Inertial behavior: Present among investors and institutions

Most of finance theory revolves around the idea that investors are constantly considering all available information when building and maintaining their portfolios. However evidence exists suggesting that individuals behave in a way that could be considered inertial or taking the path of least resistance. In other words, individuals often don’t initiate evaluation of newly available information and fail to actively manage their portfolios accordingly. In this paper, Corporate Financing Decisions When Investors Take the Path of Least Resistance, Malcolm Baker, Joshua Coval and Jeremy C. Stein set out to explore this notion of investor inertia and its effects on equity financing especially in a merger. Evidence shows that about 80 percent of individuals hold onto their newly acquired shares after a merger and display inertial behavior.

The major implication of investor inertia argued in this paper is that it reduces the negative price impact acquirers typically see in a stock-for-stock merger. However this will only occur if two conditions hold. First, the acquirer’s shares must be facing a downward sloping demand curve, which occurs due to differences in opinion of the value of the acquirer firm’s existing assets. Second, there must be some target firm investors that will hold the new company’s shares post merger that would not have actively made the decision to invest in the acquirer before the merger.

To further explain the inertia theory, the authors lay out a model that demonstrates how investor inertia affects equity financing in mergers. The basic set up of the model is as follows. There is a group of investors who all value the acquiring company’s assets differently (referred to as A-specialists). Those that value it above the current market value currently own the acquirers shares, while the others, with lower valuations for the shares, sit out of the market. In a stock-for-stock merger the investors in the target firm (T-investors) will be handed shares of the newly merged firm. If these investors realize that they are now holding a stock they otherwise would not have invested in, it would be expected that they immediately sell there shares in the open market. The people who would end up buying these shares are those less optimistic A-specialists who were previously out of the market, but are now willing to participate as the market value of the shares has dropped due to the increased price pressure. From this one can see how the firm would be better off if the T-investors simply held onto their shares, there wouldn’t be as great negative price impact.

After explaining the model the authors then support their theory that investor inertia is in fact a relevant issue when mergers occur. They separately examine institutional and individual investors tendencies to hold shares handed to them in a merger. They focused primarily on situations where there weren’t many crossover investors, meaning no investors already holding shares in the acquirer and the target firm. The evidence they gathered led to an estimate that about 80 percent of individuals hold onto their newly acquired shares after a merger and display inertial behavior. For institutions the number was less, but still significant, about 30 percent of institutions were estimated to display inertial behavior. Given that individuals appear to be much more likely display inertial behavior, it should be observed that the negative price impact on an acquirer in a stock-for-stock merger will be greater if the target firm has more institutional than individual shareholders. They also examined the trading volume around merger announcements comparing the differences in trading volume for individual and institutional investors. Their findings supported their hypothesis and showed that the acquirer has more trading volume around the announcement date when the target company has a higher proportion of institutional shareholders. This provides further support that that the return effects post-merger are in fact a result of price pressure.

One might believe the cause of this inertia could be attributed to something such as the presence of capital gains tax, or the fact that the target is large and investors believe it will help the acquiring firms performance. And thus they will want to hold onto their shares. When these factors were controlled for, the data showed no significant affect on the amount of individuals or institutional investors that displayed inertial behavior. Testing for other specifications such as these, the authors do a good job presenting robust evidence for their hypothesis. They conclude that when firms are facing downward-sloping demand curves, stock-for-stock mergers may be the best way to support a strategy of rapid, equity-financed growth.