Friday, July 30, 2004

SEC probes Krispy Kreme accounting and Donuts are not a health food

SEC probes Krispy Kreme accounting - Jul. 29, 2004: "Krispy Kreme Doughnuts Inc. announced Thursday that the Securities and Exchange Commission was conducting an informal, non-public probe into the company's accounting."

The stock, which is down over 67% since last August, fell about 15% on the news.

This just continues a very bad year for the firm. In May the company's executives were sued for "disregarding signs that the company had expanded too quickly, that its wholesale business undermined sales at its retail stores, and that it faced stiff competition."

The current problems stem from the accounting treatment of the company's repurchasing of franchises and its May earnings forecast. As the Motley Fool reports, at least one of the repurchases was from the CEO's ex-wife.

Gee, what is this world coming to? The next thing you know someone will come out with a study that donuts are high in calories. ;)

additional sources:

Leverage decision and manager compensation with choice of effort and volatility

Leverage decision and manager compensation with choice of effort and volatility

Cadenillasa, Cvitani and Zapatero (CCZ) in an upcoming Journal of Financial Economics (JFE) paper, model the incentive effects of paying executives with either levered, or unlevered, equity.

Their model, which is probably too complex to use in most undergraduate classes, separates managers based on ability level. The authors conclude that “levered stock seems to be the optimal compensation for high-type managers, while unlevered stock is optimal for low-type managers.

The intuition is that the risk-neutral shareholders would like the manager to take more aggressive actions than the manager would otherwise prefer. Levered stock provides the correct incentives to good managers, as they will be more willing to take greater risk because their higher ability will enable them to correct a possible bad state through more effort.

However, low-type managers will be reluctant to accept the risk that comes with the extra (increase in) leverage, as they are more averse to the possibility that the value of the firm drops rapidly in price. For low-type managers, it follows that unlevered stock will be the preferable type of compensation.” (paragraph breaks inserted).

Additionally the model shows that levered equity grants are less favorable for risky firms, firms with little positive momentum, and smaller firms.

Even though the authors are careful to point out that the paper is dealing with the optimal grant of levered or unlevered shares, and hence a compensation paper, it may well have ramifications on capital structure as well. For instance, if we allow other things to remain constant it could be argued that firms with better management should have higher levels of leverage. Interesting!

Lifting the Veil: An Analysis of Pre-Trade Transparency at the NYSE by BOEHMER, SAAR, AND YU

Lifting the Veil: An Analysis of Pre-Trade Transparency at the NYSE by BOEHMER, SAAR, AND YU

Boehmer, Saar, and Yu give us an interesting look at how transparency affects trading. Specifically they examine how trades happen at the NYSE after the 2002 adoption of OpenBook. OpenBook is "allows traders off the NYSE floor to observe depth in the book in real time at each price level for all securities. Before the introduction of OpenBook, only the best bid and offer (representing orders in the book, floor broker interest, and the specialist's own trading desires) had been disseminated."

The current paper empirically examines the theoretical predictions of previous authors who have hypothesized that allowing traders to know more, may affect how they trade. For instance "Harris (1996) discusses two risks that are associated with the exposure of limit orders: (i) A trader may reveal to the market private information about the value of the security, and (ii) exposed limit orders can be used to construct trading strategies aimed explicitly at taking advantage of these limit orders."

This of course is not surprising. If you know what the other traders are doing (or are willing to do), that information will almost certainly influence your own trading.

Boehmer, Saar, and Yu find some confirmation of this: "After OpenBook is introduced [we] find a higher cancellation rate and shorter time-to-cancellation of limit orders in the book. We also find smaller limit orders after the change in transparency. This evidence is consistent with the idea that traders attempt to manage the exposure of their orders." (pp. 2-3)

OpenBook also impacts those who work at the NYSE. For instance the authors report "We find that the specialist participation rate in trading declines following the introduction of OpenBook. We also find that specialists reduce the depth they add to the quote (together with floor brokers) beyond what is in the limit order book. These changes in trading strategies are consistent with an increase in the risk of proprietary trading on the part of specialists
due to loss of their information advantage."

To see whether these changes have a good or bad impact on market prices and efficiency, the authors examine price movements before and after adoption (Hasbrouck's 1993 variance decomposition). They find: "smaller deviations of transaction prices from the efficient (random walk) price. We also find some indication (though weak) of a small
reduction in the absolute value of first-order return autocorrelations calculated from quote midpoints. These results are consistent with more efficient prices that are less subject to overshooting and reversal following the introduction of OpenBook." In non finance speak: prices bounce around less.

Additionally they find that the effective spreads drop, but they are quick to point out that this does not necessarily mean that total transaction costs drop. Why? It is likely because by breaking up their trades and cutting in front, the effective spread is narrowed. However, because there are more smaller trades, overall transactions costs may remain the same.

The loser in all of this? The specialist. "The evidence of a decline in effective spreads of trades suggests that the costs incurred by liquidity demanders decrease with the introduction of OpenBook. This evidence may also suggest a decline in investors’ compensation for exposing limit orders and supplying liquidity. The decrease in the participation rate of specialists is consistent with such erosion in the profitability of liquidity provision."

In wrapping up the authors summarize some of the consequences of their findings:

1. "We find that investors do change their strategies in response to the change in market
design: They submit smaller limit orders and cancel limit orders in the book more quickly and
more often. These findings are consistent with a more active management of trading strategies in
the face of greater risk of order exposure. Additionally, we find that traders shift activity away
from floor brokers toward electronically submitted limit orders."

2. "The results we document point to two welfare redistributions that are possibly associated with the introduction of OpenBook. The first is from liquidity suppliers to demanders. The decrease in the price impact of trades and marketable orders reduces the compensation for liquidity provision, hurting limit order suppliers and specialists. The second is from NYSE members to the exchange itself. We document a decrease in the specialist participation rate, and the evidence of a shift from floor to limit orders is consistent with a decline in the business of floor brokers. At the same time, the NYSE generates revenues from the OpenBook service."

This paper is forthcoming in the Journal of Finance.

The abstract is available at

The paper is also available through FEN.

As an aside, market microstructure papers, while fascinating at some levels, often have the ability to bore those who are not already excited about finance. Hence I sometimes shy away from reviewing papers that are totally microsturcture oriented. This one however, is the exception. It is definitely interesting enough that it willhold the attention of even those who are only mildly interested in the topic and thus should be able to be used in class with no problems!

Wednesday, July 28, 2004

A look at what happens when sport stars do good and when they do bad

Have you ever wondered what happens to the stock of a sponsoring firm when the endorser does well? How about when the endorser does bad? For example, when Kobe Bryant was arrested, what happened to the firms whose products he endorsed (namely Nike, McDonalds and Coke (the owner of Sprite))? I did and this past year I got talking about it with some students and we could not find much evidence so we began to investigate it ourselves. While the students changed over the course of the project (hence the large number of acknowledgements) we finally did finish it this past week. The paper is now coauthored by Betsy Drewniak and Dr. Mike Russell.

The result? After removing firms that had other news items on the same day (i.e. confounding events), when a endorsee did well (set a world records, named MVP etc), the sponsoring firm experienced an market adjusted abnormal return of just over 1% for the -1 to + 3 day event window. For bad events (that is when the endorsee is arrested etc), the stock price fell by about 2% over the 0-1 day window. (BTW good events tend to be more predictable, hence the -1 day instead of day zero.)

SO the results fit theory almost perfectly. The paper was just submitted, but if you have any suggestions, please let us know. THANKS!,%202004.pdf

PS Yeah I know this is sort of cheating putting my own work up, but I was in a real hurry today and would love comments, so....

Tuesday, July 27, 2004

And you think Enron was bad? A look at Yukos

Sure US investors have seen their share of fraud cases (Adelphia, Enron, Worldcom etc.) However, with the seemingly imminent collapse of Russian Oil giant Yukos, it is worthwhile to remember that the US and Europe do not have a monopoly on fraud and corruption--in fact, it may be worse elsewhere!

Background:  As you proabbly know the Russian Oil giant Yukos owes an estimated $7 billion in back taxes  but does not have the cash to pay this sum off.  In order to claim those funds the Russian government is threatening to liquidate the firm. Today Yokos officials have admited they "may have to declare itself bankrupt if the Russian government carries out a forced sale of its production unit. "

The case, which has the makings of a cinema blockbuster, began in June 2003, but hit full stride in October when Mikhail Khodorkovsky (who is arguably Russia's wealthiest citizen" was arrested by "masked and armed members of the security police force FSB stormed his private jet at an airport in Siberia."

Prior to this Khodorkovsky was seen by many as "untouchable." Why? He was one of the often cited "Oligarchs" who rose in dominance after the collapse of communism through entrepreneurship, risk taking, and more than occasionally fraud. As the BBC points out in a great article, in this he was by no means alone. Operating in a quickly changing world where the business laws were unclear, transparency almost non existent, and in a society that had grown accustomed to the corruption and favoritism of former communist party officials, many of these first generation business people believed they were above the law and acted accordingly.

This feeling of invincibility may have come to an end when in June 2003, the Russian government demanded that Yukos (the oil firm run by Khodorkovsky) pay its back taxes, distrust of the government and wealthy business leaders has not. Now some in Russia are claiming that the real reason behind the government pushing for payment of the back taxes is that Khodorkovsky is politically opposed to Putin and many at the Kremlin. Moreover, even the BBC is reporting it is interesting that the "most controversial episode of all, the 1995 auction of Yukos, has been left off the charge sheet. To include it would be seen as an attack on all the oligarchs who won the auctions for Russia's mineral wealth.
Nor has there been any mention of Menatep's offshore network which might have concealed many ill-gotten gains of its clients.
The events which have been left off the charge sheet speak volumes about the current situation Russia.


Tuesday, July 20, 2004

Dividend Policy, Agency Costs, and Earned Equity by DeAngelo, DeAngelo, and Stulz

In a well done and interesting work, DeAngelo, DeAngelo, and Stulz tie dividend policy and agency costs (particularly the free cash flow problem) together. Their main point is that if firms did not pay dividends, managers would have too much cash at their disposal.

The authors begin by asking the question "why do firms pay dividends." To answer the question they examine what would happen if firms didn't pay dividends. Specifically they "conservatively estimate that, had the 25 largest long-standing dividend-paying industrial firms in 2002 not paid dividends, they would have cash holdings of $1.8 trillion (51% of total assets), up from $160 billion (6% of assets), and $1.2 trillion in excess of their
collective $600 billion in long term debt. Absent dividends , these firms would have huge cash balances
and little or no leverage, vastly increasing managers' opportunities to adopt policies that benefit
themselves at stockholders' expense."

Moreover, the paper makes the important distinction (made before by Jensen & Meckling 1976 and Easterbrook 1984) that earned equity is in someways different than contributed equity (external financing). Notably, contributed equity comes with investor imposed monitoring and the so-called market discipline that is provided when firms must raise new money. Therefore, firms with higher levels of earned equity should pay out larger dividends since these firms have (ceteris paribus) a greater likelihood of a free cash flow problem.

Sure enough, the authors find that "For the 25 longstanding dividend payers discussed above, the median ratio of earned to total equity is 97%, suggesting that this measure does in fact identify historically profitable firms with potentially large agency problems. Our evidence is uniformly and strongly consistent with the prediction that the probability of paying dividends increases with the amount of earned equity in the capital structure."
Which really should not surprise anyone.

This importance of earned equity is important even after controlling for growth, cash on hands, and other factors thus "indicating that the impact of earned equity on the decision to pay dividends that we document here is an empirically distinct phenomenon from other factors that have previously been shown to affect the dividend decision."

VERY interesting!

BTW Jensen's 1986 free cash flow problem paper is one of my favorite papers of all time. So much so that I did my dissertation on firms with high cash--finding that investors believe that firms that build up cash reserves do in fact tend to waste them as measured by lower Q values. Thus, this paper by DeAngelo, DeAngelo, and Stulz fits perfectly into my semantic network of managers, excess cash, and dividends. Here is a bad version of a paper based on my dissertation in case anyone is interested. Yeah right!

Enron Sites for class use! - Hot Topic: Enron: "ENRON COVERAGE FROM BEGINNING TO END"

Looking for Enron coverage? Given the recent arrest of Ken Lay, the problems facing Jeff Skilling, and Lea Fastow's jail time, it is worthy to look back to see how the story has developed.

So my top three list:

1. The Houston Chronicle continues to have the best coverage of the collapse of Enron and a scorecard of who is in jail, who is facing trial, etc.

2. The BBC has great coverage of the scandal. While they offer a better perspective, they lack some of the details of the Houston Chronicle site.

3. FindLaw is very good. It is surprisingly detailed and very interesting! Maybe a bit much for an introductory class, but excellent!

I will definitely be using these to help my students learn about what is arguably the most important finance story since the crash of 1987.

Readings, Teaching ideas, and non finance stuff etc

Sorry I had not posted for a few days, but it is summer here, which is vacation time right?  ;) lol.
Ok, so this will be my once a week, not strictly finance post.  But I will start off with a finance type question.  "What interesting ideas or strategies do you use to make classes more interesting?" or if you are a student "what would you like to see your FinanceProfessors do in class?"  Email me at and I will include the best of the suggestions  in future posts and in the newsletter. 
What have I been reading?  I finished three books this week.  The first was The Teller of Tales, the biography of Sir Arthur Connan Doyle by Daniel Stashhower.  It was good.  I really enjoyed most of it, but the end when it focused so much on Spiritualism dragged on for a while.  But overall, I am really glad I read it and I learned a ton.
I also finished Hallowed Grounds: a Walk at Gettysburg by James McPhearson.  Sure it was too short, and informal, but I liked it.  I wish I had ristened to it BEFORE this recent trip to Gettysburg.
The Glory of their Times provides a fascinating look at Baseball in the 1900-1920 era.  It is a series of interviews with star players done in the early to mid 1960s when Lawrence S. Ritter was writing his classic book of the same name.  This is just a collection of the actual interviews.   It is really cool to see what has changed (salaries, willingness to play through injuries, homeruns, and relief pitching) and things that have not changed (past players thinking they were better, drugs and alcohol wrecking careers, and extremely competitive players who make the sport great.   Highly recommended as a fun book! 
Ok, that is enough about my reading etc.  I am sure many of you are not interested, but I honestly do get emails asking me why I have not been updating my reading list on the blogs, so I hope it is not too annoying to the rest of you!
Have a great week!
* who is doing his Tyler Hamilton imitation in more ways than one. :(   First our dog Quincy died of cancer.  He went very very fast which is the only good thing I can say about it.  Then this past Sunday I crashed my bike.  Lots of scrapes and bruises, but fortunately nothing serious save having to buy a new helmet. 
* who is listening to every Tour stage on Eurosport.  Surely the Tour is the most exciting three weeks of the year in sports.  Even in Olympic years! 
* who is really ready for hot weather.  It has been quite cool and wet in Western New York.

Friday, July 16, 2004

Home Field Advantage: the Finance experience!

Home field advantage: Lambeau Field, Adelphia Coliseum, Reilly Center, Cameron Indoor Stadium, and the Korean Stock Market?

Do domestic investors have an edge?
The trading experience of foreign investors in Korea

Choe, Kho, and Stulz show that home field advantages do not just exist in sports, but also in finance!

They look at all trades on the Korean stock exchange for a two year period ending in November 1998 and “show that foreign money managers pay more than domestic money managers when they buy and receive less when they sell for medium and large trades.” However there does not appear to be a difference for small stocks trades (that is when the size of the trade is small).

As the authors point out, “There are at least three non-mutually exclusive explanations for this result. First, foreign investors could be more impatient or trade when liquidity is lower, so that they pay more to liquidity providers. Second, foreign investors are better informed, so that their trades have a larger permanent impact. Third, they make their trades after prices have already moved against them.”

Interestingly, they find evidence to rule out both the liquidity and the information hypotheses. Thus, they conclude that “the difference between foreign investors and domestic investors is that prices move unfavorably for foreign investors than for domestic investors immediately before they trade intensively. This difference is partly explained by the return-chasing behavior of foreign investors.”

How big of disadvantage is it for the foreign trader? “On a roundtrip trade foreign money managers face greater transaction costs of the order of 37 basis points compared to domestic money managers, which is substantial” “For instance, an investor who trades three times per year would contemplate a drag on his performance in excess of 100 basis points. To put this in perspective, Carhart (1997) reports that the difference in the monthly estimates of Jensen’s alpha between the top decile and the bottom decile of diversified mutual funds in the U.S. is 0.67% from 1963 through 1993.(See, for instance, Grinblatt and Keloharju (2000), Seasholes (2000), and Froot and Ramadorai (2001)”

While I found the article fascinating, it would be interesting to see if foreign investors were somehow tipping off their trades—maybe a different mechanism is followed, that would allow front running to exist.

BBC NEWS | Business | Five months in jail for Stewart

BBC NEWS Business Five months in jail for Stewart: "Five months in jail for Stewart"

Yahoo's page

more later...sorry, no time

Thursday, July 15, 2004

SSRN-Which Institutional Investors Monitor? Evidence from Acquisition Activity by Lily Qiu

SSRN-Which Institutional Investors Monitor? Evidence from Acquisition Activity by Lily Qiu: "Which Institutional Investors Monitor? Evidence from Acquisition Activity by LILY QIU "

There has been quite a bit of evidence of late that all shareholders do not do equal jobs of monitoring management. For example Barclay, Holderness, and Sheehan find that private placements (which have been long seen as a means of improving monitoring) may actually reduce monitoring and help to entrench managers because many of those purchasing the blocks are not actively monitoring management.

Yale’s Lily Qiu dives into this question further and finds evidence that suggests that large public pension funds (PPF) may do a better job monitoring than insurance or mutual funds. Qiu's case is built on the finding that firms with large public pension fund holdings “engage in less merger and acquisitions activity.” Moreover, when M&A deals are done, Qiu reports that “The presence of PPF ownership is…significantly and positively associated with long-term M&A abnormal returns…[and]with post-M&A improvement in asset turnover rates.”

Not convinced yet? Qiu is not done: “the negative association between PPF ownership and M&A likelihood is concentrated among cash-rich and low Q firms; among M&A firms, those with higher PPF ownership are less likely to engage in "buying growth" acquisitions.”

A quick explanation of the last sentence? Ok, low Q values (technically Tobin's Q which is market value divided by replacement value) and high cash firms are often cited as being where the Free cash flow problem (see Jensen 1986) is the worst.

Thus, at these firms mergers and acquisitions are often seen as negative projects that only serve to make managers better off. That it is at this
type of firm where the PPF influence seems the strongest, suggests that PPF are stronger monitors of management than other blockholders.

Cite: Qiu, Lily, "Which Institutional Investors Monitor? Evidence from Acquisition Activity" (December 2003).
Yale ICF Working Paper No. 04-15.

Proof of a clientele effect: evidence from Taiwan

Taxes and Dividend Clientele: Evidence from Trading and Ownership Structure By Lee, Liu, Roll, and Subrahmanyam

Lee, Liu, Roll, and Subrahmanyam (LLRS) provide convincing evidence that a dividend clientele effect does exist. While previous researchers (for example Scholz-1992, Dhaliwal, Erickson, and Trezevant-1999, and Graham and Kumar-2003) have also found the existence of a clientele effect, the current paper is different in that it is based on cleaner data and does not rely on complex modeling. Rather the authors examine trading, ownership, and tax rate data from Taiwan. As they state "Taiwan offers an excellent laboratory for studying clientele because the capital gains tax is zero and share repurchases were prohibited for most of our sample period."

Before getting to the findings, some background is necessary. Taiwan does not tax capital gains, but does tax dividend income. Data include all trades as well as approximations to the traders' marginal tax rate. Additionally the rules on stock buybacks changed in September 2000 which enabled the authors to "study the behavior of firms as they became able to evade dividend taxes."

And the findings? "Individuals appear to respond in the direction predicted by the clientele hypothesis." Wealthy individuals decrease their net buying after dividend increases and increase net buying after dividend decreases. Those in lower tax brackets "do just the opposite."

"Institutions as a group display an insignificant response to dividend changes."

LLSR further examine this using regression analysis. Consistent with the above findings, "there is a strong negative relation between dividend increases and the proportion of shares held by wealthy individuals."

Further examination of the institutional ownership suggests that "Among institutional types, both tax exempts and corporations significantly prefer higher dividends per share. They also prefer higher payout ratios and are joined in this preference by financial institutions."

Finally, the authors also look at changes in behavior after the legalization of share repurchases. They find that "firms with higher concentrations of highly taxed shareholders were significantly more likely to commence repurchase programs. More than forty percent of Taiwan firms actually engaged in share repurchasing after it became possible. A significant fraction (23%) of firms that had previously been paying dividends ceased paying them entirely and 21% reduced dividends and began repurchasing. The tendency to engage in these practices is significantly related to the proportion of a firm’s shareholders in higher tax brackets."

I am convinced. Are you? Definitely an interesting paper and it will make it to my class notes!

BTW How can there be so many interesting articles? I just do not understand. It seems like everywhere I look there are articles that are really really good! This is no exception.

Reaction speed: good news is incorporated faster. A look at the Market Reaction to Annual Earnings Announcements by Louhichi Wael

SSRN-Market Reaction to Annual Earnings Announcements: The Case of Euronext Paris by Louhichi Wael: "Market Reaction to Annual Earnings Announcements: The Case of Euronext Paris "

As I am considering doing a paper on event studies, I have been looking at a few event study papers of late. In this research I stumbled upon this paper by Louhichi Wael. Wael looks at abnormal returns following overnight earnings announcements of French firms. The findings give several insights into market efficiency.

Probably the most convincing aspect of Wael’s paper is that the stock price moves on new information. While that is obvious, it is interesting to see exactly how this price change occurs. For instance the stock price change happens for both good and bad earnings announcements, but not for earnings that are "in line" with analyst forecasts. This is obviously consistent with semi-strong form efficiency.

There are several interesting things about this paper

1. The paper uses an event study methodology but uses minutes instead of days or months as the time period.

2. The author finds that for good earnings announcements (those above analysts’ expectations) there are on average no abnormal returns after the first 15 minutes of trading. However, even within this 15 minute window it would be difficult to make large returns as approximately 55% of the 1.74% positive excess return occurs on the first trade following the announcement, and a full 95% occurs within the first 15 minutes of trading.

The reaction for bad announcements is less pronounced. For bad earnings announcements, the firms experience a 1.04% drop for the day. However, this is a smaller drop than occurs on average after the first 30 minutes of trading where the stock price tends to bottom out at -1.28%. This is evidence of a slight overreaction that occurs within the first 30 minutes of trading following bad earnings announcements.

3. Bid-Ask spreads increase immediately after the announcement. The spreads and volume return to normal more quickly (within 15 minutes) for good news.

4. Volume is unusually high before and after the announcements.

5. Actual "price volatility remains abnormally high thirty minutes following the announcement of good news and fifty five minutes after bad news."

All in all some pretty convincing evidence that while the market is not perfectly efficient, it is pretty good (and fast) at incorporating new information.

Cite: Wael, Louhichi, "Market Reaction to Annual Earnings Announcements: The Case of Euronext Paris" (January 2004). EFMA 2004 Basel Meetings Paper.

Wednesday, July 14, 2004

Another look at retirement planning. Are equities the way to go?

As hoped and expected, the recent post on Ahmet Tezel's article in the Journal of Financial Planning on how much a retiree could safely take out of his/her retirement account has sparked further discussion.

SSRN-Irrational Optimism by Elroy Dimson, Paul Marsh, Mike Staunton: "Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational. "

On one hand it is true that given the track record of equities, the more money invested in equities, the more that can generally be taken out. But equities are also risky so the more invested, the higher probability of the portfolio suffering economically significant declines. (that word generally will always get you in trouble ;) )

This is particularly important because we do not know the future and any model we use is "assumption dependent." These assumptions are not as easy to make as some may believe. For instance, consider without searching the web or a book, what is the historical return on equity investments? No doubt many of you (myself included) figured somewhere around 12% for large stocks (see virtually any investment text for these numbers) which corresponds to a risk premium of around 8%. (keeping math simple ;) )

However, Dimson, Marsh, and Staunton report that this is probably an overly optimistic number. Not because the expected equity risk premium is expected to fall in the future because the market is currently overvalued as those in the Campbell-Schiller camp believe (although it may be), but because we are not looking at the right historical returns! (BTW for more on the Campbell-Schiller view see the January FinanceProfessor newsletter Investments section)

So what is wrong? Virtually every finance text book dutifully reports US equity returns from 1926 to the present. However, this is a period where the US stock market was a very strong performer. Dimson, Marsh, and Staunton do two things to adjust for this: 1. they go back further--to 1926 and 2. they look at global returns and not just US returns. Their findings? Stocks have had lower returns and higher risks.

For instance, it has been widely reported that in the US the stock market has never lagged inflation over a 20 year period. Many have concluded therefore that stocks are safer than they really are. However, looking more globally this is not true. As the authors write: "We find only three non-US equity markets (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return."

Therefore, the authors conclude that investors who rely on the optimistic US-only data are irrational: "prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational."

So what is one to do? My favorite idea comes from Zvi Bodie who applies modern hedging theories to retirement planning. As he wrote in in 2001 Retirement Planning: a New Approach paper the first part of the plan is to assure some minimum standard of living (this is the minimum amount that you will need) by investing in "inflation-protected bonds and annuities as the way to guarantee a minimum standard of living in retirement."

The second part is to determine when you will need the money. Obviously the longer you wait to start taking money out, the more you can take out and the more risks you would be willing to live with. Bit he is careful to warn that just because you have a longer holding period, it does not mean that equities are the right investment: their risk goes up as well. This is driven home in his interview with Financial Advisor Magazine: "If stocks are safer the longer you hold them, Bodie says, a put option should be cheaper with a longer time horizon. But the cost of put options generally rise proportionally to the number of years going out."

Finally, and maybe most importantly, Bodie suggests that rather than merely investing the remainder of your portfolio in equities, you "use call options to lever potential income gains." That is, you buy long term call options to allow you to participate in stock gains without putting as much of your money at risk. This solution is not costless as options are generally not available in maturities matching the investor needs so they will have to be periodically updated, but overall it is a great (and very low risk) strategy!

Still unclear? Bodie has written a great deal on this issue. Financial Advisor Magazine has a very good article on Bodie's strategy. I highly recommend it (both the article and the strategy!)

Bodie did an interesting interview with Business Week on his strategy and of course his book Worry Free Investing focuses on the issue. (FTR I have not read his book--Sorry!)

SSRN Cite:
Dimson, Elroy, Marsh, Paul and Staunton, Mike, "Irrational Optimism" (December 2003). LBS Institute of Finance and Accounting Working Paper No. IFA397.

Tuesday, July 13, 2004

The inefficiency of internal capital markets: another part of the diversification discount ?

SSRN-Corporate Diversification and Internal Capital Markets: Evidence from the Turkish Business Groups by Halit Gonenc, Ozgur Berk Kan, Ece Karadagli:

Gonenc, Kan, and Karadagli make use of an interesting data set to give more confirmation to the view that external capital markets are more efficient than internal capital markets. They "compare the performance of firms affiliated with diversified business groups with the performance of unaffiliated firms." They find that "having a group affiliated bank affects the accounting performance measures of the group firms positively, but the market value of the group affiliated firms negatively, supporting the misallocation of capital hypothesis." This missallocation is often cited as a partial cause of the diversification discount.

One interpretation of the findings that accounting performance improves, but that stock performance does not, would be that internal markets rely more on accounting data and therefore investment is tailored to, and performance geared to, maximize the accounting returns.

Several interesting aspects to this paper:

* "unaffiliated firms use cash type seasoned equity offerings more heavily" "this supports the idea that unaffiliated firms are more bound to external markets."

* The paper focuses on 200 Turkish firms. This is important as prior research would suggest that if internal markets have an advantage it would be found in countries with capital markets less developed than the US, UK, European, and Japanese markets.

CITE: Gonenc, Halit, Kan, Ozgur Berk and Karadagli, Ece C., "Corporate Diversification and Internal Capital Markets: Evidence from the Turkish Business Groups" . EFMA 2004 Basel Meetings Paper.

SSRN-Does Governance Affect the Performance of Closed-End Funds? by Gordon Gemmill, Dylan Thomas

SSRN-Does Governance Affect the Performance of Closed-End Funds? by Gordon Gemmill, Dylan Thomas

In the most recent newsletter there was a discussion of the SEC's recent vote to require independent chairman for mutual fund companies. While I concluded that an independent chairman was a good idea, the conclusion was based more on theory than empirical evidence. Unbeknownst to me at the time, there was research that backs the conclusion.

Gemmill and Thomas have explored the link between governance and closed fund performance. They found that "for the 331 funds listed in London, returns are negatively related to expense ratios". Moreover, "expense ratios are higher for funds which have large boards, less outside directors and low ownership by the managers. The main conclusion is that companies with small boards and more outside directors perform better."

In a nutshell, governance does matter! So while we can debate whether the outside directors should be mandated, the SEC was at least on the right side of the evidence.

CITE: Gemmill, Gordon and Thomas, Dylan C., "Does Governance Affect the Performance of Closed-End Funds?" (January 2004). EFMA 2004 Basel Meetings Paper.

Do we have a new explanation of the conglomerate discount!!!!!!!

SSRN-Loyalty Based Portfolio Choice by Lauren Cohen

Are you loyal to your company? Your answer may depend on whether your company is a single division company or a conglomerate. As the University of Chicago's Lauren Cohen writes "Evidence from Social Psychology suggests that loyalty to the firm develops at the divisional level." Yeah yeah, so what does Social Psychology have to do with finance? A great deal!

For instance, Cohen suggests that if loyalty somehow shows up in investment portfolios, it is probably through overweighting shares in your own firm. (It should be noted that he acknowledges and at least partially controls for informational and transaction cost explanations.) Thus, the hypothesis that employees at "stand alone" divisions invest more in company stock than do employees at conglomerate firms. An alternative hypothesis is that because of the diversification inherent in a conglomerate risk averse employees may invest MORE (not less) in the conglomerates.

Cohen tests these hypotheses using a "unique dataset" that includes the makeup of employee's 401k retirement contributions. He finds that loyalty trumps diversification and that employee/investors who work at stand alone firms invest more heavily in their own shares than similar employees at conglomerate firms. The best evidence of this can be found at firms that were spun-off from a conglomerate. At these firms she finds a significant increase in employee investment at the now-stand-alone firm. (That deserves a wow!)

Minimally this paper is more evidence that loyalty and other seemingly non rational motives do impact investment decisions. (See also Shive and Morse's piece on Patriotism) I think this paper goes further than that however.

Not content on a merely great paper, Cohen goes on to see where else this loyalty might show up. He examines wage per employee and sure enough finds that it is lower at stand-alone firms. While he does not mention it, this could be a partial explanation of the conglomerate discount, i.e. why do conglomerate firms trade as a discount to stand alone firms (see Comment and Jarrell 1995).

Cohen, Lauren H., "Loyalty Based Portfolio Choice" (March 2004). EFA 2004 Maastricht Meetings Paper No. 5062.

You win some, you lose some....Dominos lists on NYSE, Google to List With Nasdaq. Nasdaq pulls out of Canada

The New York Times > Technology > Google to List With Nasdaq: "In an amended regulatory filing with the Securities and Exchange Commission, Google said it would list with Nasdaq"

Today's scorecard:

NYSE 1 win 1 loss
Nasdaq 1 win 1 loss

Yes, the NYSE lost the big one. Sure, it may have been expected, the Nasdaq was the favorite from the start, but many at the NYSE hoped that the search engine firm would go for the traditional stability (and arguably lower trading costs) of the NYSE. However, in their amended SEC filing, Google announced its intent to trade on the NASDAQ.

Ever gracious in defeat, the NYSE wished Google well: "Google is an outstanding company with a great management team, and we wish the company well with its initial public offering." The failure to gain Google's shares however did nothing to help the tarnished reputation of the NYSE which is still smarting from the governance shakeup, specialists' front running, and Richard Grasso's pay package. Google joins most other internet and technology related stocks that trade on the Nasdaq.

For more on Google selecting the Nasdaq,+meeny,+miny,+Nasdaq/2100-1023_3-5266094.html,2933,125415,00.html

However, the day was not a complete loss for the NYSE; Dominos Pizza's shares began trading on the NYSE. Of course, the pizza maker's shares are worth about $337 million based on first day's closing price while it is estimated that Google's shares will be worth nearly $3 Billion. Several things are interesting about the IPO. First it sold for $14 a share, which was lower than its estimated $15 to $17 price range. Why? It is hard to say but growth has been anemic and Forbes reports that the: "money raised in Domino's planned IPO will be used to repay debt and shovel $500,000 bonuses to two top execs. Insiders, including major shareholders and company officers, are cashing out."

For more on Domino's IPO

But lest you think that all is peaches and cream at the Nasdaq, the market continued to abandon its international expansion plans. After scaling back or halting operations in Europe and Japan, the market now has decided to pull out of Canada as well.

Monday, July 12, 2004

SSRN-When Labor Has a Voice in Corporate Governance by Olubunmi Faleye, Vikas Mehrotra, Randall Morck

SSRN-When Labor Has a Voice in Corporate Governance by Olubunmi Faleye, Vikas Mehrotra, Randall Morck

This one will definitely make class!!!

Faleye,Mehrotra,and Morck study firms where there are large blocks of employee owned shares that ARE VOTED. Their findings may surprise some people:

"Relative to otherwise similar firms, labor-controlled publicly traded firms invest less, take fewer risks, grow more slowly, create fewer new jobs, have worse free cash flow problems, and exhibit lower labor and total factor productivity."

Why? My best guesses as to why this happens is that the employees are a. risk averse, b. at least somewhat entrenched, and c. have a shorter time horizon than do shareholders. This is counter to the hypotheses often laid out by management "gurus" that suggests employees are longer term oriented.

FWIW Additional evidence of this short-term orientation is found in lower R&D spending as well, but it was not significant at normal levels (p=.11).

Faleye, Olubunmi, Mehrotra, Vikas and Morck, Randall, "When Labor Has a Voice in Corporate Governance" . EFMA 2004 Basel Meetings Paper.

Blowing way bubbles?--Maybe the NASDAQ Bubble wasn't a bubble

So maybe there wasn't an internet bubble. Several academic papers are trying to justify the high valuations that existed in the late 1990s.

For instance Pastor and Veronesi (P&V) examine the question and allow for uncertainty in future earnings and, unlike similar work by others, they conclude that the NASDAQ was not necessarily overvalued.

Possible the best way to understand their work is in the spirit of real option analysis where the more uncertain the future, the greater the value of the option (or in this case stock). This is important because "The NASDAQ stock prices in the late 1990s were not only high but also highly volatile, and both facts are consistent with high uncertainty about average profitability." Using a model valuation model that incorporates this uncertainty the authors conclude that "Nasdaq prices at the peak of the 'bubble' are justifable."

(just a note: This is similar to Moon and Swarttz (2000) but P&V find that the uncertainty need not be as large as Moon and Schwartz stated.)

It is important to recognize that this is not to say the market was perfectly rational at the time. As L&V state: "We don't claim that investor behavior in the late 1990s was fully rational....Good examples
of apparent irrationality are presented by Cooper, Dimitrov, and Rau (2001), Lamont and Thaler (2003), and others. Also, we don't attempt to rule out any behavioral explanations for the 'bubble.' We only argue that such explanations are not necessary, because stock prices in March 2000 are also consistent with a rational model. The notion of a Nasdaq "bubble" caused by investor irrationality should not be held as a self-evident truth."

Pastor and Veronesi

Moon and Schwartz abstract

Saturday, July 10, 2004

SSRN-Going Private via LBO - Shareholder Gains in the European Markets by Andre Betzer, Christian Andres, Mark Hoffmann

SSRN-Going Private via LBO - Shareholder Gains in the European Markets by Andre Betzer, Christian Andres, Mark Hoffmann

Betzer, Andres, and Hoffmann investigate what happened to European public firms that went private in the 1996-2002 period. Using classic event study methodology, they find "a positive and significant return...Of about 13.83% at the announcement day." (Don't you love the "about"?) Over the longer -30 days to +30 days event window, they found a CAR of 27%. Possibly more interesting, their regression analysis finds that firms with higher free cash flow problems show higher average returns. Additionally they find that firms who appeared to be undervalued relative to their industry peers, also have higher CARs.

FWIW, this paper reminds me of many of the famous event-study papers from the late 1980s-early 1990s.

Betzer, Andre, Andres, Christian and Hoffmann, Mark, "Going Private via LBO - Shareholder Gains in the European Markets" (January 14, 2004). EFMA 2004 Basel Meetings Paper.

Are men and women that different when it comes to trading?

SSRN-An Experimental Test of the Impact of Overconfidence and Gender on Trading Activity by Richard Deaves, Erik Lueders, Rosemary Guo Ying Luo

Do you remember the findings during the internet wave that female investors showed more patience and did not suffer from the same overconfidence that afflicted some male investors? Well, work by Deaves, Luenders, and Luo now draw that into question.

While the new work does find that over confidence leads to excessive trading, "women have about the same level of both overconfidence and trading activity as do men."

Is it where you live, or how much you make and what you know? A look at the Geography of Mutual Fund Investing

This one should come as no surprise, but it is interesting none-the-less. Malloy and Zhu have a working paper that "provide[s] evidence that individual investors located in less affluent, less educated, and ethnic minority neighborhoods invest more in mutual funds with expensive load fees." Which I would wager that you would all have expected.

A more interesting question (and much more difficult to answer) is why is this so. Is it _____.

a. because low minimum investment funds tend to have higher expenses and those of us who can not afford the higher minimums are more or less forced to invest with the high fees?
b. because the less affluent have little experience investing therefore do not know that expenses eat a large percentage of one's return.
c. because more marketing is necessary (if we assume marketing is a means of reminding and informing) to get the less affluent to invest and this marketing costs money so the higher fees are a means of allowing the funds to recoup the expense.
d. a form of discrimination.
e. a, b, and c

I will answer e.

Friday, July 09, 2004

MSNBC - Michael Rigas fraud case ends in mistrial

MSNBC - Michael Rigas fraud case ends in mistrial: "The case against former Adelphia Communications Corp. Operations chief Michael Rigas ended in a mistrial Friday with jurors deadlocked on 17 counts against him"

I am surprised. Having written (with Carol Fischer) 2 cases on the problems at Adelphia, I guess I am somewhat of an expert on this and I thought they all would be found guilty. So what is next? Look for a new trial to start in mid October to retry Michael Rigas.

Of course business is still going on at Adelphia (indeed I am currently connected on an Adelphia internet connection and watching TV over Adelphia cable. While corporate officials (the firm is now headquartered in Denver) say it is business as usual, most employees acknowledge the firm is up for sale.

FPA Journal - Contribution: Sustainable Retirement Withdrawals

FPA Journal - Contribution: Sustainable Retirement Withdrawals: "investors' sustainable withdrawal in retirement depends not only on expected real returns in the future, but also on the variability of returns, the planned withdrawal horizon, the willingness and ability to run out of funds before the planned horizon, and the desire to leave some wealth to one's heirs"

While I flat out refuse to be a financial planner (except maybe to family members), I have had several newsletter subscribers ask how much money can they take out of their retirement portfolio and what should they be invested in. My standard answers are "take out as little as possible" and "diversify". Now, I am not sure how much of help that is.

Fortunately Ahmet Tezel in the Journal of Financial planning comes to the rescue! Using bootstapping he looks at (A)how much diversification is needed (B) how much the investor can withdraw per year.

He concludes:
"To ensure a reasonable level of withdrawals from retirement funds, investors should"

"Diversify among large and small stocks, government bonds, and Treasury bills. Stocks, large and small, should be held in proportions as high as 80 percent to 90 percent of the retirement portfolio. Investors should invest 5 percent in Treasury bills and vary the long-term and intermediate-term government bonds allocations between 2 percent to 7.5 percent."

"For larger real withdrawal rates, 95 percent to 100 percent of the portfolio must be invested in large and small stocks, with odds of failure greater than 10 percent. There must be more flexibility to investors' spending plans in case of significant declines in the stock market if they wish to withdraw higher real amounts than indicated above.

All the methodologies assume that history provides a guide to the future. Any doubt about future trends being different from the past—such as that prospective equity risk premiums might be lower—would call for adjusting the inputs for all methods.
Including additional asset classes such as international stocks, TIPS, and annuities may improve the sustainable withdrawals."

or as I would say, diversify and take out as little as possible ;)

FPA Journal - Focus: According to Form: Choosing the Right Business Entity

FPA Journal - Focus: According to Form: Choosing the Right Business Entity: "Different motivations result in different business-entity selections."

Virtually every corporate finance class and most entrepreneurial classes cover the standard organizational forms very early in the course. The timing is somewhat unfortunate as most students are not yet warmed up to finance. In part as a result, coverage is often limited. For instance here is what my students cover in my introductory corporate finance classes. We focus largely on the tax issues and personal vs limited liabilities. However, there are many other variables that need to be considered . For instance what if you want more than 35 shareholders, a S-corporations (which does not allow more than 35 shareholders) would be inappropriate.

In the Journal of Financial Planning, Nancy Opiela discusses the choice of organizational form with financial planners. As she writes "Different motivations result in different business-entity selections, just as different personal goals inform unique asset allocations. And continuous changes in tax law and case law make any decision made today a moving target."

Good stuff! and definitely recommended to anyone starting a business!

SSRN-Are Large Boards Poor Monitors? Evidence from CEO Turnover by Olubunmi Faleye

SSRN-Are Large Boards Poor Monitors? Evidence from CEO Turnover by Olubunmi Faleye

Faleye who reports that large boards of directors are less likely to replace existing CEOs and if the CEO replaced, less likely to find a successor from outside the firm.

Moreover, when firms announce smaller boards, the firm's stock return is positive. Thus Faleye concludes: "suggest that a large size hinders the board's ability to perform its monitoring functions, and lends additional support to the current drive toward smaller boards."

Ok, let me see if I have this right. Size does matter and smaller is better?

A good day for international trade!

Two news items today that strengthen the belief that trade is good.

First, the US and China agreed to end their dispute over Chinese tax breaks on computer chips. If nothing else it shows that the WTO can be used effectively to solve disputes.

the second story, which for now is not getting much coverage but could be huge in the longer run is that Pakistan is ready to discuss trade with India -DAWN - Business; 09 July, 2004
Pakistan ready to discuss trade with India -DAWN - Business; 09 July, 2004: "Pakistan is ready to discuss trade issues with India "

Which is More good news! The more countries trade with each other, the less likely they are to go to war with each other. So, like the news of Israel and Jordan that was discussed in the newsletter, trade talks between India and Pakistan are a step in the right direction :)

Finally a New Newsletter!

July Newsletter

Well it took Ken Lay and John Rigas to get me to get the newsletter finished, but after about 20 false starts I finally finished a Newsletter. Be sure to take a look at it!

Thursday, July 08, 2004

Enron ex-boss pleads 'not guilty'

BBC NEWS | Business | Enron ex-boss pleads 'not guilty': "Enron ex-chairman Kenneth Lay has pleaded 'not guilty' to 11 criminal charges over the collapse of the former US energy giant.
The charges against Mr Lay include bank fraud, share trading fraud and making false statements."

I have had several people ask me "Why did it take so long?" My best answer is that prosecutors wanted to be sure they had a solid case before proceeding and the Enron case was/is so complex (on many levels) that rather than make a misstep, they waited until there was apparently enough information. (It will be interesting to see what Fastow and Skilling have said).

Is he guilty? My guess is that the jury will find him guilty, but it is not assured given the complexity. However, that said I sure would not want to be him. If convicted Lay is facing 175 years in prison, which is a LONG LONG time.

Friday, July 02, 2004

I'm back! and Happy July 4th!

Hi again....took a small vacation to Virginia and Gettysburg PA. It was fun. Biked 118 miles on Monday. Very pretty course from Abingdon Virginia.

On the way back stopped at JMU and PSU. Both the schools and the surrounding areas are testimony to why I hate sprawl. What had been great college towns are turning into cities with traffic problems and chain stores everywhere :(

I should have the summer newsletter out right after Independence Day (July 4th). It will have more research and fewer news stories.

Oh, I almost forgot, do you remember the great newsletters from Erisk? Well they ceased publishing them, but now a few of their former employees (including Duncan Woods) have started a new site on bank managment. Definitely check it out!!!

Ok, well I better get to work on the newsletter.