Thursday, August 26, 2004

The Politics of Internal Capital Markets

As we have repeatedly seen, conglomerate firms trade at a discount to focused firms. This is not new. (See Comment and Jarrell 1995 for more). The short version of the discount is that for some reason, 1+1 =1.5

With such an important finding, there are of course many potential explanations as to why the discount exists. A far from complete list includes:
  1. Poor managerial incentives
  2. Poor Monitoring and a lack of transparency (hard to tell who is doing what, so why not shirk)
  3. Inefficient internal capital markets (so money is wasted through misallocation)
  4. A lack of loyalty on mangers' and employees' behalves---this would lead to reduced performance and higher expenses.

There really is little doubt that all of these play a role in the discount. Moreover, we should still consider the possibility that there may not be a real discount since the firms do freely chose to become conglomerates. This endogeneity may be the result of a discount that would have been larger had the firms not become conglomerates. (A view which I doubt, but do consider worthy of attention).

At the upcoming FMA convention in New Orleans, McNeil and Smythe will present their paper that supports the view that internal capital markets are not as efficient as many would like to believe.

The authors report what every upper and middle level manager in the world already knows: that politics matter.

More specifically McNeil and Smythe write that lobbying by divisional managers plays a role in the allocation of capital. This is a problem because if the internal market were perfect, the allocation decision would be based soley on the merits (the risk and returns) of each project.

In their words:

"To test the Lobbying Power Hypothesis, we examine the sensitivity of business
segment capital expenditures to segment manager characteristics expected to
contribute to a manager's lobbying power for a sample of firms that have
identifiable division/segment managers....There are several division manager
characteristics, such as tenure as suggested by Wulf (2002b), that could be
connected to lobbying power. We collect information on division manager tenure
with the firm, time in position, salary level relative to the CEO, membership on
the board of directors, age, and whether the manager is one of the firm’s top
five executives. Each characteristic could indicate and/or impact the degree of
a manager's lobbying power. In the analysis, we examine the association between
division capital expenditures and each of the aforementioned division manager

and the findings?

"We find evidence that segment level capital expenditures are associated with
division manager characteristics which, we argue, reflect division manager
lobbying power. For example, the results indicate that relatively high q
segments receive lower capital expend itures when headed by a manager with low
tenure or by a manager competing with multiple top executive/segment


Nasdaq vs NYSE Volume from the JFR Abstracts of the Forthcoming Articles

When eating my combination breakfast/lunch (bread, bananas, and warm iced tea) I was reading abstracts from forthcoming Journals of Financial Research. While there were many good articles, one that was particularly interesting was the Anderson-Dyl paper that examines reported volumes on the NYSE and NASDAQ.

JFR Abstracts of the Forthcoming Articles: "Market Structure and Trading Volume
Anne-Marie Anderson and Edward A. Dyl"

Short Version :

Changes since 1992 have reduced the volume bias of NASDAQ but it still exists.

Longer review:

It has long been known that the reported volumes on the NASDAQ are overstated. This is due to double counting and inter-dealer dealings. As the describe it:

"The discrepancy between trading volumes reported in the two primary U.S. stock markets arises because Nasdaq is primarily a dealer market, whereas the NYSE is largely an auction market. In a dealer market...A dealer is therefore on one side of every transaction, which results in trading volume being overstated. When an investor sells 100 shares of firm X to a dealer, the dealer reports a 100-share transaction; when another investor buys the 100 shares of firm X rom the dealer, he reports another 100-share transaction. Only 100 shares of firm X have changed hands between the two investors, but trading volume of 200 shares has been reported."

The same 100 share trade on the NYSE would be reported as a 100 shares.

Moreover, "Trading volume can be further overstated due to inter-dealer trading." This occurs when a dealer trades with another dealer with no corresponding trade with investors. A common reason for this type of trade would be dealer inventory adjustments. Since NYSE specialists are involved in a smaller portion of trades (roughly 25% accoridng to Madhavan and Sofianos-1998) than NASDAQ dealers, this too adds to higher reported NASDAQ volume.

Thus, to compare volumes across markets, various algorithms have been used. The easiest is to merely divide NASDAQ volume by two. This idea received support by a 1997 paper by Atkins and Dyl that found when a firm moved from the NASDAQ to the NYSE, reported volume went down by approximately 50%.

However, that was then and this is now. For several important reasons, this overstating may no longer exist. For instance:

  1. ECN trading is making up a significant percentage of NASDAQ volume (44% in 2001). This is relevant since ECNS rarely double count their trades. However, if this increased trading is coming from dealers, then reported volumes may still go up.
  2. Rules changes in 1997 have led to increased use of public limit trades. These do not suffer from double counting. Hence we would see lower volumes.
  3. A 2001 rules change was designed to end double counting. Called "Riskless Principal Trade-Reporting Rules.....A riskless principal transaction is one where the market maker, after receiving an order to buy or sell a stock, purchases or sells the same security at the same price to fill the order. The Riskless Principal Trade-Reporting Rules require the dealer to report such a trade as one transaction."

In light of these changes Anderson and Dyl set out to see if reporting biases had changed. They examine the trading of 299 firms that changed from the NASDAQ to the NYSE in the 1997 to 2002 time period. They find that median volume does drop by about 37% which is less than the 50% number found by Atkins and Dyl (1997).

Thus, the authors conclude that NASDAQ volume numbers are still biased in comparison to NYSE reported volumes, but not by as much as they had been.

NOTE: While the paper is forthcoming, the JFR only lists abstracts. A previous version of this paper was presented at last year's FMA conference. A copy of that paper is available here.

Demand for NYSE seats is down

Gee, who would have "thunk" it? With the NYSE facing increased competition from the NASDAQ, ECNs, and regional exchanges, it only stood to reason that profits of the NYSE would fall. This hypothesis received more confirmation in the market for NYSE Membership (or seats). Evidence shows that the demand for seats is low.

A few weeks ago it was reported that seat prices were as low as $1.25 million dollars. This price was as low as membership had been in the past five years.

Now the Philadelphia Inquirer is reporting that not only have seat prices fallen, but many owners who do not want to use their membership, are having a difficult time renting the seats.

"About 60 members, or 4 percent of the 1,366 total, were awaiting rental offers in early August, according to a list kept by the exchange's membership department. As recently as 2002, the NYSE had a waiting list for memberships, which confer the rights to buy and sell stock on the floor

Meanwhile, the price to own a seat on the exchange has dropped about 50 percent in the last five years. The last one sold for $1.25 million this month.

In addition, the rental price for a seat is down: A member's stock exchange "seat" rents for about $3,000 a week now, or about half the rent charged in 2002"
Philadelphia Inquirer

All in all the evidence suggests that while the NYSE will survive and prosper, it will never have the dominance it did for much of its history and will be unable to command the large fees from investors.

Can competition make NYSE look out for investors? Yes According to NASDAQ Head.

What caused the NYSE's governance problems?

Robert Greifeld the head of the NASDAQ (who admittedly has much to gain if he is correct). he argued that the problems (which manifested themselves in Richard Grasso's pay package) were possible because the NYSE was not being held in check by competition: "That was a direct relationship to the fact that they were not under competitive pressure...."

And surprise surprise, the NASDAQ has just the competition necessary to make the NYSE look out for investors: a dual listing program that allows NYSE firms to list their shares on the NASDAQ as well.

This dual listing plan went into effect in January, but few firms (7 according to Forbes) have actually listed in both markets. But if companies regularly evaluate their listing, the systems would have to compete "and make our product better," he said. NASDAQ Chief Comments on NYSE Controversey


Wednesday, August 25, 2004

Cyberlibris blog: Finance at its best by two academic heavyweights

Cyberlibris blog:Finance at its best by two academic heavyweights%21

WOW! It just doesn't get any better than this! Interviews with both Eugene Fama and Ken French. Spectacular! They are done by Dimensional and Index Fund Advisors.


You will learn a ton!!!

* For instance, did you know that Fama had never taken a finance class? Why? It was so new!
* Or that he played football? Or that he was a French Major
* Or that he picked finance largely because he was looking for more money than he could make in Finance
* Or that Fama still teaches CAPM
* Or that French prefers the term Equilibrium over market efficiency


Watch them both, you will not be disappointed!

BTW I have been meaning to mention CyberLibris and the CyberLibris Blog. Cyberlibris is the largest European electronic business library. I love the idea and have even contributed a list of key finance articles that have been influential to me.

Their blog is aimed largely at Business majors (past and present) instead of just Finance Majors, but it is still excellent. Moreover, it was Eric Byris who helped me set up my blog :)

Tuesday, August 24, 2004

Google ranked last in corporate governance?!

"On a scale of 0 to 100, ISS gave Google a 0.2 when compared with S&P 500 companies. "It would rank dead last," says Pat McGurn, a director with Institutional Shareholder Services"

First, it really should be noted that Google is not in the S&P 500 and that comparisons to it are for illustrative purposes. But that said.

Come on, a rating of .2 on a scale of zero to one-hundred?!?! When I first saw this I figured it was just ISS trying (effectively I might add) to get some attention. However, upon further review, Google does have some policies that are at least questionable. For instance from CNNfn:

These flaws...include a dual-class capital structure that gives effective control to insiders, too few outside directors and a lack of stock ownership guidelines for executives and independent directors. The adviser also found problematic the company's compensation plan that lets Google reprice stock options if the stock price falls, as well as loans to company insiders. (

While a rating of .2 on a scale of zero to a hundred suggests otherwise, not all is bad at Google. For example, its IPO showed the firm was willing to at least try to look out for ordinary investors. Additionally the Boston Globe reports :

ISS noted several practices as positive, including Google's separation of chairman and chief executive, its compensation committee being comprised solely of independent outside directors, and its plan to hold board annual elections. Also, despite going public with several antitakeover measures in place, the company doesn't have a poison pill and allows shareholders to call special meetings.

So all does not sound quite as bad as originally reported. Mmm, maybe the judges messed up the scoring.


Friday, August 20, 2004

China considers buying Russian oil firm

Times Business: "CHINESE official said yesterday that Beijing was interested in buying the prize asset of Yukos"

Wow, this is an interesting story.

First of all it would mean that at least part of Yukos would be being renationalized. (That is it is going to be owned by a state government and not shareholders).

From the 1980s to now, privatization has been the main trend with repect to government owned businesses. This movement began in teh US and UK and then spread around the world. This renationalization would be the process in reverse with the government buying a business owned by private shareholders.

WHat makes this even more interesting is that the government buying the Russian Oil business would not be Russia, but Chinese.

On one hand it doesn't matter who purchases the oil (ignoring incentive and other inefficiencies) since the purchase is just a vertical integration. As such, the owner should still sell the oil at the variable cost (so if XYZ country wants to buy oil from China at a price above variable cost, then they should sell it). However, I am sure Tom Clancy could write such a plan into his next global thriller in a less economically neutral manner. FOr example: China wants to control the oil for military reasons. WHICH I DO NOT THINK IS THE CASE!! More likely is that China is concerned what would happen in its oil supply would be cut off.

Partially as a result of this Clancy scenario, the London Times reports that the sale of the assets to foreigners is unlikely.


Goldman Sachs to build near ground zero

New York Post Online Edition%3A business

The NY Post reported that "Goldman Sachs will build a $1.8 billion, 40-story headquarters tower in Battery Park City with the help of $1 billion in tax-exempt Liberty Bond financing, the Wall Street firm and Gov. Pataki announced yesterday.

Construction of the 1.9 million square foot skyscraper, to be completed in 2009, is to "coincide" with the rise of the Freedom Tower a short stroll away at Ground Zero"

There are three reasons why this is relevant for the blog:

1. Goldman is arguably the biggest name in investment banking and their decision to stay in Manhattan is important for NYC a city that is fighting to keep financial jobs from going to NJ and beyond.

2. It is a good example of why governments will offer tax-exempt financing. By doing so, NY State helped assure that the jobs would remain in NY rather than moving to NJ.

3. Because not only will it help students who will be interviewing with Goldman this fall, but also will be of interest when our finance club goes to NYC.

Jay Ritter on Google's IPO

Lessons of Google's Dutch auction

Well it is done. Unless you have spent the last 24 hours in on the moon with Ignignot and Err (bonus points if you get the reference :) ) or backcountry hiking, you probably have heard that Google did in fact go public yesterday. The shares were sold at $85 which was the lower end of the $85 to $95 price range (which had been revised downward--see Wednesday's blog entry)

In the secondary market the shares ended the day trading just over $100 a share.

So the obvious question has to be asked, is this better or worse than could have been anticipated had Google opted for a more traditional IPO. No more of an expert than Jay Ritter (who had worked with Google on the Dutch Auction IPO) has come to the quick conclusion that the choice of IPO process really did not matter.

Specifically he does not think the firm raised any more money, paid lower transaction costs, or resulted in more individual investors owning the firm.

(Note: several other sources, for example NY Post, disagreed with the last claim. However, I will go with whatever Ritter says until proven wrong with empirical evidence.)

It is also worth mentioning that in spite of the Dutch Auction which is designed to find the market clearing price, shares were rationed.

Overall, Ritter maintains that the Dutch Auction was the correct way to go since it could have raised more money than the traditional process. That things went poorly and they still raised as much as the more ordinary route suggests that more Dutch Auction was the right choice.

"Ritter's bottom line: We'll see more Dutch auctions in the future, particularly for companies that are as large, well-established, and widely known as Google. But they are unlikely to become the norm for the new issue market in general."


Thursday, August 19, 2004

SEC Vote Prohibits Mutual Funds From Directed Brokerage

SEC Vote Prohibits Mutual Funds From Directed "The Securities and Exchange Commission yesterday unanimously approved a new rule that bars mutual fund companies from steering trades to brokers who promise to promote the funds in exchange for stock and bond business"

This marks a continuation in the SEC's attempt to reform the mutual fund industry. Specifically, the newest rules change is an attempt to lessen the conflicts of interest and level the playing field in the ever important mutual fund industry. This rule change came about partially as a result of the scandals that have occurred in the past few years involving fund companies.

As the NY Times puts it:
"The rule on increased commissions, incentive payments known as "directed brokerage," resulted from an industry wide investigation of fund sales practices that regulators began last year. Morgan Stanley and MFS Investment Management have each paid $50 million to settle S.E.C. accusations that they failed to disclose the payments. The companies neither admitted nor denied the accusations.

The incentive payments are often hidden from investors and can taint brokers' advice, officials said at yesterday's meeting."

A definite step in the right direction!

Just an interesting note, many of these new rules were at least mentioned in a December 2003 speech by SEC Commissioner Harvey Goldschmid. It makes good reading. (or if your hands and eyes are busy elsewhere, good ristening--use the text to sound link).


Just in time for class, another CAPM Review :)

Galagedera provides an excellent review of the Capital Asset Pricing Model. From its beginnings (growing out of the work of Markowitz), to its possible demise the paper reviews the history of CAPM without breaking any new ground, but rather assuring that we are all up to speed with what has been done.

Some of the high points:

  1. The review of the existing CAPM literature is excellent and laid out in an easy to follow format. From the Capital Market Line to the work of Sharpe and Lintner, the paper describes the "whys", the "hows", and even the "why nots" of the CAPM.
  2. Unlike most textbooks, the author takes seriously the problems with non-normal returns. For instance:

    "Many researchers investigated the validity of the CAPM in the presence of higher-order co-moments and their effects on asset prices. In particular, the effect of skewness on asset pricing models was investigated extensively. For example, Kraus and Litzenberger (1976), Friend and Westerfield (1980), Sears and Wei (1985) and Faff, Ho and Zhang (1998), among others extended the CAPM to incorporate skewness in asset valuation models and provided mixed
    results....Investors are generally compensated for taking high risk as measured by high systematic variance and systematic kurtosis. Investors also forego the expected returns for taking the benefit of a positively skewed market. It also has been documented that skewness and kurtosis cannot be diversified away by increasing the size of portfolios (Arditti, 1971). "

  3. The author concludes that the assumptions (especially of normality) are important, but even when the problems of assumptions are adjusted for, CAPM still has very mixed results.
  • As a note, given Fama and French's CAPM review (See April's FinanceProfessor Newsletter, and June's FP Blog Archive ), I do feel a bit sorry for Galagedera, but it none-the-less is a very well done article and it is easy enough for upper level undergraduates to grasp with little problem. (Which is a hint to all of my students ;) )


Wednesday, August 18, 2004

The trials and tribulations of the Google IPO

Sooner or later the Google IPO will be completed, but in the mean time we can all take solace in the fact that it will provide class room material to FinanceProfessors for years to come. Almost every day the firm is giving us a great example for teaching!

Friday-- we learned that Google's founders had done an interview in playboy. This caused some problems as many feared it would violate the SEC's Quiet Period. Interestingly, the interview was done before the firm had filed for its IPO, but the publication came out after the filing and during the quiet period.

As I am sure many of you were looking forward to reading the interview, but didn't want to buy the magazine because of the pictures (right? ;-) ) , here is the interview sans pictures.

Tuesday's problem was that that SEC temporarily withheld its approval pending further investigation into how the firm "distributed stock to employees." Reportedly the firm did not properly register these shares. A fact that may lead to fines down the road.

Today (Wednesday) the NY Times reports that Google is cutting the price by about 25% (from an original price range of $108 to $135 to between $85 and $95 a share. This lowers the value of the firm to just under $26 billion--which no so coincidentally is more in line with what the NY Times said that analysts had priced the firm at in the first place).

The lower price is also causing some of the insiders who had planned on selling their shares to reconsider.
Thus, there will be fewer shares sold. The new estimate is about 19.6 million shares to be sold (down from almost 26 million). As an aside, insiders who already own shares often sell at the same time as the IPO. This lowers the transaction costs of the deal since share offerings have a large fixed cost component. Moreover, generally there is a lock-up period after the IPO where the insiders are not allowed to sell.

Is Google to blame? To a degree, but definitely not completely. For instance the timing of the Playboy interview was not the firm's fault. While the firm may have been overly optimistic in setting the price range of the shares, pricing securities is difficult and lowering valuations is not that uncommon. More than likely the firm's insistence on a rather unique IPO process (Dutch Auction) and the attempts to leave less on the table and to allow all investors to participate have led to some of the problems just because it is something different.

Perhaps Arthur Levitt (former SEC chairman) wraps it up best in Bloomberg:

"Google has been hit by the perfect storm. What's occurred is a meltdown in
technology stocks, an incredibly complicated way of handling a good new [IPO]
process, and maybe most significantly the firms sponsoring the Google offering
have been so spooked by over-regulation. Google has been a victim, actually, of
all these events.''


Tuesday, August 17, 2004

Leary and Roberts answer "Do Firms Rebalance Their Capital Structures?"

Mark Leary and Michael Roberts answer the question: Do Firms rebalance their capital structures?
And their answer? Yes!

Short Version:
Leary and Roberts find that once adjustment costs are considered, firms do in fact try to return their capital structure towards some long run average or optimal level. This is contrary to previous literature on the topic,
Longer Version:

Longer Version:
In virtually all corporate finance classes there is a discussion of capital structure (how much debt a firm uses). Once Modigliani and Miller’s assumptions are relaxed, we generally conclude that there is some “optimal level” of debt, or minimally an “optimal range.” This range is determined by the type of assets (if the asset can be used as collateral it supports more debt), the type of business (risky businesses support less debt), growth options (more options, less debt), and other factors.

Empirically this is supported when we look at industries where by and large there is similarity between the debt levels of the firms. However, the support is far from perfect and the exceptions and deviations from what long run averages (that could somehow be seen as optimal) have led many researchers to examine whether firms do try to keep their debt ratios at some “target ratio.”

Many of these authors have found that the deviations from the target seem to be larger and to exist for longer periods, than would be expected. For example
Leary and Roberts write:

“Fama and French (2002) note that firms' debt ratios adjust slowly towards their targets. That is, firms appear to take a long time to return their leverage to its long-run mean or, loosely speaking, optimal level. Baker and Wurgler (2002) document that historical efforts to time equity issuances with high market valuations have a persistent impact on corporate capital structures. This fact leads them to conclude that capital structures are the cumulative outcome of historical market timing efforts, rather than the result of a dynamic optimizing strategy. Finally, Welch (2004) finds that equity price shocks have a long-lasting effect on corporate capital structures as well. He concludes that stock returns are the primary determinant of capital structure changes and corporate motives for net issuing activity are largely a mystery.”

[A problem with] “Most empirical tests, however, [is that they] implicitly assume that this rebalancing is costless. In the absence of adjustment costs, firms can continuously rebalance their capital structures towards an optimal level of leverage. However, in the presence of such costs, it may be suboptimal to respond immediately to capital structure shocks.”

In the current paper Leary and Roberts set out to correct for this problem by considering adjustment costs. When they do so, they find that firms do, albeit sometimes slowly, adjust their capital structures.

In their words: “the effect of equity issuances on firms' leverage is erased within two years by debt issuances. Similarly, the effect of large positive (negative) equity shocks on leverage is erased within the two to four years subsequent to the shock by debt issuances (retirements).”

“Further, when firms do decide to visit the capital markets they tend to do so in several closely spaced, often consecutive, quarters. This temporal pattern
in financing decisions is consistent with the recent empirical evidence of Altinkilic and Hansen (2000), who show that debt and equity issuance costs consist of both a fixed cost and a convex variable cost.”

The paper goes on to explain why these findings are consistent with both the pecking order and the tradeoff model. And to show that the findings are also in line with survey literature that shows executives do have a target capital structure in mind.

Overall a very good and important article!


Leary , Mark and Roberts, Michael R., "Do Firms Rebalance Their Capital Structures?" (June 7, 2004). 14th Annual Utah Winter Finance Conference; Tuck Contemporary Corporate Finance Issues III Conference Paper.

New Newsletter is online!

I sent out the August Newsletter today. I really think it is the best one I have done. (definitely the top 5). So many great articles!

Here is a link to the newsletter

and a link to subscribe to it if you do not already.

Of course all of this is also available at

Have fun!

Monday, August 16, 2004

How many Boards does a director serve on? Too often the answer is too many!

Forbes has an interesting, albeit short, article that identifies 12 people who are on the boards of five or more S&P 500 firms.

Why might this be a problem? Board Members are supposed to oversee the firm's management and look out for shareholders' interests. Being on several boards can take up much time. As the article reports: "Just showing up takes 180-200 hours a year [per company]--that's just your basic work, not a company crisis.' "

Moreover, there is always the potential conflict of interest issue as well. How so? Suppose that you serve on the board of XYZ and ABC firms. What if XYZ wants to buy out ABC, or enter into a long term agreement with ABC. How can you fairly represent each firm's shareholders?

Serving on multiple boards has been a hot topic in recent years and Forbes is quick to point out that fewer directors are serving on a large number of boards.


Saturday, August 14, 2004

What will the US economy do? Probably more slow growth

I have had two emails and two phone calls this week asking my opinion on the US economy. So I might as well share with you my answer.

Short answer? Tough to say, but I think we will continue to see slow growth.

A caveat, gauging how the US economy will do in the future is only slightly easier than determining how the Buffalo Bills will do this year (BTW my prediction: 9 and 7).

Events and news that suggest the economy is doing well:

  1. The economy has been doing well: the revised numbers for the first quarter suggest a 4.5% increase in GDP. And like any giant economy, it takes some time to change course. Thus, whatever happened in recent past is likely to continue for some time. Unquestionably, the rate of the expansion is slowing, but it is unlikely to go from fairly solid growth into negative growth in a short time frame. Moreover, most Leading Economic Indicators are still heading up, even though their rate of growth has slowed considerably.,,
  2. While job growth has slowed and only 32,000 new jobs were created in July , iInitial jobless claims were down slightly this past week.
  3. In spite of rising energy prices, inflation seems low.,,
  4. July retail sales that were again up.
  5. While public opinion suggests the contrary, the latest numbers show strong growth in the US manufacturing sector.
  6. The Fed, who presumably has better information than any of us, signaled its belief that the economy was doing well as it raised interest rates (to slightly slow the economy and prevent inflation) for the second time this year.,

Events that suggest the economy is slowing down

  1. Consumer confidence as indicated by The University of Michigan Index of Consumer Sentiment Index fell in August.
  2. The US trade deficit swells in June as Exports dropped an almost staggering 4.3% in June. [Their largest drop since September 2001],
  3. Oil Prices are near or at record highs. This will serve as a drag on growth at a time when the economy is already showing signs of slowing. So far this has not corespsonded to rapidly rising gasoline prices in the US, but assuredly higher oil prices will negatively impact the economy.
  4. The US Budget deficit is rising, leaving government stimulus projects as unlikely and costly alternatives.,
  5. Job Growth has ground to a near standstill. Only 78,000 new jobs in June and 32,000 in July.,

Ok, so get off the fence. What will the economy do?

It is a very tough call but I will go with the Fed's information advantage as being the most important factor. Thus, my prediction (which is more a guess than a prediction) is that the US economy will continue to grow at a slow (less than 2.5%) rate for the rest of the year. That said, if I were on the Fed, I think I may be a bit reluctant to raise rates again until there is some better economic news.

From a political side, it will be interesting to watch the presidential candidates do battle over the economy. With so much economic data to choose from, both side will have plenty of ammunition to support their claims.

A few useful Web sites that track economic events

  1. Has a very cool "scorecard at the bottom of the page. Excellent!
  2. Not as good as t used to be, but still pretty good, up to date and thorough.
  3. Business Week's Economy -good, but not as complete as some
  4. The Fed's site for economic data. If you like your data without interpretation.
  5. Maybe the best. Yes it is a pay site, but a VERY good pay site!!
  6. MSNBC--As the above links suggest, I do use this one quite a bit.
  7. The Washington Post's Economy Page - More in depth coverage and analysis than many of the "news" sites.

Friday, August 13, 2004

SSRN-Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them by Michael Jensen, Kevin Murphy, Eric Wruck

SSRN-Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them by Michael Jensen, Kevin Murphy, Eric Wruck

In many ways, Murphy and Jensen's 1990 paper on CEO pay may have been one of the most influential finance papers written in the past 15 years. It showed not only how CEOs were being paid, but also stressed the importance of incentive based (pay for performance) pay. As I wrote in the summary of that paper for my classes: This is a classic work in the field. It laid the groundwork for much of the executive compensation research that followed.

Regular readers will realize that in the 15 years that have followed Murphy and Jensen have kept more than busy with each rising still higher into the upper-Echelon of academic finance. While Jensen has been busy in many areas within finance, Murphy has specialized in Executive compensation.

Now the two stars have again gotten together (with the assistance of Eric Wruck) to produce what may well be considered the definitive look at executive compensation in the post corporate governance crisis era. They now only show how things have changed since 1990 (the pay level has gone way up and options dominate more than anyone would have dreamt in 1990), but also show how things are changing as a result of both accounting scandals (Enron, Etc) as well as the public outcry from Grasso's compensation from the NYSE and Jack Welch's pay from GE.

In a move that is often outside of academic writings, the authors also make 38 recommendations that can be used by company Boards of Directors as well as financial market regulators to improve the way executives are rewarded. (As an aside, these recommendations are near the top of the paper and will likely serve as a good executive summary for in-class usage.)

While I am not going to attempt to completely review the entire 116 pages here (that was not a misprint! the paper is over 100 pages long!), I will point out some of the more important points.
  • "Companies should embrace enlightened value which 'creating firm value' is not one of many objectives, but the firm's sole or governing objective" (R1) This must then be integrated with the pay system.
  • Try not to use employment contracts (R2)
  • Do not reward "incompetence" or when the executive is replaced "for cause"
  • Recognize (i.e. expense) the cost of stock options
  • Be as transparent as possible with pay packages
  • Do not allow overvalued equity to exist. Communicate to the market that it is overvalued, even though it will lead to a lower stock price. This is not a contradiction. Too many problems result from poor incentives and from basing decisions based on overvalued equity. In the long run, communcating the truth to the markets will be better for shareholders. (Note this is identical to the Jensen 2004 paper we reviewed in June.)
  • Short Sellers may know something. Audit committees should "cummuncate" with them to know what to look out for.
  • FinanceProfessors should teach of the dangers of overvaluation (consider it done). I love their quote, one we have used in class before: "Maximizing firm value does not mean maximizing the price of the stock." To which iI would add: know the difference between short-term maximazation based on information assymentries and true long term maximization.
  • Make sure boards know they work for shareholders and not for the CEO.
  • Independent chairman persons are prefered.
  • Stock options should be adjusted for dividend payments
  • Stock options should be indexed so that the stock price must rise at a rate above teh company's cost of equity.
  • "Do not measure performance anywhere in an organiztion with ratios. Simply put: if it is a performance measure and a ratio, its wrong"

Wow. What a paper! I can imagine teaching out of nothing else but this paper for several class periods! I HIGHLY RECOMMEND READING IT!!!!


Jensen, Michael C., Murphy, Kevin J. and Wruck, Eric G., "Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them" (July 12, 2004). Harvard NOM Working Paper No. 04-28; ECGI - Finance Working Paper No. 44/2004.

This paper is copyrighted by the authors.

BTW In the interest of full disclosure I must say that I took a class from Murphy at the University of Rochester and it was one of my favorite 4 or 5 classes I ever took. So my writing on his work may be slightly biased. But I doubt it ;)

SSRN-Facts and Fantasies about Commodity Futures by K. Rouwenhorst, Gary Gorton

SSRN-Facts and Fantasies about Commodity Futures by K. Rouwenhorst, Gary Gorton

If you talk to most investors, they consider investments as only stocks and bonds. However, other assets should also be considered. For example real estate and commodities can be very useful as ways of reducing risk.

Why are commodities so important? They play an important role in diversifying a portfolio. For instance, Rouwenhorst and Gorton find that "While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns."

Which of course is ideal from a diversification perspective! :)

Rouwenhorst, K. Geert and Gorton, Gary B., "Facts and Fantasies about Commodity Futures" (June 14, 2004). Yale ICF Working Paper No. 04-20.

Thursday, August 12, 2004

CBC News: Gene therapy turns lazy monkeys into workaholics

CBC News: Gene therapy turns lazy monkeys into workaholics

Compensation (which is essentially reward for work) is one of my favorite topics in finance. So of course this story on monkeys made me take notice!

Short version: how hard you work may be partially genetic. Which might help to explain why some people do not respond to changes in pay plans etc.

From the CBC:
"Without the dopamine receptor, they consistently stayed on-task and made few errors, because they could no longer learn to use visual cues to predict how their work was going to get them a reward," said Richmond said.

In effect, the monkeys became workaholics. "This was conspicuously out-of-character for these animals," he said.

Both monkeys and humans tend to procrastinate when they know they have to do more work before getting a reward, and then work harder as a deadline looms.

The researchers hope the study will help them to understand some mental disorders. People who are depressed often find work unrewarding while those with obsessive-compulsive disorder may work incessantly for little reward.

The study appears in this week's online issue of the Proceedings of the National Academy of Sciences"

Also :

gee, this would make a perfect Dilbert episode!

SSRN-The Rational-Behavioral Debate in Financial Economics by Alon Brav, James Heaton , Alex Rosenberg

SSRN-The Rational-Behavioral Debate in Financial Economics by Alon Brav, James Heaton , Alex Rosenberg

Looking for a finance paper without complex models or rigorous math? This is it! Brav, Heaton, and Rosenberg discuss the debate over behavioral finance and conclude that neither side is totally correct.

Most of the existing debate centers on findings of apparent irrationality (example over trading, over confidence, price bounces, etc). The behavorialists find this anomaly and then the rationalist attempts to explain it in the context of rationality. Thus, when something that apparently does not jive with rationality, it must be that the model that the researcher is using must be incorrect.

In what is the paper's biggest contribution, Brav, Heaton, and Rosenberg correctly point out that in doing this, rationalists are making an implicit assumption, namely that people are rational. And this assumption, which may or may not be valid, flies in the face of what Milton Friedman position that the key part of any positive science is its predictive ability.
"The most controversial consequence of Friedman's approach is' the idea that the
realism of "assumptions" is irrelevant to the assessment of a theory follows
from the primacy of predictive success. Put simply, those who worry about the
realism of assumptions unnecessarily constrain the 'proper' objective function
of a predictive science. Since that constraint may eliminate highly
'unrealistic' assumptions that nevertheless maximize predictive power, the
constraint hinders the 'ultimate goal of a positive science' and is therefore
ill-advised. "
However, as the authors point out this lack of assumption importance is not the case. "Rather, rational finance seeks to 'explain' price behavior with coherent stories based on a constrained portion of the assumption space-- that portion that includes only assumptions consistent with complete rationality."

(As an aside, the section by Mark Rubenstein is very good! Short version?: When I went to financial economist training school I was taught 'the Prime Directive': explain asset pricing by rational models. Only if all attempts fail, resort to irrational behavior. That is, as a trained financial economist, with the special knowledge about financial markets and statistics that I had gained and aided by the new high tech computers, databases and software, I must be careful how I used my power. Whatever else I did, I should follow the Prime Directive." Which while funny, is not that far from the truth. )

Following this opening, the authors shoot down most of the so-called successes of rational finance (no arbitrage, market efficiency, and NPV) as lacking predictive success or as being untestable (reversing the traditional attack on behavioral finance). The big success of rational finance? "the relative success of predictive models in derivative pricing is undeniable. Tellingly, derivative pricing theory may be the only theoretical endeavor in which assumptions regarding market structure are reasonably 'realistic'.

Moreover, many of these failures are derived (no pun intended) from institutional particularites that do limit the ability of participants (even those who are behaving rationally) from acting as so called rationalists would expect. Thus "the very flexibility of rational modeling that may help support the
existence of irrationality-induced anomalies in financial markets"

The authors conclude with a desire for a peace.
"Taunts traded by each side in the rational-behavioral debate are often both
inconsistent and unconstructive. Rational finance advocates have long criticized
behavioral finance for lacking novel and quantifiable predictions of financial
market behavior. But rational finance itself has few achievements of that sort.
At the same time, behavioral finance advocates criticize the effort to
'rationalize' behavior by factoring information sets, utility functions, and
transactions costs into the rational choice model [see De Bondt (2002)].
Behavioral finance advocates are perhaps right to criticize the flexibility of
the rational apparatus. But they go too far when they deny the role that
'rationalization' plays in supporting the limits of arbitrage."


"At the end of the day, however, the pretended debate over 'testability'
and 'prediction' often hides the real successes and failures of both sides,
and masks the interesting but unexplored links between the two approaches."

I told you it would get you thinking! :)

Brav, Alon, Heaton , James Breckinridge and Rosenberg, Alex, "The Rational-Behavioral Debate in Financial Economics". Journal of Economic Methodology, Forthcoming

Tuesday, August 10, 2004

SSRN-How the Inflation Illusion Killed the CAPM by Randolph Cohen, Christopher Polk, Tuomo Vuolteenaho

SSRN-How the Inflation Illusion Killed the CAPM by Randolph Cohen, Christopher Polk, Tuomo Vuolteenaho

Wow! It seems like I say that frequently, but what this paper definitely deserves a wow.

CAPM is dead. We know that. Only the most optimistic of those (myself included) hold out hope of its recovery.

Its death has been widely reported since Fama and French (1992). However, that does more to say that CAPM is dead, not why or how it died.

The CAPM had been on its sickbed for years. Looking back we see the evidence. In addition to a slew of anomalies (size, market to book, calendar to name but a few), there was more serious trouble in the findings that suggested CAPM worked sometimes and didn’t work at other times. For instance CAPM did a bad job of explaining returns in the in the 1950s and in the post 1980 period. Additionally, previous literature (for instance Black, Jensen, and Scholes (1972) had found the empirical SML to be flatter than expected and to have an intercept (zero beta portfolio return) that is greater than the Risk Free rate.

Maybe, just maybe we now know some of the details of CAPM’s death thanks to the work of the great detectives Cohen, Polk, and Vuolteenaho (who are in reality professors but will play the role of detectives in this report). They released their findings in the paper “How the Inflation Illusion Killed the CAPM.” (

The short version of the work is as follows:

To set the stage a bit: remember that the Expected market risk premium is the expected return on the market minus the expected inflation rate (which is largely the risk-free rate). So (ERm – RF) equals the expected market risk premium.

They begin off by further investigating Modigliani and Cohn’s 1979 suggestion that the market incorrectly values assets because of irrationally accounting for expected inflation rates. While this irrationality was difficult to accept when the M&C paper was published in 1979, there has been enough time-series evidence since that time to make the hypothesis more palatable (Sharpe 1999, Asness (2000), Campbell and Vuolteenaho (2004) etc.).

In simple terms, Modigliani and Cohn (1979) stated that investors irrationally accounted for inflation by overemphasizing recent inflation rates. Thus, when inflation is high, investors expect inflation to remain high. This is ok as far as it goes, but the error comes when they (the investors) fail to realize that earnings will also grow with inflation. Consequentially, when inflation is high, the market risk premium is too low (since the expected inflation rate is subtracted in the risk premium calculation).

To test this, the authors (err detectives) “propose a behavioral hypothesis that the market uses the Sharpe-Lintner Capital Asset Pricing Model (CAPM, Sharpe 1964, Lintner 1965) but suffers from inflation illusion.” They then proceed to “ show that an implication of this joint hypothesis is that the security market line (the relation between an asset’s average return and its CAPM beta) is steeper [i.e there is a larger risk premium] than predicted by the Sharpe-Lintner CAPM when inflation is low or negative. Conversely, when inflation is high, the security market line is shallower [i.e. there is a smaller risk premium] than the Sharpe-Lintner CAPM’s prediction.”

The results? Sure enough, the empirical evidence supports the hypothesis of Modigliani and Cohn. And the author/detectives conclude that “we find that the CAPM fails predictably with inflation, consistent with the Modigliani-Cohn inflation illusion hypothesis.”

So what does this all mean? For starters, we may have an important piece of the puzzle as to how assets are priced. Moreover, there is more evidence that investors are not always perfectly rational and that they may over emphasize recent conditions.

A question that merits future attention is whether this finding could help to explain the growth and value anomalies. For example, if value stocks do better when the economy is doing well (and hence inflation may be higher), is the apparent outperformance a market problem or a model problem? I do not know but definitely look forward to finding out!

BTW this is definitely going to be required reading for my classes, I hope you read it as well and do not just rely on this review.

As an aside, Richard Cohen (yes one of the authors) sugggested the following which makes the paper more readily understandable:
"One point might be worthy of clarification if it can be done without making things too complicated. It's not that investors are wrong to assume inflation will be similar to recent inflation. Their mistake is forgetting that earnings will go up with inflation. Thus if T-Bills pay 12% because of 10% expected inflation, and earnings yields are at 11%, investors look and say, hey, the (safe) T-Bill return beats the yield available in the market [I'm oversimplifying here]; let's sell our stocks and buy T-Bills." They should be saying, "not only do stocks yield 10%, but the earnings will grow at 11% next year because of high inflation, making stocks very attractive indeed." "

Cohen, Randolph B., Polk, Christopher Keith and Vuolteenaho, Tuomo , "How the Inflation Illusion Killed the CAPM" (May 12, 2004).

A newer version of this, entitled "How Inflation Illusion Killed CAPM" is available at

The New York Times > Washington > Crucial Unpaid Internships Increasingly Separate the Haves From the Have-Nots

The New York Times > Washington > Crucial Unpaid Internships Increasingly Separate the Haves From the Have-Nots

I can not stress enough the importance of internships. They are critical in getting a permanent job. Internships provide valuable experience that serve both as a learning experience and a test job. I definite;y recommend that any student get one (or more) before they graduate. That said, non paying internships do make for difficult decisions: take a job that pays or an internship that will pay off in the future.

The NY Times reports on internships by correctly stating that internships continue to increase in importance: "The focus on internships as a tool for professional success has never been greater, according to Mark Oldman, co-author of "The Internship Bible" and co-founder of Vault Inc., a career counseling company. About 80 percent of graduating college seniors now have done a paid or unpaid internship, according to surveys by Vault, compared with about 60 percent a decade ago. "

"The interest in internships is at a fever pitch," Mr. Oldman said. "It used to be that internships used to be a useful enhancement to one's résumé. Now it's universally perceived as an essential stepping stone to career success"

However, the article points out that non-paying internships are particularly difficult for those from lower economic classes who need a paying job. "As internships rise in importance as critical milestones along the path to success, questions are emerging about whether they are creating a class system that discriminates against students from less affluent families who have to turn down unpaid internships to earn money for college expenses"

Monday, August 09, 2004

BW Online | August 9, 2004 | Oil Prices Could Get Even Worse

Business Week speculates that we could see $50 a barrel oil sooner than we expect.

Why? Demand increases as well as production limits brought about not so much by OPEC but by not having excess capacity in the production of more oil. This lack of capacity is in part driven by lack of investment in the past, in part due to political turmoil, and partially because of OPEC's production limits. With this little excess, any small problem would quickly be magnified and it would lead to higher oil prices.

What would higher oil prices do? For starters, higher prices would slow the economy. For instance, the BBC reports current prices could already be "[shaving] as much as half a percentage point off global growth."

Longer term however, higher prices would also encourage the market-driven development of alternative energy sources. It is for this reason that some in OPEC are beginning to worry.

BBC NEWS | Business | First Islamic bank to open in UK

BBC NEWS Business First Islamic bank to open in UK

Well it took a long time, but finally the first purely Islamic Bank is set to open in the UK. Of course, traditional British banks have been offering some "products tailored for Muslims".

The biggest difference between traditional Western banking and Islamic Banking is the absence of Interest. Consequentially the banks have to come up with alternative ways to make money. They do this with leasing and arrangements similar to repurchase agreements.

For more in Islamic Finance (including its relation to socially responsible investing), please check the notes I use for my International Finance Classes. The notes were developed with the help of my friend Luma Zetani.

The New York Times > Financial Times > International Accounting Reform is on the way :)

The New York Times > Financial Times > Business > Hand that guides EU accounting reform

The New York Times > Financial Times > Business > Hand that guides EU accounting reform: "More than 7,000 listed companies in the EU will use international accounting standards, in what will be the biggest accounting reform in Europe for a generation"

John Tiner, the chairman of the Committee of European Securities Regulators' financial reporting group is interviewed in the Financial Times today. He is the regulator in charge of helping to guide EU members' accounting regulation.

Short version: some reform and standardization are on the horizon, but not complete standardization. As anyone who has ever looked over international financial statements will vouch, more standardization is necessary! Standardized accounting systems will increase transparency, lower transaction costs, and allow international investing to increase. While this it is not the end of the story, but it is a step in the right direction!

A few highlites from article:

* "Mr Tiner's CESR group is focused on how to ensure the 25 EU countries have strong enforcement bodies that can spot and correct accounting abuses"

* "The biggest challenge is how to prevent the emergence of 25 versions of international accounting standards. This could happen if the bodies make significantly different interpretations of the 36 international standards"

* "Mr Tiner does not rule out the possibility of a pan-European enforcement body emerging"


Friday, August 06, 2004

SSRN-Lifetime Earnings, Social Security Benefits, and the Adequacy of Retirement Wealth Accumulation by Eric Engen, William Gale, Cori Uccello

SSRN-Lifetime Earnings, Social Security Benefits, and the Adequacy of Retirement Wealth Accumulation by Eric Engen, William Gale, Cori Uccello: "Engen, Galle, and Uccello provide new evidence on the adequacy of household retirement saving." Their findings may surprise some given the gloom and doom reporting by many in the popular press.

Short Version: the wealthy and middle class largely are saving enough, but the poor are not.

Longer version: It is no secret that "The United States has traditionally depended on the so-called three-legged stool -- Social Security, private pensions, and additional personal saving -- to finance retirement, but all three legs are becoming increasingly creaky. " So Engen, Galle, and Uccello provide a valuable service when they investigate (via simulation) the degree to which the "additional personal savings" leg is up to the task of filling in any gaps that may (will?) exist after pensions and social security.

The paper is remarkably thorough and well done in investigating everything from tax rates, to death rates, to savings rates, to returns on investment, to the optimal color of kitchen sinks (ok, you got me there, just wanted to make sure people were still reading :) )

Not surprisingly they find the wealthy are doing fine with respect to savings. Somewhat surprisingly, the middle income earners seem to be doing OK as well. The poorest 25% of the population however is not saving enough (SHOCK!).

In possibly the biggest contribution of the paper, it acknowledges that life is risky. Doing so forces the researcher to incorporate this randomness into any analysis. This makes for a much more robust and complete model.

A further consequence of the risk is that people do not know exactly how much to save and that some people may not be able to save as much as they had planned. In the words of the authors: "in a stochastic life-cycle model that allows for uncertainty in earnings and mortality. Uncertainty about future earnings implies that there will be a distribution of optimal wealth-earnings ratios, rather than a single benchmark ratio, among households that are otherwise observationally equivalent (that is, have the same age, education, pension status, marital status, and wage history). This finding fundamentally changes the interpretation of observed saving patterns relative to a non-stochastic model. In particular, it implies that some households should be expected to exhibit low ratios of wealth to lifetime earnings even if every households is forward-looking and making optimal choices."

Of course, everyone wants to know what would happen in the event of a cut in social security. The authors test this and find that a cut would be harmful to those without enough savings (really!?).

More shocking is their claim that "The overall effect of a 30 percent social security benefit reduction is several times as large as the effects of a 40 percent reduction in stock market values." (FTR they unfortunately have seemingly ignored the economic effects of a 40% drop in stock value. (Example it would also impact pensions, income, etc)). Predictably, they find that a 40% decline in stock values would not impact all families equally:

1. "There is essentially no effect on highly-educated households".
2. "The change would hit moderate earnings households particularly hard."

Overall: An important paper that should take some of the fear out of retirement savings discussions.

All quotes signify direct quotes of the authors work. The actual paper is copyrighted by the authors. (not sure why that would not be assumed, but the paper says to put it in, so I did.

Wednesday, August 04, 2004

Save the environment, call a financier.

Finance to the rescue! An interesting deal with Amazon “açaí (pronounced ah-sigh-EE) - a dark purple berry rich in nutrients that sprouts atop the millions of palm trees lining the riverbanks in the Brazilian jungle” harvestors/farmers allows them to lock in a better price in return for preserving some wild areas. (gee hedging again! Do you notice a theme?) The buyer? Sambazon, short for Saving and Managing the Brazilian Amazon Rainforest, who is now selling the products in the US and around the world.

Today’s accounting lesson? Tell people when you change accounting policies!

Without admitting guilt, Halliburton agreed to pay a $7.5 million fine to the SEC. This investigation has drawn much attention because the reason for the investigation (questionable accounting practices) happened during John Cheney’s (current VP of US) reign as CEO. “The accounting change dealt with the way Halliburton booked cost overruns on projects….The actual change in accounting, the commission said, was permissible under generally accepted accounting principles, but the failure to inform investors that the change had been made - and of its effect on the company's reported profit - violated securities laws.” NY Times 8/4/2004

Score another one for increased transparency!!! :)

Hedging: It’s good for you and good for your company

European Airlines Review Hedging As Oil Prices Rise: "Already grappling with stiff competition and deep cost cuts following a slump in global travel, rising fuel costs are the latest blow to the beleaguered industry"

Oil prices are at all time highs (in nominal terms) on both supply (OPEC said they could not pump much more at present) and demand (higher than expected) concerns. Now I am guessing you have heard that from a zillion places. And moreover, I would wager that you probably expected oil prices to fluctuate. So is it just me who is angry every time airlines (this time it was American Airlines) complain about the price of fuel.

Why? They can easily be hedging this risk.

While hopefully their CFOs are all subscribers to the FinanceProfessor Newsletter and read all about the good aspects of hedging when we reviewed the Simkins, Carter, and Rogers paper on airline industry hedging practices. The paper is so interesting we reviewed it a twice. First in 2001 and then again this past spring-the latter review is listed below. But maybe the executives missed those issues (spam filters being what they are and all).

So if they did miss that, and are still not reading this, maybe these constantly complaining executives may happen to have heard of a firm called Southwest Airlines ;) The low cost airline from Texas recently named Gary Kelly as their new CEO. Kelly, an accountant who was formerly the CFO, is probably most famous for his hedging of jet fuel. How well did he hedge? The firm is reported to have locked in oil at $24 and $25 a barrel for much of the next two years. Remember current market price is over $44 a barrel! Gee, I bet that helped his reputation 
It is interesting to see the how other airlines (both in the US and abroad) are dealing with the high jet fuel prices. For instance, Ryanair had hedged much of their fuel only through October. When this fact was admitted, the stock price fell about 3% on volume that was twice its average. “Scandinavian airline SAS plans to announce next week it has decided to resume hedging after being left exposed since the first quarter, while Swiss International Air Lines faces more potential losses after selling hedges to boost cash reserves.”

I will concede that there is truth to the claims that hedging long term risks is more expensive for firms with high financial risks, but the added cost is not a good excuse! So get out there and hedge! You too may end up as CEO.


Articles on Southwest’s hedging,1,6498775.story?coll=hc-headlines-business

Article on other airlines hedging —VERY GOOD!

For complaints on high jet fuel prices:
From Reuters on July 31, 2004:
“``Record-high fuel prices and an intensely competitive domestic revenue environment have made the need for further cost-cutting all the more clear,'' Gerard Arpey, chief executive of American parent AMR Corp. (AMR), said earlier this month.
Continental Airlines (CAL) has said in recent months that fuel prices would add an extra $700 million in operating expenses this year, and it might have to lay off workers as a result.
``The current revenue and fuel environment have overwhelmed our efforts to return to profitability, and we now must achieve significant additional cost reductions,'' Continental CEO Gordon Bethune said when the airline released its quarterly earning in July.


From the January 13, 2004 FinanceProfessor newsletter:

My chairman Jeff Peterson complained recently that academic publications travel at "glacial speed". The paper is by Simkins, Carter, and Rogers and looks at hedging in the US Airline industry is one such paper. It really is one of my favorites. I saw it presented a few years ago and I thought it was close to publication then, but I guess the glacier has not yet completed its journey as the paper was presented at this year's AFAs. Their findings? Hedging does create value. Using regression analysis, they report that hedging increases firm value by over 10%! How? One hypothesis is that hedgers can better afford to maintain capital spending when jet fuel prices climb. This view is supported by their finding that there is a "positive relation between hedging and…increases in capital investment."

Tuesday, August 03, 2004

Do takeovers destroy wealth for acquiring firms? Yes, according to Moeller, Schlingemann, and Stulz.

Moeller, Schlingemann, and Stulz examine the returns to acquiring firms in takeovers. They find that "from 1991 to 2001 (the 1990s), acquiring firms' shareholders lost an aggregate $216 billion, or more than 50 times the $4 billion they lost from 1980 to 1990 (the 1980s), yet firms spent just 6 times as much on acquisitions in the latter period."

However, before you say that all takeovers are bad, there are several key points that can get buried in the headline. For instance, most firms did not lose money. The large losses seem to be concentrated in the 1998-2001 time period and further concentrated in a relatively few large deals.

In the author's words: "the average acquisition creates wealth for acquiring-firm shareholders. Instead, this large loss is caused by an increase in the size of the dollar losses of acquisitions with the worst dollar returns that is not offset by an equivalent increase in the size of the dollar gains of acquisitions with the best dollar returns. Statistically, the distribution of dollar returns in the late 1990s exhibits substantially more skewness compared to earlier years"

They continue: "Out of the 4,136 acquisitions from 1998 through 2001, 87 are large loss deals. The aggregate wealth loss associated with these acquisitions is $397 billion, while all other acquisitions made a total gain of $157 billion. The large loss deals represent only 2.1% of the 1998 to 2001 acquisitions, but they account for 43.4% of the money spent on acquisitions." This negative return is both large and significant: "The excess return of the large loss deal portfolio over the matching-firm portfolio is -39%."

Prior to making the bad acquisition, the acquiring firms had been a. active in the acquisition market and b. outperforming the market. Thus, "the evidence is consistent with the view of Jensen (2003) that high valuations give management more discretion, so that management can make poor acquisitions if it [management] values growth more than shareholder wealth." However, the authors do not feel this high valuation " is not sufficient to explain the change in returns associated with acquisition announcements, since these firms have comparable valuations when they announce previous mergers or acquisitions that are associated with positive abnormal returns." Rather it is hypothesized that "the acquisitions led
investors to reconsider the extremely high stand-alone valuations of the announcing firms."

Attempts to explain this negative returns using regression analysis are only marginally useful and can only explain about 20% of the negative abnormal return.

Moreover it does not appear to be due to diversification: "Large loss deals are more likely to be hostile and more likely to be tender offers than other transactions, but the fraction of large loss deals that are tender offers or hostile is small enough that these deal characteristics seem unlikely explanations. The acquisitions in our large loss deal sample are more likely to be within the acquirer's industry than are the other acquisitions, but the difference is not significant. The large loss deals cannot be attributed to diversification attempts."

To summarize: most deals are slightly positive or at least neutral, however many of the larger deals (especially in the later 1990s) appear to be losers and the size of these deals is enough to make the overall average return negative. This is consistent with Jensen's overvaluation problem.

Of course what can not be measured is how far the firms would have fallen had they not done the deal (see Shleifer and Vishny 2003--yeah I know this version is a 2001 version, but I cannot find a link to their 2003 JFE article.

This paper is forthcoming in the Journal of Finance:

A previous version of this is available through FEN.

NYSE to increase electronic trading

As the NY Times reported "Electronic Trading on Big Board upstages Terror Talk"

It has long been assumed that sooner or later the NYSE would become more electronic. Today the world's most famous stock market decided that there is no time like the present and announced that the NYSE would become more of a hybrid market with both electronic and floor trading.

As the NYSE press release states "The New York Stock Exchange is undertaking a significant upgrade in the utilization of technology to execute securities transactions. On Aug. 2, the NYSE filed with the SEC to expand the NYSE Direct+® system, which currently accounts for approximately 10 percent of trades executed. Limits will be eliminated on the size, timing, and types of orders that can currently be submitted via Direct+, and a number of other new features requested by our customers will be incorporated. At the same time, the NYSE will retain the advantages of the agency auction model, which has proven to provide the most efficient, lowest cost executions and the best ability to cope with market stress."

Thus the current limits on electronic trading are being removed which will allow more electronic trading, BUT the current system of a specialist and floor traders will still exist (especially when there are market imbalances and at the open and close).

Why is it being done? Again the NY Times "Institutional investors have long complained that they cannot trade with speed and anonymity at the exchange and as a result they have directed much of their trading to the Big Board's electronic competitors"

Looking for people who will not be happy with the change? Look no further than specialists and floor brokers. They will not be in favor of the change (especially in active, liquid stocks that are currently most affected by the constraints) as they will be losing more market share.

The press statement:
The NYSE's press releases and new conference
BTW Listen to the press conference--23 minutes and it is really interesting!