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Neglected disciplinary effects of investor relations: evidence from corporate cash holdings

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Abstract

We examine whether, and how, investor relations (IR) quality affects managerial malfeasance by exploring the potential effects on the value, accumulation, and uses of cash holdings. Using European data, we find that an increase in the IR quality rank from the lower quartile to the upper quartile raises the marginal value of cash, on average, by €0.40 to €0.69. The effect is more pronounced for firms with weaker (stronger) external (internal) governance structures. We further document an inverted J-shaped relationship between IR quality and the propensity of firms to hoard cash. Specifically, higher-quality IR initially constrain the propensity of firms to accumulate cash; however, the effect is partially reversed as IR quality rank exceeds 0.69. Cash-rich firms with lower-rated IR programs are also more likely to dissipate cash through value-decreasing capital expenditures. Unexpectedly, IR quality seems not to matter for acquisitions and R&D spending nor for repurchases. Instead, IR quality has a negative impact on the propensity of firms to pay dividends, which attests to the shareholder power hypothesis. Overall, we show that higher-quality IR are a market-based approach to increased investor protection that effectively constrain both the profusion and insiders’ negligent allocation of corporate liquid assets. Actually, visibility improves firm transparency, making possible processes of managerial subjection to investor rights.

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Notes

  1. By way of comparison, studies on disclosure quality (e.g., Huang and Zhang 2012) and governance quality (e.g., Dittmar and Mahrt-Smith 2007) report an interquartile range of $0.60 and $1.2, respectively. Moreover, Pinkowitz et al. (2006) find that cash is worth $0.33 ($0.91) in countries with poor (higher-quality) institutions.

  2. Admittedly, conflicts of interest or implicit incentives on the side of these “watchdogs” might even exacerbate agency problems rather than mitigating them. To develop our hypotheses, we instead abstract from implicit incentives of external monitors, thus empowering these market participants to be the guardians of investors’ rights.

  3. On behalf of the magazine Capital, the DVFA each year administers web-based questionnaires to more than 400 affiliated analysts and fund managers in about 300 financial institutions, and commissions a researcher to compute a score of the quality of IR departments of the most important German and European companies. This database covers 308 distinct firms included in five European equity indices: EURO STOXX 50, DAX, MDAX, TecDAX, and SDAX. The firms are regrouped in ten ICB (level 3) sectors: Basic Materials (21), Consumer Goods (33), Consumer Services (35), Financials (56), Healthcare (26), Industrials (68), Oil and Gas (19), Technology (32), Telecommunications (8), and Utilities (10).

  4. The DVFA principles for effective capital market communication can be downloaded using the link: www.dvfa.de/verband/publikationen/effektive-finanzkommunikation/ (accessed August 29, 2014).

  5. Given the potential for a correlation between IR quality and disclosure quality, in untabulated analyses we control for disclosure quality using analyst forecast dispersion (DISPERA) and analyst forecast errors (ERRORF) as proxies for earnings guidance and disclosure quality. We also use firm-initiated media-target disclosures (PDISC), as measured by the log of the number of firm-initiated articles in Factiva (e.g., Bushee and Miller 2012). In addition, we use idiosyncratic risk (IDIOR), because firms with high idiosyncratic risk have greater incentive to seek investor recognition (Merton 1987). Akin to Ali and Kallapur (2001), we add an indicator variable, LITIG, and expect a positive association with IR quality “because firms in highly litigious industries may have a greater need to manage communications with investors and analysts” (Kirk and Vincent 2014, p. 1431). Governance characteristics (GOV) are captured by board size and CEO duality. We control for board of directors’ effects using board size that is reported to have two competing effects on corporate decision-making: enhanced monitoring (Boone et al. 2007) and rigidity of decision-making (Yermack 1996). Because all the variables mentioned in this footnote do not alter the inferences (many of them are indeed insignificant), we decide to use the parsimonious model shown in Eq. (2).

  6. To that extent, perceptions of IR quality seem to be subject to a cognitive bias, the “halo effect.” That is, if a firm has strong and predictable performance, the analyst or investor will have a positive view toward the firm that will positively bias their rankings of IR quality for that firm. If a firm has poor or volatile performance, then even very credible IR programs will tend to be rated negatively because the management team is viewed as low-quality based on the performance of the firm. Therefore, to increase the integrity of our analysis, we test the (1) information transmission, (2) hyping, and (3) rating bias hypotheses as formulated in Jiao (2011). For IR quality to be the driving force behind the effect we document in this study, we should provide evidence in support of the information transmission hypothesis that implies that future operating performance is related to current IR quality (Jiao 2011, p. 651). While we unambiguously reject the hyping hypothesis, we fail to completely rule out the rating bias hypothesis, as current IR quality impacts positively and significantly on current operating performance. Reassuringly, we attest to the information transmission hypothesis given that current IR quality contains relevant information about future operating performance, substantially weakening the rating bias hypothesis (see also Sect. 4.4; more detailed results are available upon request).

  7. The existing literature suggests that investments in internal, professionalized internal IR can partly be explained by mimetic processes (Rao and Sivakumar 1999). To address the concern whether this spills over to IR quality, we integrate not only peer characteristics but also their actions (in their lagged form to allow for emulation). In 3 out of the 5 models shown in Table 2, lagged values of peer firms’ operating performance adversely affect the perceptions of the quality of a firm’s IR programs. In contrast, we find no evidence of firms engaging in higher-quality IR programs solely because their peers are doing so. If anything, we find in unreported analyses that there are signs of proxy effects where firms simultaneously increase IR quality because they potentially share similar characteristics or because they are exposed to similar institutional constraints.

  8. We obtain this figure as follows: €0.88 = 0.348 − 0.0451 × 0.3487 − 0.0457 × 1.5332 + 0.6609 × 0.7712 − 0.1005 × 0.57 + 0.0381 × 2.1632 + 0.9749 × 0.0841.

  9. We obtain similar results when we consider only the lower and the upper quartiles of the distribution of IR ratings. The sample size alone is significantly reduced, particularly when we impose the restriction that excess cash needs to be positive.

  10. We obtain similar, albeit weaker, findings when we use CASH and XCASH as alternative measures of liquid assets. These untabulated results are available from the authors upon request.

  11. Column (2) in Table 5 suggests that, even if the coefficient estimates on the IR quality variables are higher than in column (1), the inferences are robust to omitting the indicator variable, splitting the sample in firms with IR quality above and those with IR quality below the median (i.e. 0.5). When we use TIRS instead of IRRANK, the coefficient on TIRS is −0.76 (p < 0.001) and +0.22 (p = 0.096) on its square (untabulated).

  12. This threshold is even as low as 0.57 in the RHS plot of Fig. 1, where the dependent variable is excess cash and equivalents (XCASHEQ).

  13. In untabulated analyses, we also have examined the role that IR quality plays in acquisitions, R&D expenditures and share repurchases. However, we find no significant effects. The insignificant effect of the interaction of cash items and IR quality in acquisition regressions may stem from the existence of possible alternative means of payments in merger deals such as stock-financed deals. These results are available from the authors upon request.

  14. The lowest figures in Table 8 pertain to model (4) and are €0.83 and 0.44€ for firms with IR quality above the median and below the median, respectively. Also, in unreported analyses, we use a logit model (dependent variable is an indicator variable whether IRRANK is above the median) to estimate Eq. (2) and use the fitted probabilities in Eq. (1). This specification yields results reported in Tables 3, 4, and 8. These unreported results are available upon request.

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Acknowledgments

We would like to thank the Society of Investment Professionals in Germany (DVFA) for making their data available to our study. Houdou Basse Mama gratefully acknowledges the financial support from ESCP Europe Business School (Grant No. EERF 2014). We thank Nicolas T. Koch and seminar participants at the University of Hamburg and ESCP Europe (Berlin Campus) for useful comments. Any remaining errors are our own.

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Authors and Affiliations

  1. ESCP Europe Business School, Heubnerweg 8-10, 14059, Berlin, Germany

    Houdou Basse Mama

  2. University of Hamburg, Von-Melle-Park 9, 20146, Hamburg, Germany

    Alexander Bassen

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  1. Houdou Basse Mama
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  2. Alexander Bassen
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Correspondence to Houdou Basse Mama.

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Table 9 Variable definitions
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Basse Mama, H., Bassen, A. Neglected disciplinary effects of investor relations: evidence from corporate cash holdings. J Bus Econ 87, 221–261 (2017). https://doi.org/10.1007/s11573-016-0818-4

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