The Margins of Investment and Price Inertia

J.W. Mason has another excellent blog pointing out that even though risk-free rates are very low, the hurdle rate for new investment remains high, creating a situation in which there is insufficient investment when firms at least appear to respond to revealed shareholder preferences.

I think there are two factors at play here.

First, it’s not the passive investor that prices the firm. The investor that buys the market basket explicitly removes himself from the decision to price the earnings of the firm relative to the earnings of the market basket. It is only someone who takes an outsized position in the firm that is able to price it relative to the market return.  Not everyone can be a passive investor.

That means that if you are sending price signals to the firm, then you are an activist investor that is is shorting the firm and going long the market, or shorting the market and going long the firm. Therefore you can send a signal to the firm or you can be on the efficient frontier, but not both. It is as if signaling the firm is inherently expensive — and you need the firm to earn an excess return just to break even between spending the money to send the price signal or not caring about the price of the firm at all. But the firm only pays attention to those investors who care about its price. This gives rise to inertia, in which a reduction in the market return does not correspond to a reduction in the hurdle rate as signaled to the firm by investors. It also means that in many cases it is more efficient for the firm to ignore investors over the short run. The first factor is the cost of sending price signals or information inertia.

The second effect would be that entering new markets or creating new products is more risky than replacing depreciated capital in established markets. Think, for example, of the risks that Apple took with the introduction of the Apple Watch. At present, it is an enormous risk. What do you think is the chance that the risk pays off? 50/50? Once we know what the demand is, we have new information, and the cost of supplying capital for the Apple watch will decline, but by that time, investments on the margin will be dominated by other risky ventures. So the second effect is that the acquisition of information is expensive, and these costs dominate the risk free rate in forming a barrier to investment on the margin.

The Margins of Investment and Price Inertia

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