or "awake" are you when it comes to your stock portfolio? If you're like most people, you probably don't spend a great deal of time monitoring your investments. So when another company uses stock to acquire a firm in which you hold a stake, what do you do with the new shares you suddenly own of a company that you never intended to buy in the first place?
Logic suggests that you would be likely to sell those shares. But research by Associate Professor Malcolm Baker, Professor Joshua Coval, and Harvard University professor Jeremy C. Stein shows that 80 percent of individual investors and 30 percent of institutional investors appear to be more inertial than logical. They take the default option, passively accepting the shares offered as consideration in stock mergers and acquisitions.
In "Corporate Financing Decisions When Investors Take the Path of Least Resistance," a paper forthcoming in the Journal of Financial Economics, the authors argue that this sort of passive behavior can have a significant effect on how companies make strategic financing decisions.
It all fits under the heading of behavioral finance, the focus of Baker's research and the title of a second-year course he teaches at HBS.
"At the foundation of finance is the idea that investors and managers act rationally, so that capital market prices reflect fundamentals and managers respond to incentives in predictable ways," he says. "But investors don't act like computers in financial models. Behavioral finance replaces these idealized decision makers with real and imperfect people who have social, cognitive, and emotional biases. My work focuses on how the resulting inefficiencies in the capital markets can create opportunities for investment managers and firms."
It pays to analyze the typical patterns in investor psychology and respond accordingly.
"Investor irrationality is something that people tend to focus on when they think about investing in capital markets," he continues, "but there are also implications for corporate finance." For example, when investors hold onto stock they've received in an acquisition—taking the path of least resistance—it keeps those shares off the open market and makes the price relatively higher than it would have been otherwise.
"Normally, when a company sells its own stock in a follow-on offering, the price falls, in part because you're putting more supply on the market for a given level of demand," Baker says. "In the context of a merger, the acquiring company is often issuing shares to someone like me, who passively accepts them. The bottom line is that there's less of a negative impact on their stock price."
As a result, the acquirer has a cheaper source of equity financing when pursuing growth opportunities, Baker explains, using the example of a hypothetical company with a fixed strategy that involves acquiring another company—the target—and building a new factory. If the target and the factory each cost $100, and debt can only be used to finance one of the two transactions, how should the remaining $100 of equity be issued?
"I could borrow $100 to buy the target company, then issue new stock in a follow-on offering to raise enough money to build the factory," says Baker. "Or I could borrow $100 to build the factory and acquire the target with stock. If shareholders in the target are inertial—and our evidence suggests they are—it is more cost-effective to raise equity in the context of a merger, and borrow money to build the factory."
Baker points out that this is just one example of a market inefficiency that has consequences for corporate financial management.
"Once you establish the view that investor behavior is not fully rational, and that it has an effect on stock prices, there is a wide range of corporate finance implications," he says. "How does a company determine its capital structure? What sort of dividend policy might it undertake? How do market inefficiencies change how a company markets securities, or communicates with shareholders?"
It pays to analyze the typical patterns in investor psychology and respond accordingly, Baker says. Institutional money managers, for example, can find an edge in exploiting the stock price patterns created by irrational investor behavior; and companies can look for similar opportunities to reduce their cost of capital. Individuals, of course, should examine their own biases and attempt to improve their investment decisions.
But this is easier said than done. Much of this so-called irrational behavior is adaptive. Baker notes that our biases come from the innate, quick, and mostly unconscious decisions that enable us to function effectively in our day-to-day lives.
"Our perceptual shortcuts are often out of place in modern capital markets," Baker says, "but we wouldn't be able to drive to work without them."