All investors are not created equal. Each, whether individual or institutional, varies in the attention and resources — whether in time, ability, finances, computing power — he can devote to maximizing their investments. Typically the most sophisticated investors are active gatherers and users of information about firms, while the less sophisticated don’t cull as much high-quality information or are unable to make the best use of the information they do collect.
Because of these differences, says Professor Alon Kalay, what firms disclose and how they disclose it matters. In a recent paper, Kalay articulates a new way to detect whether investors in publicly traded firms are sophisticated or unsophisticated; he then correlates the relationship between what and how firms disclose to the types of investors who tend to invest in those firms. He calls this a disclosure clientele effect, the idea that if investors do vary in ability, sophisticated investors — those who build an information advantage — prefer to invest in firms that provide certain types of disclosures. Alternatively, less-sophisticated investors prefer to invest in firms that provide disclosures in a way that makes information easier to use.
A common proxy used to measure the sophistication of the investor base is to measure the percent of a firm’s shares held by institutional investors or specific types of institutional investors. The assumption then made is that these institutional investors are sophisticated. Kalay sought a more elegant method that would capture not just the percentage of shares held but how investors actually behave, arguably a more fine-tuned signal about investors’ abilities. To do so, he turned to the options market.
When investors buy call options on stocks, they can in some cases earn extra profit by exercising options early in an optimal manner. Kalay uses open (unexercised) options as a proxy for unsophisticated investors: leaving options unexercised that, if exercised early, could have led to higher profits likely signals an investor’s limited ability to gather and analyze relevant information. He established a measure of how sophisticated a firm’s investors are and found significant variation across firms.
Kalay’s next step was to look at his observed variations in the options markets in conjunction with different disclosure channels that public companies use to provide information to investors. Kalay looked at three types of disclosure:
Press dissemination. Some firms are more likely to be covered by the press than others, and press coverage is often viewed as a low-cost shortcut for culling important information about firms. Kalay found that unsophisticated investors concentrate their investments in firms with more press dissemination. “If the press publishes information in a more accessible manner than other sources of information, firms with increased press dissemination make it easier to gather and analyze information. Thus the more comfortable these unsophisticated investors may feel,” Kalay says.
Investor relations (IR). Kalay finds that firms rated highest for IR by industry publication IR Magazine are more likely to attract a greater proportion of unsophisticated investors. “As with the press, good IR departments issue information in a well-organized way and disseminate it in a way that is easy for investors to access.”
Earnings Guidance. Some firms issue earnings guidance on a regular basis, forecasting earnings for future periods. While this can help market watchers understand firms over time, there’s debate about how desirable this prevalent channel of disclosure is. Many firms worry that issuing forecasts will attract speculators, for one thing. Kalay finds that it is largely sophisticated investors who follow these firms. (The effect was larger before the implementation, in 2000, of Regulation Fair Disclosure, or RegFD, an SEC rule mandating that publicly traded firms provide disclosure to all investors simultaneously. But even post-RegFD, Kalay finds that the relationship between guidance and sophisticated investors remains strong.)
“You may expect a future single number to be easy and quick to understand, and for less sophisticated investors to prefer to invest in these firms,” Kalay says. “However, when you think about who plugs these forecasts into their spreadsheets, it makes sense that sophisticated investors utilize guidance more effectively.”
The 10,000-foot view is that more disclosure isn’t always better. “All investors are not created equal, and all disclosure activities are not created equal,” Kalay says. “Managers should understand that better disclosure may be a matter of substituting one form of disclosure for another, and we can’t just say that more disclosure will lead to a better regulatory environment, transparency, or a level playing field for all investors. What information firms release and how they release it matters.”
Alon Kalay is assistant professor of accounting at Columbia Business School.