Do Firms Choose Their Stock Liquidity? A Study of Innovative Firms and Their Stock Liquidity. Nishant Dass Vikram Nanda Steven C.

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1 Do Firms Choose Their Stock Liquidity? A Study of Innovative Firms and Their Stock Liquidity Nishant Dass Vikram Nanda Steven C. Xiao

2 Motivation Stock liquidity is a desirable feature for some firms Higher liquidity is associated with lower expected return on assets and thus lower cost of capital (Amihud and Mendelson,1986) Liquid stock, which incorporates more information in the price, plays a stronger role in monitoring the managers (Holmström and Tirole, 1993) However, not every firm may want or need liquidity facilitates market for corporate control; leakage of proprietary information..

3 Motivation Firms can adopt liquidity-enhancing policies to improve liquidity - Amihud and Mendelson (2000) suggest a number of means to increase stock liquidity including increasing investor base and reducing information asymmetry. - Many papers have linked changes in liquidity to firm actions such as equity issuance

4 Motivation However, evidence documenting the efforts of firms to improve the stock liquidity is lacking We ask whether firms choose stock liquidity by studying a group of firms that, we contend, are more reliant on equity financing: innovative firms

5 Motivation Firms with focus on innovation produce unique products Firms with unique products will have greater ripple effects of bankruptcy on their customers, suppliers, and workers. (Titman, 1984; Titman, Wessels, 1988) Innovative firms tend to have more intangible assets which have lower collateral value Therefore, innovative firms will have lower leverage ratios and more reliant on equity financing

6 Motivation We classify firms as innovative either by their investments in R&D or number of patents/citations Intuitively, one would expect innovative firms to have lower stock liquidity as their assets are informationally more opaque to the market However, we find that innovative firms are positively associated with stock liquidity, suggesting that these firms might be taking deliberate actions to improve their stock liquidity.

7 Motivation: Summary of Findings We identify that innovative firms indeed take actions that are known to improve liquidity: - Issue more frequent guidance (Coller and Yohn, 1997) - More likely to do stock splits (Muscarella and Vetsuypens, 1996; Lin, Singh and Yu, 2009) - More likely to make SEOs (Eckbo et al., 2000; and Kothare, 1997) - More likely to hire reputed underwriter (Amihud and Mendelson, 1988; Ellis, Michaely and O Hara, 2000) - More likely to have option listed (Mayhew and Mihov, 2004) More importantly, these actions do help innovative firms improve their stock liquidity

8 Motivation: Summary of Findings (cont) An exogenous increase in liquidity improves firm value and such effect is stronger for innovative firms - we find that this stronger effect is concentrated among innovative firms with more equity-based compensation Innovative firms are more likely to have access to public debt, higher credit rating, and fewer (quantitative) covenants in bank loans The role of monitoring is taken by equity holders - Innovative firms are associated with higher institutional ownership, higher likelihood of a blockholder, and higher equity-based compensation for managers

9 Hypotheses H1: Innovative firms have greater stock liquidity but less so when they have access to alternative sources of capital or less financially constrained H2: Innovative firms will take deliberate actions that are known to improve stock liquidity H3: The impact of a marginal increase in liquidity on value (Tobin s Q) would be greater for innovative firms

10 Data: Dependent Variables Four proxies for stock illiquidity Amihud s (2002) Illiquidity: Negative Turnover:

11 Data: Dependent Variables Bid-Ask Spread: Probability of Informed Trading (PIN) by Easley, Kiefer, O Hara, and Paperman (1996)

12 Data: Innovativeness R&D: ratio of R&D expenditure to lagged assets Log Patent: log( 1 + number of patents/100) Log Citation: log( 1 + number of citations/100) Innovation Index: first principal component of the correlation matrix for the three innovativeness measures.

13 Empirical Analysis: H1 To confirm the negative association between innovativeness and illiquidity, we estimate the following model: Firm characteristics includes: Log Assets, Leverage, Cash, Tobin s Q, NYSE Dummy, ROA, Tangibility, Firm s Age, Return Volatility

14 Empirical Analysis: H1

15 Empirical Analysis: H1 H1: Innovative firms have greater stock liquidity but less so when they have access to alternative sources of capital Test whether relationship between innovativeness and illiquidity is weaker when firms have access to public debt, high market power, and pay dividend:

16 Empirical Analysis: H1

17 Empirical Analysis: H2 H2: Innovative firms will take deliberate actions that are known to improve stock liquidity We test whether innovative firms issue more frequent earnings guidance, more likely to have stock splits, more likely to make SEOs, and more likely to hire reputed underwriter

18 Empirical Analysis: H2

19 Empirical Analysis: H2 H2: Innovative firms will take deliberate actions that are known to improve stock liquidity We test whether these actions indeed improve stock liquidity We instrument actions with industry median (or mean) of these action variables to rule out endogenous decisions

20 Empirical Analysis: H2

21 Empirical Analysis: H3 H3: The impact of a marginal increase in liquidity on value (Tobin s Q) would be greater for innovative firms We test whether an exogenous change in illiquidity negatively impact Tobin s Q First, instrument change in illiquidity with median change in illiquidity of the industry

22 Empirical Analysis: H3

23 Empirical Analysis: H3 Second, we look at an exogenous shocks to the firms stock illiquidity -- decimalization Specifically, we test whether change in illiquidity surrounding decimalization negatively impact firm value

24 Empirical Analysis: H3

25 Empirical Analysis: Debt of Innovative Firms What type of debt financing do innovative firms prefer? We argue that attempts of innovative firms at mitigating the information asymmetry in stock market benefit them in the debt markets Firm also lower the information asymmetry by generating information in the public debt markets Due to lower leverage ratio, innovative firms should receive favorably from creditors

26 Empirical Analysis: Debt of Innovative Firms We find that innovative firms: - Are more likely to have public debt - Higher credit rating - Fewer (quantitative) loan covenants

27 Empirical Analysis: Who Monitors Innovative Firms? Innovative firms have lower leverage ratio and fewer covenants in their bank loans Due to reliance on equity financing, equity holders assume the role of monitoring We find that innovative firms have greater institutional ownership, more likely to have blockholders, and higher equity-based compensation

28 Empirical Analysis: Who Monitors Innovative Firms?

29 Empirical Analysis: Does Incentive Contract Help? Innovative firms, whose assets and managers decisions are more opaque, benefit more from incentive contract We examine whether value effect of liquidity is greater for innovative firms with high equity-based compensation We test this again with the exogenous shock to liquidity (decimalization)

30 Empirical Analysis: Does Incentive Contract Help?

31 Concluding Remarks Innovative firms are positively associated with stock liquidity Innovative firms take actions to improve liquidity and these actions do work Innovative firms benefit more than others by having higher stock liquidity in terms of firm value

32 Concluding Remarks Innovative firms return to public capital markets, which helps reduce information asymmetry; their private debt is less likely to have covenant or fewer covenants if any Equity-holders assume the role of monitoring innovative firms As innovative firms have greater incentive contract, an exogenous decrease in illiquidity increases firms value more than other firms, consistent with the argument of Holström and Tirole

Do Firms Choose Their Stock Liquidity? A Study of Innovative Firms and Their Stock Liquidity

Do Firms Choose Their Stock Liquidity? A Study of Innovative Firms and Their Stock Liquidity Nishant Dass, Vikram Nanda, Steven Chong Xiao August 9, 2012 Abstract We ask whether firms can choose, or at