How Beneficial is the Financial “Democratization” Movement?

Is it better for a company’s shares to be owned by large investors or small investors, institutions or retail investors?

Last week, the brokerage and trading platform Robinhood raised $2 billion through an initial public offering (IPO) of stock. But it was no typical IPO. Instead of only selling stock through investment banks to their wealthy clients and to institutions, Robinhood also allocated up to one-third of the offered shares to their own customers, mostly retail investors. According to media reports, more than 300,000 Robinhood customers participated in the IPO and purchased around 20% of the offered shares. This episode was reminiscent of an earlier attempt to “disrupt” IPOs, when Google decided to conduct their 2004 IPO through a Dutch auction in which all types of investors, whatever their resources, could enter a bid for Google shares.

Both of these firms were likely motivated by the belief that a shareholder base of small and (hopefully) loyal individual investors would be advantageous for their businesses. This follows in the recent footsteps of another firm, the movie theater chain AMC Entertainment, focusing on the cultivation of a loyal retail investor base. AMC’s CEO, Adam Aron, adopted a targeted media campaign for attracting and maintaining its Reddit-oriented investor base of “apes”, including offering free popcorn to AMC’s investors, tweeting memes (see below), and donating to the Dian Fossey Gorilla Fund in their honor. [Alas, he has not yet donated to the Blindfolded Chimpanzee blog, and is unlikely to do so if he ever finds out about my earlier blog post on AMC’s ridiculous valuation.]

And the hilariously funny memes keep coming. pic.twitter.com/mG7B6G6wuy

— Adam Aron (@CEOAdam) May 12, 2021

The recent boom in small investor interest in stock ownership and trading, and attempts by companies to attract this demographic into buying their shares, leads to the following question: Is it better for a company’s shares to be owned by large investors or small investors, institutions or retail investors? There is no simple answer as there are pros and cons to each side, and any advantages and disadvantages depend on who we are talking about. But if one’s (detached) goal is the maximization of sales, profits, and business success, the case for less direct holdings by retail investors has the preponderance of the evidence behind it.

In finance as in politics, it’s possible to have too much democracy.

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The PRO side

Proponents of having a larger fraction of company shares owned by retail investors argue that wealthy individuals, and especially institutions, are less “loyal” to the firms they own, more focused on short-run prospects, and more likely to sell shares in response to a bad announcement leading to stock price declines.

Another way to say this is that institutional investors, who are hired to manage money on behalf of others and employ professionals with expertise in stock valuation, are more “price conscious”, in the sense that they are unwilling to hold stocks that are overpriced and thus have lower future expected returns. In contrast, retail investors are more likely to attach value to a company’s non-financial characteristics: for example, whether they are also customers of the company’s goods or services, whether the company is socially responsible, or the “coolness” of its CEO.

The bottom line is that a larger retail investor base is associated with greater stock volatility and stock prices that are less precise signals of the firm’s underlying value. Under limits to arbitrage, they are also more likely to be overpriced because it is harder and costlier to arbitrage away overpricing (through short selling) than underpricing (through buying).

So how does having an artificially-inflated stock price help a firm’s business? Several ways. The firm can raise more money than it otherwise would by selling its stock, lowering the firm’s cost of capital and allowing it to invest in more projects or to repay its debt. For instance, AMC has raised hundreds of millions of dollars this year through stock sales, allowing it to survive a tough period when its revenues declined 90% due to the pandemic. Firms can also take advantage of their overpriced stock to purchase other businesses, as AOL famously did with Time Warner at the peak of the dot-com bubble. Finally, it’s advantageous to founders and executives with large stakes in the firm who can sell shares in the secondary market for more than they would otherwise receive.

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The CON side

On the other side of the ledger is the large academic literature on the principal-agent conflict between shareholders and corporate managers, and how best to address this issue. As Michael Jensen and William Meckling describe in their 1976 seminal paper, Theory of the firm: Managerial behavior, agency costs and ownership structure, the crux of the problem is that the folks running the firm (e.g., the CEO, CFO, etc.) make decisions that are in their own best interests, but not always in the best interests of the firm’s owners, i.e., the stockholders. The board of directors is theoretically supposed to ensure that managers are making the right decisions for shareholders, but in reality, it is often “captured” and in cahoots with management.

One way to address this problem is to give managers financial incentives such as stock options which align their interests closer to those of shareholders. Another way is by monitoring them; if managers feel there is someone “looking over their shoulder”, they are more likely to make the right decisions. Unfortunately, an investor base of small investors is not conducive to extensive monitoring due to the free rider problem. Since monitoring takes time, energy, and money, each small investor doesn’t have the incentive to do it herself, and would prefer to let someone else incur the monitoring costs while reaping the benefits from the improved managerial behavior.

In their 1986 paper entitled Large Shareholders and Corporate Control, Andrei Shleifer and Robert Vishny analyze the role of a blockholder, a minority shareholder with a large stake in the firm. Their main takeaway is that in addition to blockholders playing a larger role in monitoring, they can also help facilitate takeovers of firms with poor management, the threat of which helps discipline management and increase firm value. More recent research shows that even passive institutional investors like index funds use their voting power for improved firm governance, leading to better firm performance.

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Conclusion

The recent trend toward democratization of investing has seen some firms actively trying to cater to and attract a shareholder base of small investors. While this can be beneficial in the short-run for some firms, especially ones looking to raise capital by selling stock, it can be costly in the long run if management starts to operate in a way that is not in the best interest of its stockholders. In finance as in politics, it is possible to have too much democracy.  

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