Do Institutional Investors Prefer Near-Term Earnings over Long-Run Value?

Abstract

Critics often argue that institutional investors have an excessive focus on short-term firm performance that leads corporate managers to make decisions to boost short-term earnings at the expense of long-run value. This paper examines whether institutional investors exhibit preferences for near-term earnings over long-run value and whether such preferences have implications for firms' stock prices. Using the Ohlson [1995] model, I separate firm value into three components-book value, expected near-term earnings, and expected long-term (terminal) value-and test whether institutions prefer firms for which more of firm value is expected to be realized as near-term earnings rather than as long-term earnings. The results indicate that the level of ownership by institutions with short investment horizons (transient institutions) and by institutions held to stringent fiduciary standards (banks) is positively (negatively) associated with the amount of value in near-term (long-term) earnings. This evidence indicates that institutions with the strongest incentives to favor firms with a high proportion of value in near-term earnings exhibit such preferences. This evidence that banks and transient institutions prefer near-term earnings over long-run value raises the question of whether such institutions myopically price firms, overweighting short-term earnings potential and underweighting long-term earnings potential. Evidence of such myopic pricing would establish a link through which institutional investors could pressure managers into a short-term focus. The results provide no evidence that high levels of ownership by banks translate into myopic mispricing. However, high levels of transient ownership are associated with an over- (under-) weighting of near-term (long-term) expected earnings and a trading strategy based on this finding generates significant abnormal returns. This finding supports the concerns that many corporate managers have about the adverse effects of an ownership base dominated by short-term-focused institutional investors.