ITHACA, N.Y. -- Conventional wisdom has it that companies wanting to attract more institutional investors can do so by paying out more dividends. Not so, a new study by two Cornell University professors shows.

In fact, it turns out that companies attract more institutional investors by repurchasing shares of their own stock and paying out fewer dividends. The study, "Institutional Holdings and Payout Policy," by Roni Michaely, professor of finance at Cornell's Johnson Graduate School of Management, and Yaniv Grinstein, assistant professor of finance at the Johnson School, reverses earlier thinking on how companies actually attract institutional investors.

Institutional investors -- pension funds, mutual funds, banks and others -- are among the major investor groups in the United States, holding about 50 percent of equity in U.S. public firms, Michaely notes. In an era when people are losing confidence in corporations, those firms that attract more institutional investors are the best bets to thrive. Institutions are likely to be better investors than individuals, he says, because they can improve corporate value. They have more resources to study and monitor the firms they invest in, thereby inducing management at those firms to be more accountable for their actions. That, in turn, may spark the confidence of individual investors, prompting them to buy stock in the companies.

"Since the common belief has been that institutions like more dividends, some would argue that you can improve governance" -- as well as corporate value and investor confidence -- "by paying more dividends and attracting more institutions," says Michaely. "We find that is not the case. In fact, institutions prefer repurchases to dividends. So if a firm wants more institutional holdings, it should repurchase more in lieu of dividends."

Although their study shows institutions do prefer companies that pay dividends to companies that don't, it also revealed that paying fewer dividends is better. When a firm increases its dividend payouts, institutions tend to decrease their holdings, observe Michaely and Grinstein. Furthermore, acquiring more institutional investors does not lead a company to pay out more dividends, they note. The study suggests that pension funds and banks find dividends attractivemainly because of stricter "prudent-man" rules, rather than because of a sizeable payout. The findings reverse earlier assertions by other researchers that more dividends attract more institutional investors.

Michaely and Grinstein also test the causal relationship between institutional holdings and payout policy. They show that an increase in institutional holdings is not followed by a change in payout policy. Only after firms change their policy do institutions increase their holdings. This evidence suggests that institutions are not proactive in changing payout policy. Given the tendency of some managers not to pay out, but instead keep money in the firm and not always use the money optimally, this finding should send a message to institutions that they should play a stronger role in affecting firms' payout policies.

The researchers examined a large set of annual data on corporate dividend payouts and repurchases and institutional holdings from 1980 through 1996 and used regression analysis and other mathematical models to test past theories against the data and come up with their findings. The results of the study will be useful to companies seeking to attract institutional investors. For a copy of the study, contact the person listed at the top of this release.

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