Lake Internal-funds-be-gone: Where All The Investments Are Above Average

Hal Varian offers an explanation for why companies finance investment out of retained earnings more often than many financial models suggest they should:

What Can We Learn From How a Manager Invests His Own Money?, by Hal R. Varian, Economic Scene, NY Times: In the simplest textbook model of financial markets, companies pay cash dividends each year to their shareholders, who can then invest this money ... [in] its most profitable use. In reality, companies often retain earnings and invest them internally rather than distribute profits to their shareholders. Such behavior is generally considered detrimental for shareholders since it forces them to reinvest in the same company... Furthermore, these retained earnings can seriously distort corporate investment decisions. If a good investment arises that is too large to be financed out of existing cash reserves, companies may pass it up ... On the flip side, internal investments that are not particularly profitable may be financed just because there is a lot of cash on hand.

Why do companies retain earnings, if they reduce shareholder choice and lead to investment distortions? According to one theory, managers are overly sensitive to cash on hand because their interests are not fully aligned with shareholders. They would rather use retained earnings to buy corporate jets or walnut desks than pay more dividends. An alternative explanation rests on ... access to information: corporate insiders understand investment opportunities available to them better than the stock market, so they prefer to invest using internal funds rather than pay the higher financing costs associated with the stock or bond markets.

In the December 2005 issue of The Journal of Finance, Ulrike M. Malmendier of Stanford Business School and Geoffrey Tate of the Wharton School offer a new and provocative explanation ... They argue that this behavior is partly explained by the personality characteristics of the chief executive. The title says it all: "C.E.O. Overconfidence and Corporate Investment." Their explanation begins with the Lake Wobegon effect: we all tend to think that we are above average. ... Successful business executives are particularly susceptible to this affliction. An overconfident chief executive may well believe that he can value investments better than financial markets and thus decide that retaining and investing earnings is better for the shareholders than letting them invest the money themselves. Alternatively, whenever he does not have cash at hand, ... [b]eing overconfident, he feels that his company and his investment plans are undervalued by investors and bankers and, hence, finds that raising the equity or the debt to finance the project is too expensive.

One way to see whether executives may be overconfident in corporate investments is to look at their behavior in their personal investments. Top executives often receive large grants of options and stock as compensation. Having all your eggs in one basket is quite risky, and prudent investors diversify as soon as it makes economic sense. The authors determine a sensible policy for ... a chief executive and then identify those who depart from such a policy as "overconfident." They tend to be chief executives who exercise their options much later than would seem reasonable and hold more company stock than appears prudent.

The question is whether these executives ... also appear to be overconfident with respect to the corporate investments they control. ... They found ...[that] chief executives who appear to be overconfident in their personal investment practices seem to be particularly sensitive to cash flows in their corporate investment decisions. The authors also examine how other personal characteristics ... affect corporate investment decisions. Those with engineering or science backgrounds tend to be more sensitive to cash flow in making investments than those with a financial background. The chief executives who grew up in the Great Depression seem to be particularly influenced by cash on hand, perhaps because they developed a distrust of financial markets and a predilection for self-sufficiency.... A chief executive who sells shares may be signaling prudent investment behavior rather than pessimism about future prospects. Examining how a chief executive manages his own money may well signal how he will manage yours.

[Link to free version of paper, Journal of Finance Version]