Stock Duration and Misvaluation

1. Stock Duration and Misvaluation Inquire Europe Seminar Munich

2. Big Picture • Extensive debate on short-termism by institutional investors • Inefficient, myopic firm policies • Weak corporate governance • Stock prices deviate from fundamentals • … • But: Little empirical evidence

3. Research Questions • How short-term are investors? • How has investor horizon involved over time? • Is the presence of short-term investors related to mispricing? • Do short-term investors cause bubbles? • Does the presence of short-term investors predict future returns?

4. Main Results • Stock Duration has increased • New measure of holding durations (“Stock Duration”) of institutional investors • From about 1.2 years (1985) to 1.5 years (2010) • At the same time: Share Turnover increased from 72% to 300% • Stock Duration is related to mispricing • Mispricing goes up when short-term investors come in • Shorter Stock Duration associated with higher valuations • This leads to a predictable reversal pattern • Lower stock returns over the following period • Results stronger if limits to arbitrage are larger

5. Theoretical Background • Bolton, Scheinkman, and Xiong (2006) • Heterogeneous beliefs combined with short-sales constraints • Short-term investors make managers take speculative actions that lead to bubbles in stock prices • Daniel, Hirshleifer, and Subrahmanyam (1998, 2001) • Overconfidence leads to overreaction to private information which can lead to mispricing

6. Data • Sample • US common stocks • 01/1985 to 12/2010 • Exclude stocks in the bottom NYSE size decile and stocks with prices below USD 1 • Data • Institutional Investor Holdings Data from Thomson Financial CDA/Spectrum (13f filings) • Stock Returns from CRSP • Financials from Compustat

7. Calculating Stock Duration I • Investors can be long-term in some and short-term in other firms • Account for managers with different horizons managing portfolios within the same institution • Different from share turnover or institutional turnover • Intuitive Definition: • How long has a stock been in an institutional investor’s portfolio? • Quarterly holdings • Weighted by investment

8. Calculating Stock Duration II • Formal Definition: • Step 1: For each investor and stock • Bi,j= total percentage of shares of stock i bought by institution j between t = T-W and t = T-1 • Hi,j= percentage of total shares outstanding of stock i held by institution j at time t = T-W • αi,j,t = percentage of total shares outstanding of stock i bought or sold by institution j between time t-1 and t, where αi,j,t > 0 for buys and <0 for sells • Step 2: ComputeStock Duration at the individual stock level • Average institutional stock level Duration­i,j,T-1over all institutions currently holding the stock • Use as weights each institution’s total current holdings in the stock

9. Related Investor Horizon Variables • Transient Investors • Percentage ownership of transient investors (investors with high portfolio turnover and diversified portfolios) • Share Turnover • Number of shares traded divided by number of shares outstanding • Institutional Turnover • Weighted average of the turnover of institutional investors

10. Evolution of Stock Duration over Time

11. Stock Duration for Selected Companies

12. Stock Duration for Institutional Investor Types

13. Determinants of Stock Duration

14. Determinants of Stock Duration Stock Duration is smaller (shorter horizon) if there is more fundamental uncertainty (higher analyst dispersion or earnings volatility) and if past returns are high

15. Misvaluation and Stock Duration • Presence of short-term investors related to temporary price distortions? • Look at both contemporaneous and predictive relations between Stock Duration and misvaluation • Misvaluation measures • Market-to-book ratio • Misvaluation proxies (regression residuals) • Pastor and Veronesi (2003) • Hoberg and Phillips (2010)

16. Misvaluation and Stock Duration

17. Misvaluation and Stock Duration One standard deviation decrease in Stock Duration (shorter horizon): Increase in market-to-book ratio by 14.6% (higher misvaluation) One standard deviation decrease in Stock Duration (shorter horizon): Decrease in market-to-book ratio by 12% next year (lower misvaluation)

18. “Event Time” Results

19. “Event Time” Results

20. Role of Limits to Arbitrage Results are strongest when limits to arbitrage are largest

21. Results from Portfolio Sorts: Sorts on Stock Duration Long-short portfolio (long in stocks in the highest Stock Duration quintile and short positions in the lowest quintile: 3-factor alpha of (12*0.34%=) 4.1% per year

22. Double Sorts on Stock Duration and Misvaluation

23. Double Sorts: The Details CAPM alpha in the high MB ratio/lowStock Duration group: -0.41% per month CAPM alpha in the high MB ratio/high Stock Duration group: +0.18% per month

24. Portfolios: Further Results • Accounting for liquidity risk • Results robust to adding the Pastor and Stambaugh (2003) liquidity factor • Alternative measures for investor horizons • Cannot find the predictability results for those measures (share turnover, institutional turnover, transient investors) • Limits to Arbitrage • Create 5x3x2 triple sorts on Stock Duration, misvaluation, and proxies for arbitrage costs • Predictability results strongest if limits to arbitrage are large

25. Summary • Investor horizon did not decrease over time • From about 1.2 years in 1985 and to around 1.5 years in 2010 • Stock prices tend to go up (down) relative to fundamentals when short-term investors move into (out of) stocks • Predictable pattern of price reversals in stock returns • For example, a portfolio that buys (sells) stocks with long (short) durations creates annualized risk-adjusted return of 4%