Investor base, cost of capital, and new listings on the NYSE

The notion that investor base has an effect on share value has intuitive appeal and is strongly supported by “streetlore.” But standard finance theory, as represented by the familiar Capital Asset Pricing Model (CAPM) or its recent challenger, the Arbitrage Pricing Theory (APT), does not attribute any particular role to the size of investor base as a determinant of share values. Indeed, from the perspective of traditional finance theory, each of the corporate actions cited above is viewed as value neutral. Yet empirical research suggests that certain of these corporate practices are associated, at least on average, with an increase in share values. While various explanations have been offered for these increases in share value, the role of investor base has been largely unexplored.

In this article, we report the results of our recent study of 273 companies that during the 1980s decided to switch the trading locale of their shares from the over-the-counter (OTC) or NASDAQ market to the NYSE.1 We found that share prices increased by about 6%, on average, at the time the stocks became listed on the NYSE, and that the investor base of these firms increased by almost 20%. We also found that the average stock experienced a reduction in bid/ask spread of about 5% after listing. In an analysis of the relation among share prices, investor base, and bid/ask spread, we found that the stock price increase was significantly correlated with both the percentage increase in investor base and the reduction in bid/ask spread.

In short, our analysis supports the popular idea that an expanded shareholder base can increase a firm's stock price.

We are not, of course, the first to study the effect of an NYSE listing on share price. That honor appears to belong to a study published in the Journal of Business in 1937.2 Like most research on listings that came after it, this early study came to the conclusion that a new listing on the NYSE is associated with an increase in stock price.3 Financial theorists have tended to attribute this increase in value to the increase in “liquidity” that is said to accompany stocks that switch to the NYSE. Typical of this thinking is a 1986 study (involving one of the present authors)4 which argues that the differences in the market structure and means of transacting between the NYSE and the OTC market could lead to a lower cost of transacting and, therefore, greater liquidity. The greater liquidity, in turn, leads to a higher stock price.

We conducted our analysis on a sample of 273 NASDAQ stocks that became newly-listed on the NYSE during the period August 1980 through December 1989. This sample includes all stocks that listed over this period (except those that listed during October 1987) for which sufficient data were available to conduct the study. The sample covers a wide range of industries, with firms representing 50 of the 83 possible two-digit Standard Industrial Classification (SIC) codes. Of the 273 companies, 188 are industrials, 77 are financials, and 8 are utilities.

As shown in panel A of Table 1, the new listings were spread reasonably evenly throughout the decade. As shown in panel B, the sample is balanced between firms with a relatively long history of trading in the OTC/NASDAQ market and those with a short history of OTC/NASDAQ trading. For example, 26% of the sample firms had traded in the OTC/NASDAQ market for more than 10 years, while 31% had traded in the OTC/NASDAQ market for three years or less. Finally, as shown in panel C, the sample is not dominated by stocks with either very low or very high prices. The median price of the stocks just prior to listing was $19 5/8.

To determine whether listing on the NYSE during the 1980s was accompanied by an increase in stock price, we calculated each stock's rate of return (after adjusting for overall market movements) from the week that the company first announced that the stock would change its trading locale until the week the stock actually began to trade on the NYSE. This interval averages four weeks, with a maximum of 22 weeks and a minimum of one week. Of the stocks in the sample, 69% earned a positive market-adjusted return over this interval and the average market adjusted return was 5.8%. On an annualized basis, this amounts to an “excess” return of almost 70%.

Clearly, during the 1980s, listing on the NYSE was accompanied by a boost in shareholder wealth.

As we noted, traditional finance theory does not attribute any particular role to investor base as a determinant of share values. But, in his 1987 Presidential Address to the American Finance Association, Robert Merton proposed a theory of asset pricing based on the premise that investors invest in only a subset of all available securities.7 To support his premise, he posits that investors—perhaps because it is costly to gather and assimilate information— have limited ability to be aware of the almost limitless set of available securities. He also observes that some institutional investors are restricted in the types of securities in which they can invest.

The net result of Merton's analysis is a model of asset pricing in which investor base plays a prominent role. In particular, the Merton model extends and supplements the traditional Capital Asset Pricing Model (CAPM) model of security pricing by including a second risk factor (the first, of course, is beta) that depends upon the size of a stock's investor base. The smaller the investor base, the higher this risk factor and thus the higher the stock's required rate of return. Or, to put it differently, in Merton's version of the CAPM, actions that management takes to increase the firm's investor base can reduce the firm's cost of capital and so increase its share price.

From our perspective, Merton's model accomplishes two things. First, it provides a theoretical justification for corporate management's concern with investor base. Second, the model provides the conceptual framework in which we conducted our statistical analysis of the effect of investor base on stock price when shares become listed on the NYSE.

The first set of terms, R_f + B_k[E(R_M)−R_f], represents the expected return according to the familiar CAPM. The new term, I_k−B_kI_M, is an additional risk premium that reflects investors’ compensation for investing in companies with a smaller investor base.

The investor base risk premium has two components: a firm-specific component, I_k, which reflects the degree to which a specific firm's investor base is less than “complete”; and a market-wide component, B_kI_M, which reflects the degree to which the average firm's investor base is less than complete.

According to the model, then, a change in the cost of capital brought about by a change in investor base is equal to the change in I_k. Therefore, to determine whether a 19% increase in shareholder base can explain a 6% increase in stock price, we have to assign values to the various components of l_k. Because the annual non-beta risk for a typical stock is about 8%, we begin by assuming that S²_k = 0.08. The average market value of equity for the firms in our sample was $290 million, and the market value of all stocks traded on the NYSE, AMEX, and the OTC market at the time was approximately $3.5 trillion8 (thus making M_k = 290/3,500,000, or .00008). Suppose that a firm had 10,000 shareholders before listing and there are approximately 40 million shareholders in total (making Q_k = 10,000/40,000,000, or 0.00025). Finally, empirical studies of aggregate risk aversion suggest that A = 2 is a reasonable estimate.9

Putting each of the above values into equation (1), we estimate the average I_k of the firms in our sample to be 0.053 prior to listing. This can be interpreted as saying that the average firms’ cost of capital before listing on the NYSE contained an investor base risk premium of roughly 5.3%.

If we then repeat the same calculations with 12,000 shareholders (which represents a 20% increase from 10,000), the firm's post-listing I_k falls to 0.044. Thus, the annual expected return on the average stock in our sample is now 0.9% (0.053–0.044) lower than it was prior to listing. If we assume that the expected return on the average stock prior to listing was 15%, a reduction of 0.9% in the cost of capital translates into a one-time increase in stock price of 6%.

In short, using Merton's model with reasonable parameters, we can explain our reported 6% increase in share prices solely in terms of the effect of increasing investor base.

A Liquidity Model. As we mentioned at the outset, earlier empirical studies have typically attributed the increases in value that come with new listings to increases in liquidity that supposedly accompany such listings. In a 1986 study, Yakov Amihud and Haim Mendelson developed a theoretical model of asset pricing and liquidity as measured by bid/ask spread.10 In their model, a stock's expected return declines along its bid/ask spread.

Thus, if listing reduces a stock's bid/ask spread, this model predicts an increase in the stock price. The Amihud and Mendelson model provides the theoretical underpinnings for our empirical analysis of the relation between stock prices and bid/ask spread when stocks list on the NYSE.

As we also noted, our first look at the data showed that new listings are associated with an increase in investor base and a decrease in bid/ask spread. To determine which, if either, of these factors can explain the increase in stock price that accompanies a new listing, we estimated a multiple regression in which the dependent (“left-hand-side”) variable is the stock's market-adjusted return over the listing period and the independent (right-hand-side) variables are the changes in the stock's investor base risk premium and bid/ask spread after listing.

Based upon the results of the regression analysis, both of the independent variables are statistically significant. In the parlance of econometrics, both the change in investor base and the change in bid/ask spread help to “explain” the increase in stock price that accompanies a new listing.

For widely-held stocks, the effect of the investor base factor on expected returns is likely to be modest at best. But, for firms with few shareholders, a small investor base could significantly increase the firm's cost of capital. This suggests that managers of firms with few shareholders have an incentive to take actions that expand their firm's investor base.

We have cited a number of corporate practices designed to expand investor base: stock splits, the hiring of shareholder relations officers, meetings with security analysts, the issuance of ADRs, and the listing of shares on major domestic and international exchanges. Others come to mind. For example, firms that issue equity can choose an underwritten as opposed to a rights offering. In an underwritten offering, the newly issued shares reach new investors, thereby expanding the firm's investor base; whereas in rights offering they do not. Another way in which a firm might expand its investor base is through scheduled press releases that generate media coverage and increases investor recognition of the firm. Or perhaps the initiation of a scheduled dividend policy making the firm eligible to investors prohibited from investing in non-dividend paying stocks may have the effect of increasing investor base. In general, any action that eliminates a constraint on investors’ ability to hold the security is likely to increase the investor base. Such constraints may be deliberate, such as “prudent investor” rules that prohibit funds from investing in particular types of stocks, or they may arise unintentionally from information constraints that result in a lack of awareness by investors.

Of course, actions to increase the investor base, like almost all decisions, involve a cost/benefit tradeoff. Whether the benefits of a particular action exceed the costs requires the quantification of each. Merton's model provides a framework within which such decisions can be analyzed. Our empirical analysis gives some indication of the effect of investor base on stock value.