Published with permission from Knowledge @ Wharton, Wharton's online business journal.
Making corporate disclosures widely available definitely benefits investors and companies, but it could have unintended downsides, too, according to a recent paper by Wharton finance professor Itay Goldstein, Shijie Yang, assistant professor of accounting at the Chinese University of Hong Kong, and Luo Zuo, associate professor of accounting at Cornell University.
“Broader information dissemination leads to a decrease in the cost of capital and an increase in the level of equity financing and corporate investment,” they said in their paper titled “The Real Effects of Modern Information Technologies: Evidence from the Edgar Implementation.” But they also found that “greater dissemination of corporate disclosures crowds out investors’ private information acquisition and reduces managerial learning from stock prices.”
The authors arrived at those findings based on a study of more than 3,000 companies that used the Electronic Data Gathering, Analysis, and Retrieval (Edgar) system in the U.S., the regulatory mechanism since 1993 for electronic filing of corporate financial statements and other reports. “This setup allows us to examine how a shock to the dissemination of information from the firm to the market, brought by technological advances, affects corporate investment, and what the implications are for the efficiency of capital allocation and investment decisions,” the paper stated. The authors studied those impacts of regulatory filings between 1993 and 1996, the period during which Edgar was implemented in phases.
“If there is more information that is easily available about a firm, then new investors will feel that they are less in the dark, and they will feel more comfortable giving money to the firm,” said Goldstein. While that direct effect is the intended positive outcome, there is an indirect negative effect on the investment sensitivity to stock prices: “an indication that managers are relying less on the price when they invest.” In other words, managers are not able to glean new information from stock prices about the investment appeal of their firms’ projects and base their investment decision on such insights.
Lower Cost of Capital and Revelatory Price Efficiency
Goldstein explained the mechanism by which the cost of capital falls for firms with more widely available information: Investors who do not have all the information they need might feel they are being shortchanged compared to better-informed investors. Such investors, who are exposed to high levels of uncertainty, will demand a higher return, which implies a higher cost of capital. But once that information is more widely disseminated, then investors will not be as concerned that they might be taken advantage of, and consequently, they would accept a lower return for their investment. “This allows the firm to invest more; it relaxes the financial constraint of the firm,” he added.
The paper also explained how the Edgar implementation affected revelatory price efficiency. In a market with uneven information dissemination, investors try to gain an advantage by acquiring information that is not disclosed by firms and might not be otherwise known to firms. They typically evaluate a company’s growth opportunities by analyzing market trends, competition and consumer demand, and with inter-firm comparisons. But once more information is available to everybody (through mechanisms like Edgar), investors have fewer incentives to acquire additional information. That then also reduces the quality of the signals they send through stock prices.
“Prices in general can reveal information to managers about how good their investment opportunities are, relative to other opportunities that the firm may have,” said Goldstein. Essentially, revelatory price efficiency is the ability of managers to update their assessment of their investment options based on the market price of the firm’s shares and make more informed investment decisions, he added.
Impacts on Growth vs. Value Firms
The paper sharpened the effects in terms of growth firms and value firms, which it based on their market-to-book ratios in 1992, the last year before Edgar was implemented. It defined a value firm as one whose market-to-book ratio in 1992 was below the median, while that ratio would be above the median for a growth firm. Learning models assume that investors are unlikely to possess new information about a firm’s assets in place since managers observe first-hand information on these assets, the authors noted. However, investors of growth firms are likely to possess more information that is new to managers than the investors of value firms.
“We went into the value versus growth distinction to take a closer look at that effect – investment relying on price,” said Goldstein. “That effect should be more prominent for growth firms, because they have more speculative investment opportunities than value firms. As a result, they may benefit more from the insights in the price and learning from the price. We found that after Edgar implementation, performance deteriorated for high-growth companies.”
The study found that that Edgar implementation led to a 10% increase in the level of corporate investment, on average. That increased level of investment can be driven by improved equity financing in value firms. “On average, Edgar implementation leads to an increase in firm profitability and sales growth in value firms, but hurts performance in high-growth firms where managerial learning from the market is particularly important,” the paper stated.
How Wider Information Access Crowds Out Savvy Investors
The study found that Edgar implementation resulted in a 20% decrease in the investment-to-price sensitivity. That pointed to a crowding-out effect, which reduces the ability of firms to use new information in prices as guidance for their investment decisions, the authors explained.
The crowding-out effect is pronounced among institutional investors because they lose their information advantage, Goldstein said. Institutional investors are typically more sophisticated than the average investor, and they also may have had access to firms’ disclosures before they became widely available. “It takes time to develop high-precision signals, and the trading profits based on these signals are reduced when low-precision signals have already been reflected in prices,” the paper noted.
With those divergent outcomes of information dissemination, what are the final takeaways? “It is important to consider the tradeoff between financing and learning from prices when evaluating the real effects of modern information technologies,” the paper stated. On the one hand, fintech innovation through big data or machine learning techniques will make the investing public obtain more information at relatively low costs, which in turn would increase forecasting price efficiency, the researchers wrote.
On the other hand, they found that such innovation might dampen investors’ incentives to engage in private information acquisition and reduce managerial learning from prices. Also, contrary to what one might assume, “greater information production and dissemination may not necessarily enhance the welfare of investors as they can lead to a reduction in risk-sharing and trading opportunities among investors,” the authors added.