Fama on Market Efficiency- Not the same old thing!

sometimes I hate technology! I have rewritten this three times now. It keeps disappearing.

WOW! If you have not read today's WSJ piece on Market Efficiency be sure to do so! It is on the first page (far left hand column) by Jon Hilsenrath. It is worth making a trip out to buy the paper if you do

Short version:

Even Fama is now admitting that behavioral finance has its place in the field.


As a rule I will not link to material you have to pay for, but this is so good I had to!

http://online.wsj.com/article/0,,SB109804865418747444,00.html?mod=home%5Fpage%5Fone%5Fus



more to follow...

Norwegian, American share Nobel economics prize - Oct. 11, 2004

Norwegian, American share Nobel economics prize - Oct. 11, 2004

Congratulations to Finn Kydland and Edward Prescott on winning the 2004 Nobel Prize for Economics!

While economic forecasting is difficult, our understanding has improved greatly in recent decades. We have come to understand that monetary and fiscal policy are important and that the supply side (not just the demand side) must be considered. These insights are in no small part because of Kydland and Prescott.

In any Macro Economics class or Money and Banking class it is now standard fare that supply shocks matter. For instance, the economy soared in the 1990s in part because of the increased technology that was available. Kydland and Prescott were at the forefront of this economic revelation when in 1982 "they created a model which showed that supply-side shocks -- such as technology -- are a driving force behind the business cycle, rather than variations in demand alone." (CNN)

Their famous 1982 Econometrica paper also showed the importance of expectations on the business cycle. For instance, if higher inflation is expected, but not here yet, market participant's will act as if it is there. This was particularly important during the 1970s when central bankers continually changed their policies designed to keep the inflation in check. Predictably, these changes often led to higher inflation. From the San Francisco Chronicle:

"In the 1970s, many Western countries had high inflation because their central
banks didn't keep a consistent monetary policy. They accepted rising inflation
for a short-term decrease in unemployment, said Per Krusell, a member of the
Nobel Committee for Economics. A 1977 article by Prescott and Kydland
highlighted this problem, which led to many countries forcing their central
banks to stick to certain policies, regardless of market forces."

Kydland teaches at Carnegie Mellon University and the University of California. According to the SF Chronicle he was teaching when he herd he had won:

"Kydland told The Associated Press he learned about the prize during a lecture
at the Norwegian School of Economics and Business Administration in Bergen,
Norway. "I was a little perturbed when they interrupted my lecture until I got
to the secretary's office and found out what the phone call was about,"

Prescott teaches at Arizona State. No reports as to what he was doing when he heard.


Overall a very good choice! FWIW I still think Jensen and Fama are deserving of the award. Maybe next year!

Finally something economists agree on: Free Trade! A speech by the Fed's Roger Ferguson

FRB: Speech, Ferguson--Free Trade: What Do Economists Really Know?--October 7, 2004

Quick what is the only thing that economists can agree on? Free Trade! That said, many in the "public at large" do not agree. That is why it always serves us well to go back and see why free trade is a "good thing."

Bravo!! Fed Vice Chairman Roger Ferguson does a wonderful job defending Free Trade!

Ferguson begins off by explaining that many factors influence the economy, but his talk would focus on free trade. This focus is largely because in recent years there has been a split between economists and "the public at large" over free trade.

From a longer time perspective free trade is increasing:

"In the past half-century, global trade has become freer and has expanded rapidly. The ratio of trade (exports plus imports) to worldwide gross domestic product rose from only 16 percent in 1960 to 40 percent by 2001. In 1960, the United States, Germany, and Japan had average tariff rates of around 7 percent; these rates were more than halved by 1993."

Although most economists welcome these trends, the public at large has been much more ambivalent about international trade. Attitudes toward free trade in principle remain generally positive, but a substantial--and, perhaps, growing--minority of Americans hold more negative views."

Ferguson goes on to list benefits of free trade:

1. "International trade allows us to choose from a wider array of goods than would otherwise be available." This he estimates to be worth approximately 3% of GDP.
2. "A second benefit of international trade is its role in reducing the cost of goods and hence in raising our standard of living" While acknowledging the difficulty in valuaing this benefit of this cost reduction, he cites examples of products that enjoy the benefits of protection and shows that these goods have not fallen in price as much as goods and services that are subject to competition.
3. A "third key benefit of free trade is that it allows economies to specialize in the activities they do best. This notion was at the core of the classical economists' defense of free trade."
4. "In addition to promoting specialization, trade boosts productivity through a fourth channel of influence: opening the economy to heightened competition. This effect could occur either as firms are spurred by foreign competitors to become more efficient, or as the least productive firms are forced to close, thus raising the average level of productivity for the economy as a whole."

Ferguson also lists "Arguments agsinst Free Trade"

1. Trade has "given rise to large trade and current account deficits."
2. Trade leads to lost jobs. Here Ferguson gives several variants of the basic theme that free trade costs jobs. The key point: "Import competition clearly has cost some American workers their jobs and has caused them considerable hardship as a result. However, economywide equilibrating forces, including monetary policy, ensure that over time such employment losses are offset by gains elsewhere in the economy, so that the nationwide unemployment rate averages around its equilibrium level. In fact, the inflow of foreign capital that finances our trade deficit provides the funding for investment projects that employ U.S. workers." While the number of people losing their jobs as a result of international trade is relatively small, "We cannot and should not minimize the hardships of workers displaced by imports."
3. Many believe that "discuss is that import competition, whether or not it affects the number of jobs, shifts the employment mix from high-quality jobs to low-quality jobs.... However, no conclusive evidence has shown that, over the long haul, the service jobs being created pay less or are otherwise less desirable than manufactured jobs being displaced. Moreover, the declining share of manufacturing in U.S. employment most likely stems less from import competition than it does from the rapid pace of productivity growth in manufacturing; this growth outpaced the productivity "

Yeah yeah, but what about outsourcing? Again he answers this:

“There are no conclusive data, but a prominent study puts the number of jobs displaced through services outsourcing over the next decade or so at fewer than 300,000 annually, or less than 2 percent of the 15 million in total gross job losses I noted earlier. Moreover, only a fraction of those jobs represent high-skilled, high-wage jobs; these numbers are quite difficult to pin down, but one study puts the number of software jobs lost to India since 2000 at fewer than 50,000 annually.”

A problem with convincing many of the benefits of free trade is that the benefits are often hidden whereas the costs are often more readily seen. For example, we can easily see that a local plant has been closed and jobs shifted overseas, but we do not realize that we are paying less for cars etc because of free trade. Or your job just got outsourced and you do not care about how many millions of jobs are NOT outsourced.

To combat this, Ferguson suggests free trade advocates turn this around and showing how the absence of free trade (i.e. protectionism) can hurt. This is easier to quantify:

"Rather than arguing the merits of international trade in the abstract, advocates of free trade might gain more traction by arguing against concrete examples of protectionism"

Case in point, the steel tariffs of the US that were imposed to protect steel makers. Not only did they not work, they probably ended up costing more jobs (even in the US)!

"...by raising the cost of goods that are inputs for other producers, import barriers may destroy more jobs in so-called "downstream" sectors than they save in protected sectors. According to one study, the 2002 steel safeguard program contributed to higher steel prices that eliminated about 200,000 jobs in steel-using industries, whereas only 187,500 workers were employed by U.S. steel-producers in December 2002."

Moreover, protectionism designed as quatas can actually serve to help foreign producers by allowing them to sell at a higher price AND to be compensated (through WTO fines) for the illegal protectionism laws.

Overall Ferguson believes free trade will continue, but movements for freer trade may slow unless the costs and benefits are clearly delineated.

Well done!

http://www.federalreserve.gov/boarddocs/speeches/2004/20041007/default.htm

The Evolution of the FinanceProfessor.com newsletter

In the past week I have had several emails, and two phone calls, from people asking about the newsletter. So in part to save time and in part to explain to all, I will make a few public comments about the newsletter.

First of all, yes it is coming out. Soon. Or so I say. It just takes too long! I estimate about 8 hours. Now if I had an extra 8 hours laying around...lol.

But even more than the time it takes to create the newsletter, is the large number of newsletters that get sent to bulk (or junk) mail accounts or blocked outright by the anti-spam software packages. For instance, I tried sending myself test newletters (to my Yahoo account) and three times in a row (even after I marked it as not spam), the test message was delivered to my bulk mail account. On top of that I have herd from professors at several schools saying that they (or the students) has stopped getting the newsletter even though they see I am still publishing it.

It is one thing to devote the hours of making a newsletter if people are going to receive it (let alone read it), but if it is not even making it to the correct mailbox, then I sort of have lost my motivation.

Hence the blog! As I mentioned in the August Newsletter, I am very excited about it! And now that I have had some time to work with it, I think it may be even better than I hoped and better in some ways than the old format (admit it, it is difficult to make time to read a 16 page newsletter!).

Thus, the newsletter (which I will try to make monthly) will be more of a recap of what has been happening on the blog, along with some other things (example important news, what I am reading, etc.).

However, the emphasis has turned more to research papers. To those of you just wanting the news, I apologize. But given that there are many news sources out there, in some ways I would be merely replicating their efforts.

If you want a daily newsletter (almost same format as mine if you select the text option), I suggest that you subscribe to the free New York Times Deal Book. They link to many stories (not all on the NY Times site) and the newsletter is VERY good! From their web site:

DealBook Edited by Andrew Ross Sorkin, The Times's chief mergers and acquisitions reporter, DealBook provides exclusive interviews, breaking news about M&A, IPOs, Private Equity transactions and Venture Capital Deals. See sample.

NPR : The Marketplace Report: Forgiving Third World Debt

The nearly annual debate as to whether developed nations should forgive the debt owed them by less developed nations has been in the news again this week. MarketPlace is one of my favorite (non music) radio shows and All Things considered each had reports on it.
NPR : The Marketplace Report: Forgiving Third World Debt

All Things Considered also discussed it:
http://www.npr.org/templates/story/story.php?storyId=4057267

While NPR seems to be more convinced than other sources that the debt will be forgiven, all agree that there are roadblocks and problems.

So let's step back and examine them: The basic idea is that many poor nations have borrowed so much debt, that debt service (repayment of principle and interest) is preventing the nations from growing economically.

On one hand, forgiving debt will free money that could then be used to help the poor, build new infrastructure or make other improvements. But would it? Empirically it is hard to dismiss the possibility that, at least in some nations, the money be used to further leaders' lavish lifestyles.

Moreover, is it fair to forgive the debt of only a select few nations? And what about the precedent that the debt forgiveness would create: go ahead and waste the money, we won't make you repay it.

Indeed, it could be argued that one of the things that led to the US being an economic power was the hard stance that Alexander Hamilton took too force the repayment of Colonial Debt.

But of course you probably know this and are bored with it as the debate has been waged for years. But before you dismiss it as the same old same old, there is a difference this year.

What makes it different this year is that rather than being waged by Bono and crew, the call for debt forgiveness is being led by US government. Why? A large reason is that the US is pushing for forgiveness of much of Iraqi debt to help the nation recover from the war and current terrorism.

Of course, it is not so easy as if you forgive one nation, do you forgive all nations? Where do you draw the line?

As an aside, some of the discussion is just silly. For instance, when a backer of forgiveness says that the nations have paid back more than they borrowed already due to interest payments. Any student in an introductory finance course should be able to rip that argument to shreds with only a modicum of knowledge of the time value of money.

GREAT IDEA!!! Jump Start International

This is not a typical blog entry, but it does bring finance and business into a much better light and helps to reduce the unemployment in Iraq. I sure hope it is legit. It is almost too good to be true.

Those of you who have been subscribers for a while probably remember my editorial on how finance could help in the war against terrorism. By providing the funding necessary to improve the economies of the nations while (and this is important) opening the institutions and markets. Now of course safety is a MAJOR concern and no business would currently open operations in Iraq. But a charity is doing just that. JumpStartInternational.

To quote their website: "Our programs hope to spur employment and the generation of private businesses and public opportunity." BRAVO!

Currently, the group is doing is working to clean and rebuild after years of destruction, wars, and more recent looting and burning. Almost all of the employees are previously unemployed Iraqis.

Unfortunately, this work is dangerous (A co-founder was assassinated and many workers were injured in a bomb explosion), but getting people back working and fixing up their nation is invaluable work.

As an aside, it was interesting to hear the remaining founder Sean O'Sullivan tell how he pays about a third of what government organizations are paying for supplies---mmm, maybe incentives matter after all ;) There, finance content :)

Anyways, I highly recommend having a look at what they are doing.

FWIW, I was so excited I wanted to donate immediately but I could not find a spot to donate online. I did email them and will let you know if I get a reply. In the interim, from their website:

You can help financially. Send checks payable to JumpStart International

JumpStart International, 6800 West Gate Blvd, Ste 132Mailstop PMB #123Austin, TX 78745

They also have a blog to allow us to keep up to date on what they are doing.

Dilbert Comic Strip Archive - Dilbert.com - The Official Dilbert Website by Scott Adams - Dilbert, Dogbert and Coworkers!

Dilbert Comic Strip Archive - Dilbert.com - The Official Dilbert Website by Scott Adams - Dilbert, Dogbert and Coworkers!

This is great! Now that we have Dilbert on our side, I am sure managers will start expensing executive stock options! :)

Seriously, I have long railed on the need to expense the options. I will try to review an article or two this coming week on executive options.

Are you ready for some football? Super Bowl and stock returns

Football in New Orleans! No, I am not talking the Saints, the Green Wave, or even LSU. But rather the paper by Fehle, Tsyplakov, and Zdorovtsov that will be presented at the FMA conference in New Orleans.

Short version: Super Bowl advertisers outperform the market by about a half a percentage point on Super Bowl Monday. This increase, which apparently is permanent, is concentrated in heavy advertisers and caused by buying activity by individual investors. This is consistent with a behavorial finance view of the world.

Longer version: Fehle, Tsyplakov, and Zdorovtsov study the stock price of firms that advertise during the Super Bowl. While overall there is no abnormal return, there is a positive abnormal return of slightly less than a half a percent for heavy advertisers.

The stock price jump does not appear to be driven by either increased expected sales or enhanced liquidity. To establish the mood and to tie this paper to behavioral finance, the authors begin by showing that previous research has shown that investor mood and attention, and not just financial variables, may influence stock prices. For example "Hirshleifer and Shumway (2003) document that the good mood associated with the weather...can still affect investor behavior."

Once this link is established, the authors state that this same type of link can exist with Super Bowl advertising. Again in their words:

There are good reasons to believe that mood and attention effects on investor
behavior may exist as a result of advertising. Extensive marketing literature
suggests that a person exposed to an affect-evoking advertisement about any
object, tends to change his or her attitude toward a more favorable
consideration of the object. Thus, advertising promoting the company image may
create a positive mood in the minds of investors and also potentially render
them more optimistic in their evaluation of a company’s fundamentals. [footnotes
removed]

The authors then set out to find this relationship. And sure enough they find it. For instance:

While there do not appear to be significant abnormal returns for the overall
sample on average, abnormal returns are greater for firms readily identifiable
from the ad contents and increase in the number of ads employed....For
recognizable companies with the number of ads greater than the sample mean of
two, the event is followed by an average abnormal Monday return of 45 basis
points. Interestingly, the effect appears to be non-transitory in nature as the
20-day post-event cumulative abnormal returns for this subset average 2%.

What might be more important is the finding that this increase in price is caused by buying concentrated in small buyers.

"Our hypothesis is that small, less sophisticated investors are most susceptible
to such effects, and thus tend to buy stock of companies recognized in Super
Bowl ads. This hypothesis is in line with work by Barber and Odean (2002)
showing that small individual investors are more prone to be net buyers of
attention-grabbing stocks....Consistent with our hypothesis, we find that small
trades for recognized companies exhibit significant abnormal net buying
activity."

This is interpreted as supportive of the view that investors, in particular small investors, are making decisions based on the ad and not on the underlying economics of the firm. This is understood to be consistent with a behavioral finance view of the world.

The authors correctly note that there are alternative explanations to these findings. For instance:

1. The ads are of higher than expected quality and high quality ads lead to more sales, and hence a higher stock price.
2. The ads reduce information costs and therefore lead to a more diffused shareholder base and higher liquidity.

These explanations are considered and then refuted. The easiest refutation is that if there is a response to information costs and liquidity storoes, then the stock price should move on the announcement of the ads, and not on the Monday following the game.

The authors comment on this:

Given that Super Bowl ads are pre-announced, we expect that any positive or
negative effect of the ad on sales is priced in before the Super Bowl. The only
unexpected component of the sales effect could be due to the quality of the ad.
However, there is no reason to believe that investors’ expectations of ad
quality should be biased and therefore we do not expect abnormal returns in the
cross-section after ad quality is revealed.

What may be most interesting is the suggestion that the advertising firms know this relation exists and are running the ad as a means of raising stock prices. "...the decision to run a commercial can be viewed as a costly, endogenous and possibly strategic choice by firms that may aim to exploit investors’ misreaction. The potential for such strategic advertising suggests a possible link between behavioral finance and traditional corporate finance topics."

My view: “Getting noticed” is a factor in pricing. And yes one aspect of advertising is to get noticed. However, it is not a major determinant in asset pricing (the abnormal returns were less than ½ a percentage point). Given transaction costs (both information costs and trading costs), it is probably not worth it for investors to readjust their portfolios prior to when the advertisement actually runs.

Additionally, this “getting noticed” is, as the authors suggest, arguably more important for smaller firms. This size story would also be consistent with the finding that the price jump is driven by small trades since larger trades would gravitate to larger firms.

That said, I am ALMOST convinced. This ALMOST is quite a concession from a market efficiency adherent and testament of a job well done by the authors. When I first read the abstract, I defensively thought of several explanations other than the behavioral finance story. But the authors addressed these arguments. So I am forced to admit that the behavioral finance angle is compelling.

Very interesting paper! I am sure the session in New Orleans will be well-attended, so get there early!

http://207.36.165.114/NewOrleans/Papers/8101402.pdf

The Stock Market and Political Cycles by John Nofsinger

Our tour of FMA papers continues with The Stock Market and Political Cycles by John Nofsinger.

John Nofsinger examines the historic relationship between who in office and how the stock market does. Contrary to previous papers that used data that went back to only to 1927, Nofsinger reports that for a longer time period (back to 1828!) "The full time-series history reveals that stock market returns are not different between the two political parties"

Talk about a timely paper! It is nearly impossible to watch TV without election coverage inundating you. Moreover many of you undoubtedly have been asked what does one party's candidate mean for the stock market. This speculation has been a hot topic on TV and in the popular press. For example: Business Week, Smart Money, The Baltimore Sun, CNN, and many others have done stories on what the presidential election means for the Stock Market.

The problem with many of these articles is that they are based more on opinion and short data sets (for example, the stock market was up when Clinton was president, therefore Democrats must be good for the stock market).

In academia the tie between presidential election and stock returns has also been looked at. While the data sets are bigger (generally from 1927 on), and the analysis more thorough, the findings are still quite mixed. For instance Santa-Clara and Valkanov report in a recent Journal of Finance article that the stock market does better when a Democrat is president than when a Republican is in office. This can be contrasted with Riley and Luksetich (1980) who find that the market rises on the news of a Republican victory.

Nofsinger examines this apparent contradiction by going back further in time. Using monthly stock data from 1802 (WOW--how cool is that?!! Jefferson was president!), and election data from 1828, he finds no apparent difference in stock market returns based on which party "owns" the White House.

In addition to this important finding Nofsinger proposes an important relationship that may exist. This "social mood theory suggests that the mood of the nation is reflected in the...stock market." (Is anyone else thinking of Charoenrook's Does Sentiment Matter?)

In Nofsinger's own words:

"As an alternative to the political policy theory, I propose that the performance of the stock market is a predictor of who will be elected president. When social mood is optimistic, the stock market is high and voters are content to reelect the incumbents. When social mood is pessimistic, the market is low and voters vote out the incumbent party. Therefore, this social mood theory suggests that stock market performance influences who wins the presidency...."

And later in the paper:

"In the social mood theory, I propose that people suffer from a misattribution bias (see Hirshleifer (2001)) when voting for president. That is, they miss attribute the source of their mood to the incumbent presidential party. They credit the incumbent party for their positive or optimistic mood and blame incumbents for a negative or pessimistic mood."

As such, "stock market returns are more likely to predict presidential elections than elections are to predict the stock market." (p. 1) Specifically, Nofsinger finds that the the return in the 3 years (36 months) prior to the election is a good predictor of whether the incumbent or challenger will win the election.

All in all a fascinating article and one that will definitely makes great conversation at many conference "sessions." (You can also read 'session' as party, social etc. ;) )

BTW the paper is also full of some cool facts such as equity ownership was less than 2% at turn of 20th century as opposed to about 50% now.
So read it! :)

http://207.36.165.114/NewOrleans/Papers/8101383.pdf

Does sentiment matter?

Does sentiment matter? By Anchada Charoenrook

Super Short version: Yes!


Slightly longer version:

Sentiment, as measured by the University of Michigan Consumer Sentiment Index, does affect stock prices. Charoenrook finds that “changes in consumer sentiment reliably predict excess stock market returns at one-month and one year horizons.


Long version:

This paper tries to settle the debate that exists in finance as to whether sentiment plays a role in asset pricing. This is interesting question for, as the paper states, in a purely rational market, sentiment would play no role.

Alternatively, sentiment plays a role in many behavioral finance markets: “Delong, Shleifer, Summers, and Waldman (1990) propose a model of asset pricing based on the idea that irrational investors guided by sentiment misprice stocks, and the unpredictability of investor sentiment impounds resale risk on assets that they trade. In other behavior-based asset-pricing models, investor sentiment or belief distorted by psychological attributes drives stock prices away from their fundamental valuations.”

Past empirical evidence does not provide a clear answer as to whether sentiment matters or even how to most efficiently measure sentiment. For instance, “in the closed-end fund literature, some researchers argue that small investor sentiment can be measured by change in the discount on closed-end fund equity returns.” Consequently, many finance papers have used closed end fund discounts as a proxy for market sentiment.

This proxy has occasionally led to conflicting conclusions. “Lee, Shleifer, and Thaler (1991) report empirical evidence that the discount on closed-end fund return is a factor in the stock return-generating process.” While on the other hand “Elton, Gruber, and Busse (1998) find that the discount on closed-end fund return is not priced and hence is unimportant in the return-generating process.”
In this current paper, Charenrook around the improper proxy problem relating changes in the widely reported University of Michigan Consumer Sentiment Index to changes in stock market returns.

She finds “that change in the consumer sentiment index is negatively related to future value-weighted and equal-weighted excess aggregate stock market returns at one-month and one-year horizons.” That is if investors are happy (higher sentiment) the returns one month and one year out, tend to be lower.

This relationship “remains a strong and consistent predictor of returns after controlling for other established predictors. [Such as] dividend yield, the book-to-market ratio of the Dow Jones Industrial Average (DJIA), the slope of the term structure, the yield spread between Baa and Aaa bonds, the short rate yield, lagged excess market returns, and the consumption-wealth ratio.”

The author disputes suggestions that such a relationship is due to ties to the business cycle: “Empirical test results…show that the predictability of change in consumer sentiment is unrelated to economic cycles measured by real gross domestic product growth or consumption growth. Moreover, change in consumer sentiment has incremental predictive power for aggregate stock return after controlling for lagged consumption-wealth ratio, which is a strong predictor of business cycles (Lettau and Ludvigson, 2001).”

It is important to note that this relationship is not just statistically significant but economically significant as well: “in the one-year returns sample, a one-standard deviation improvement in consumer sentiment predicts a 6 percentage points a year lower excess return relative to the unconditional mean. Moreover, change in consumer sentiment index performs better than the benchmark ARI model in out-of-sample forecasting.”

In conclusion the author identifies the paper’s main contributions: “First it uses a direct survey of sentiment instead of proxies such as closed-end fund discounts….Second, this study contributes to the debate on whether sentiment can cause systematic mispricing in the aggregate stock market….The results suggest that it is premature to reject a behavioral explanation.”

Very interesting and well done.

BTW the discussion of how the Sentiment Index is calculated in well worth your time!


http://207.36.165.114/NewOrleans/Papers/3301937.pdf

Maybe Fraud is not even needed--Earnings restatements and Management turnover

The Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover by Desai, Hogan, and Wilkins.

At the same FMA conference session as Jayaraman, Mulford, and Wedge's Accounting fraud and Management turnover, is The Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover by Desai, Hogan, and Wilkins. This latter paper finds that fraud may not be needed to increase turnover: Management turnover increases following Earnings Restatements.

Specifically:

In a sample of 146 firms that announced restatements in 1997 and 1998, we find
that at least one senior manager (Chairman, CEO or President) loses his/her job within 24 months of the announcement of the restatement in 60% of the firms. The corresponding rate of turnover among industry-, size- and age-matched control firms is 35%. The significant difference in turnover persists even after controlling for other factors associated with management turnover, such as performance, bankruptcy, and governance characteristics. Moreover, only 17 out of 114 (15%)displaced managers of the sample firms secure a comparable position at another public firm, compared to 17 out of 63 (27%) displaced managers at the control firms.

There are several points to deserve further mention.

1. Have the times changed?

Previous research by Beneish (1999) did not "find a significant difference in the managerial turnover rate between sample firms and size-, age- and industry matched control firms" following GAAP violations." And closely related is the "Agrawal, Jaffe and Karpoff's (1999) investigation of the consequences of corporate fraud"

Thus that the findings of the current paper coupled with the findings of Jayaraman, Mulford, and Wedge suggest that boards of directors are taking a harder stance on fraud and overly aggressive accounting practices.

A logical question to ask is why have Boards of Directors gotten tougher? Readily apparent explanations include because of larger institutional holdings, more active shareholder activism, and/or threats of SEC action.

2. Interestingly, both abnormal returns and management turnover are related to whether the company (or auditor) instigated the restatement or whether the restatement was SEC instigated. "68% of both company-prompted and auditor-prompted restatements result in a turnover. On the other hand, only 48% of the restatements prompted by the SEC or other parties result in a turnover."

This turnover finding is slightly surprising given the finding that SEC-prompted restatements are met with less of a price drop: the "reaction to the 60 company-prompted restatements is -11.33%, while the reaction to the 22 auditor-prompted restatements is the strongest at -15.21%.

This is consistent with the idea that if a board is concerned enough to force a restatement, then the board is also in disagreement with the manager's actions and would be more inclined to replace the manager.

Explanations as to why SEC-prompted restatements are met with less of a price change is that they may contain more leakage and thus the price drop may occur prior to the event window and/or the SEC acts on less important issues than do Boards.

3. Not surprisingly, firms that restate their earnings are more likely to end up in bankruptcy than are control firms: "there is a greater frequency of bankruptcy filings for sample firms as compared to the control firms (15 out of 146 sample firms filed for bankruptcy within 24 months of the announcement of the restatement whereas only 4 control firms filed for bankruptcy).

4. Reputation matters!

This is possibly my favorite part of the paper looks at what happens after the manager is replaced. The authors state it very nicely:

"If the managerial labor market imposes a significant penalty on displaced managers by shunning them when they attempt to locate alternative employment opportunities, such an outcome would be consistent with Fama's (1980) notion of ex-post settling up." And would therefore serve as a deterrent to risky accounting measures (including but not limited to fraudulent accounting practices).

The authors set up their findings with a quote from the Economist:

"A sacked CEO, says Tom Neff, chairman of Spencer Stuart and doyen of America's
recruiters of chief executives, 'may be literally unemployable.' He is extremely unlikely ever to run another public company, although he may be able to 'hang on to a board or two' as a non-executive, or to gain a seat on the board of a couple of
unimportant companies. Hardly anyone returns from the dead." (The Economist,
Oct. 25, 2003, p. 13.)

The findings support this: "32 out of the 114 displaced managers of the sample firms (28%) are able to find some form of employment following their departure. The corresponding number for the control firms is 31 out of 63, or 49%. This difference is also significant (p-value=0.01). "

The paper goes on to check other measure of future employment with qualitatively similar results. "Collectively, these results show that the future employment prospects (at any level) for the sample firm managers are significantly worse than those of the control firm managers. This evidence is consistent with the existence of significant reputational penaltiesand/or ex-post settling up in the managerial labor market."

Why do I like this section so much? Because it shows that the managerial labor market does incorporate publicly available information and it gives further proof that reputation matters. This should reduce the incidence of fraud and risky accounting by raising their costs.

5. Given the market discpline described above, one might be tempted to ask "are efforts by government to reduce fraud necessary or merely redundant? "

While this is virtually impossible to answer, the governmental actions and fines are apt to be a little consequence, but do add to the market penalty and as such will at the margin help to discourage the undesired behavior. However, the question remains whether govenmental resources could be better spend increasing information transparency (which will increase the probablity of being cheaters being caught) rather than merely penalizing those who are caught.

VERY INTERESTING and Highly recommended!

http://207.36.165.114/NewOrleans/Papers/1401148.pdf

Accounting fraud leads to higher management turnover--Go figure!

Our trip to the FMA meetings continues with a look at Accounting Fraud and Management Turnover By Jayaraman, Mulford, and Wedge.


Jayaraman, Mulford, and Wedge ask the question “What impact does accounting fraud have on the turnover of top management?” Their answer really should not surprise anyone who has been paying attention in recent years: fraud leads to higher turnover. However, just because the outcome is known, it does not mean the paper is not worth reading!

Short Version:
Accounting fraud leads to a higher likelihood of upper management turnover in the 5 year event window surrounding the inclusion in the SEC Accounting and Auditing Enforcement database


Longer version:

“Accounting fraud and scandals have been occupying a central stage in the public policy debate in the recent years. This paper studies firms’ management turnover as a result of accounting fraud.”

Existing literature on the topic is surprisingly mixed. For example, if you presume firms are more likely to cheat when times are bad, there is several papers that suggest that CEO turnover increases as performance is bad. However, in a paper that is closer to this one, Agrawal, Jaffe and Karpoff (1999) “do not find systematic evidence of unusually high turnover among senior managers and directors. Even for financial fraud firms, they do not find higher top management and director turnover rates than control firms.”

It is in this context that Jayaraman, Mulford, and Wedge begin their paper.

Their sample is composed of 291 firms that were the target of SEC action for accounting fraud from 1990 to 2000. The authors examine management changes over the 5 years (+/- 2 years) from the first SEC Accounting and Auditing Enforcement Release (AAER). This event window is noteworthy both because of its length (5 years) but also because it is for 2 years prior to the SEC announcement. This is because there is often a long time period between when the fraud was committed and when the SEC announces their investigation. For many firms it is likely that the news of the fraud, and possibly the pending investigation, is already incorporated by the market prior to the official announcement.

Over this 5 year time period, the authors “identify top management turnover in 180 of the 291 firms.” This is significantly more than found at control firms. Again to quote the authors:

“In all models, top management is significantly positively related with AAER
dummy at 1% to 5% level, after controlling for size, growth opportunities, returns and board information.”

Why the difference between this and previous work?

The authors respond to this question: “Our result is different from Agrawal et al (1999) where they do not find significant relationship between fraud and top management turnover. There are several reasons for our stronger findings: First, they do not document the turnover prior to the event when it is more likely to happen as a correspondence to the fraud investigation. Second, their sample includes frauds of all kinds while our sample primarily focuses on accounting fraud….Third, they collect data from Wall Street Journal, which is more likely to document fraud of larger companies. Our sample includes all firms in AAER releases and does not have the same size bias. One can argue that fraud has less direct impact on management turnover in bigger and more complicated firms.”


Overall it is an interesting paper that, while seemingly relatively early in the publication process, does fit what we would expect to see.

Board Size debate continued: Faleye upholds tradition!

A more traditional view of Board size: Smaller is better

A great thing about academic conferences is that you can see multiple sides of most issues (group think is generally not a problem!) For instance at the upcoming FMA meetings Olubunmi Faleye will present a paper that represents the traditional view (at least since Yermack 1996) that smaller is better when it comes to board size. To quote myself in the August FinanceProfessor newsletter:

“Faleye 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.” These findings lead Faleye to conclude "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."

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=498285


That Faleye uses some cool techniques and has some important findings that help shed light on the board controversy is undebatable.

1. Rather than examining CEO turnover conditional on firm performance, the author looks at unconditional performance. Why? A good board would replace a CEO BEFORE performance suffered, not after. (The logic for this comes form Hermalin 2004.)

2. Larger boards are significantly less likely to replace managers! “The probability of CEO turnover during the period is significantly decreasing in boardsize: An additional director reduces the odds in favor of turnover by 13%!” (Emphasis is mine.) I would caution CEOs who would like to use this finding to entrench themselves that this is non linear or else putting 8 new board members would lead to life long entrenchment.

3. Replacement by smaller boards is tied to better stock performance: “announcement period abnormal return is significantly negatively related to board size, which implies that investors view CEO replacement decisions made by smaller boards more positively than those made by larger boards.” This could be because smaller boards are more apt to replace with an outsider.


So how does this paper fit with the papers by Coles, Daniel, and Naveen (CDN), or with Larcker, Tuna, and Richardson (LTR)? Interesting question!! They are not as different as they may first appear.

For starters that the findings are slightly different should not be surprising. The authors are looking at different samples and more importantly they are not looking at precisely the same thing (although close!). For example CDN use Q values as the dependent variable. LTR use “a wide set of dependent variables, e.g. abnormal accruals, excessive CEO compensation, debt ratings, analyst recommendations, Q, and over investment.” Faleye looks at the likelihood of CEO replacement and abnormal returns on the replacement.

That said, I think what I will take away from these papers is further evidence that smaller boards do appear to be better monitors. BUT (and this is big) better monitoring can come at a cost of expertise and advisement. This cost varies with firm specific factors.

What is still a bit troubling to me is that if the market knows this and incorporates it in the price ( for example LTR show that smaller boards are better where monitoring is more important), why is there still a difference in stock returns following the replacement? And it is more pronounced for smaller boards, the opposite of what would be consistent with the market anticipating the change.

Is this return somehow tied to firm specific factors (maybe industry specific) that is not being picked up by Faleye?

Obviously much left to be said on the topic. It is unfortunate that LTR and Fayele are not in the same session in New Orleans.

Corporate Governance by the Numbers: It Doesn't Work - Knowledge@Wharton Larcker, Tuna, and Richardson

http://knowledge.wharton.upenn.edu/article/1041.cfm: "Another paper that shows that governance is not eaily quantified."



Short Version: Larcker, Tuna, and Richardson provide more more evidence that corporate governance is not easily quantifiable and what works for one firm may not for other firms.

Longer Version:

Consistent with Coles, Daniel, and Naveen, but opposed to what many so-called corporate governance experts are trying to sell, is a recent paper by Larcker, Tuna, and Richardson. They find that corporate governance is endogenous and that there does not appear to be an easily quantifiable means of differentiating good and bad governance.

The authors did try to quantify goverance. They examined data on "more than 2,100 public firms" to find what factors led to good governance and what variables wee tied to poor governance. Somewhat surprisingly, they could not find any relationships: ""Our overall conclusion is that the typical structural indicators of corporate governance used in academic research and institutional rating services have a very limited ability to explain managerial decisions and firm valuation."

Why? The most likely explanation is by trying to find single factors that fit all firms, they are losing the relevant importance. For example (in the spirit of Coles, Daniels, and Naveen) what works well at a diverse firm (a large board) may not work well as a single-line firm. Or while insiders are good for R&D intensive firms, insiders may magnify agency costs at slow growth firms.

As Richardson summed up "The recipe book is big, and there's a different recipe for each company." And to those that are using governance report cards to evaluate or instruct firms, Richardson adds "As far as we can tell, there's no evidence that those scorecards map into better corporate performance or better behavior by managers."

What does this mean to financial research? My best guess is that using the "structural indicators" (example number of outsiders on board, board size, etc) will only have meaning in a controlled context. For instance, it will no longer be enough to measure governance by saying there are X% of outsiders on the board, but rather one will have to say "within the same industry, one firm has more insiders than the other firm." Which will be much more time consuming and difficult, but maybe if we have the proper matching, then we can begin to see what does and does not work.