BusinessWeek Online: 2005 Executive Compensation Scoreboard

The 2005 Business Week Executive Compensation "scoreboard" is now online!
BusinessWeek Online: 2005 Executive Compensation Scoreboard

In the accompanying article, Louis Lavelle writes "BusinessWeek's 55th annual Executive Pay Scoreboard found that increases were moderated in 2004 by the continued impact of corporate reform, an ongoing shareholder revolt over astronomical pay levels, and pending accounting changes that are reining in the use of stock options. Our survey of 367 CEO pay packages showed that:

-- Total CEO pay was up smartly, to an average $9.6 million -- a 15% increase from $8.3 million in 2003. But that average was skewed by the outsize pay package of our most highly compensated CEO, Yahoo! Inc.'s (YHOO ) Terry Semel, who received a package worth $120 million made up almost entirely of options. Take him out of the mix and the average raise was 11.3%, not far off the rise in shareholder gains."

An important change in this year's scoreboard is that the options are valued using the Black Scholes formula rather than merely looking at exercise gains.
This will make "pay anomalies are now easier to detect, thanks to a new methodology that BusinessWeek began using this year. Instead of counting the windfalls from option exercises as part of the annual pay package, as we have in the past, we're counting the value of annual option grants. The values are calculated using the Black-Scholes formula...."

Another important trend was the increased use of restricted shares at the expense of option grants.

"In 2004 the 200 big companies tracked by New York pay consultants Pearl Meyer & Partners granted options equal to 2% of their outstanding shares, down from 2.7% in 2001. CEOs saw the stock option portion of their pay packages decline from 51% to 37% in just one year -- in part because grants of restricted stock increased"

Still not convinced you can teach ethics

Teaching ethics is hard and as the WSJ reports, colleges are not having an easy time of it.
CollegeJournal | MBA Track: "Three years after coming under attack for their M.B.A. graduates' involvement in the many corporate scandals, schools are still grappling with how to teach ethics more effectively."

How can you teach ethics? My best advice is to attempt to show why it really is in your best interests (i.e. think long term!) to act ethically and to show that the market is a harsh disciplinarian.

It would be interesting to see how many finance classes incorporate ethics. (if you know of any study on that, please send it along). My classes do discuss ethics, but not we do not devote an entire section to it, but rather bring it up whenever it seems appropriate. (for instance, dumping toxic wastes may seem a good short term solution, but in the long run, is really really stupid.)

Of course, the success of any ethics effort is debatable.

Who will replace Greenspan?

Rueters has an interesting article on who will replace Greenspan when the time comes. Preseason favorite? Ben BernankeLatest News and Financial Information | Reuters.com

Another look at Capital Structure and Market Timing

Market Timing with respect to capital structure changes is an interesting and controversial topic that combines capital structure theory with market efficiency theory. On one side of the aisle pure market efficiency proponents maintain there is no place for market timing as the current price is always right. The other side of the discussion is held by those who believe that capital structure tradeoff or pecking order theories are sufficiently robust to capture changes in capital structure.

Most recently is has appeared that the timing camp has been winning. Over the past few years much esearch has shown what the authors interpreted as market timing (that is, issue equity when stock prices are relatively high, issue debt when interest rates are low). For example Baker and Wurgler (2002), Flannery and Rangan (2004), and Alti (2004) all suggest that market timing does occur.

Now Hovakimian draws that interpretation into question. Namely he suggests that timing is less important than the persistent relation between market to book ratios and growth opportunities. Specifically: "These results are consistent with the hypothesis that the importance of historical weighted-average market-to-book is due to its association with current growth opportunities."

In other words:

"results also show that cross-sectional differences in market-to-book ratios of firms issuing and repurchasing debt and equity dwarf the changes in market-to-book experienced by these firms over time."

Interesting! I am not totally convinced that timing does not play a more important role than suggested here, but do (and always have) admit that timing is not the major determinant in capital structure decisions. However, I will be surprised if in the end we do not conclude that it does play a role.

Interesting!

Suggested Citation:
Hovakimian, Armen, "Are Observed Capital Structures Determined by Equity Market Timing?" (June 3, 2003). AFA 2005 Philadelphia Meetings. http://ssrn.com/abstract=413387

Risk Free?

This is not my editorial comment, I just thought it was funny. President Bush was disparaging the safety of the IOU's held by the Social Security Trust.

The New York Times > Opinion > Editorial: Shameless Photo-Op

For the record, all bonds are just IOUs! And as for the credit worthiness of the debtor, let's hope we don't need to worry about that!It is the US!!! Maybe President Bush does not realize that those IOUs are largely assumed to be risk free!

"He posed next to a file cabinet that holds the $1.7 trillion in Treasury securities that make up the Social Security trust fund. He tossed off a comment to the effect that the bonds were not "real assets." Later, in a speech at a nearby university, he said: "There is no trust fund. Just i.o.u.'s that I saw firsthand.""

SSRN-Do Analyst Conflicts Matter? Evidence from Stock Recommendations by Anup Agrawal, Mark Chen

SSRN-Do Analyst Conflicts Matter? Evidence from Stock Recommendations by Anup Agrawal, Mark Chen

Agrawal and Chen have a really cool paper that looks at conflicts of interest with investment bankers and their affiliated brokerages. They find sure enough that the conflicts of interest do influence recommendations. However, the authors also make a pretty convincing case that these conflicts and biased recommendations probably are known by investors and therefore the market place is not tricked.

I'll try to find some time to write more about this paper soon. It is definitely worth reading!

Suggested Citation
Agrawal, Anup and Chen, Mark, "Do Analyst Conflicts Matter? Evidence from Stock Recommendations" (March 2005). http://ssrn.com/abstract=654281

SSRN-Portfolio Concentration and the Performance of Individual Investors by Zoran Ivkovich, Clemens Sialm, Scott Weisbenner

SSRN-Portfolio Concentration and the Performance of Individual Investors by Zoran Ivkovich, Clemens Sialm, Scott Weisbenner

It is always nice when research confirms what we had theorized. For instance Ivkovich, Sialm, and Weisbenner show that when investors take highly undiversified positions, they on average earn higher returns than when they are diversified. However before you scrap all diversification theory, these higher returns come at the expense of added risk.

Why would investors hold a "concentrated" portfolio? It could be because of fixed transaction costs or because of information advantages, or because of what collectively could be called behavioral reasons.

"There are a few key reasons why households might hold poorly diversified portfolios. First, a lack of diversification could be prompted by behavioral biases such as familiarity, overconfidence, or risk-loving behavior such as holding stocks in “entertainment accounts.” Second, individual investors might hold concentrated portfolios because they are able to identify stocks with high expected abnormal returns."

Overall the authors find that "Consistent with Odean (1999), we find that, on average, the stocks bought by individual investors underperform the stocks they sell by a wide margin."

However, when larger portfolios (over $25,000) are examined concentrated investors earn higher returns.

"Regardless of portfolio size, the purchases made by diversified households underperform the appropriate Fama and French (1992) benchmark portfolios based on size and book-to-market deciles by one to two percentage points in the year following the purchase....the purchases made by concentrated households with large portfolios do substantially better, exceeding the appropriate Fama and French benchmark portfolios by 1.3 percentage points for those with relatively large portfolios (i.e., $25,000 or more) and by 2.3 percentage points for those with the largest portfolios (i.e., at least $100,000)."

However, before you scrap diversification plans (A DEFINITE NO-NO in my book!), these added returns come at the cost of added risk. While acknowledging problems with the Sharpe Ratio, the authors find that "wealthy households holding highly concentrated portfolios perform significantly better than the wealthy households holding widely diversified portfolios, we also find that their levels of total risk are larger and the Sharpe ratios of their stock portfolios are lower."

So why would investors take on this added risk? While some argue behavioral reasons (see above), however, such a view would have predicted no higher returns for the concentrated investors. Thus given the higher returns, the best explanation seems to be that the investors have superior information for these stocks and are trying to take advantage of this information.
Consistent with the information explanation, the authors write that "The excess return associated with concentration is stronger for investments in local stocks and stocks that are not included in the S&P 500 Index (which tend to have less analyst coverage and national media attention), potentially reflecting concentrated investors’ ability to exploit information advantages. In sum, these findings are consistent with the hypothesis that skilled investors can exploit information asymmetries by concentrating their portfolios in the stocks about which they have particularly favorable information."

True. However, to get this excess return the concentrated investors (a term I like more than "skilled investors") do take on added risk. It is unclear whether they can earn an excess return on a risk adjusted basis.


VERY Interesting!

As an aside, does anyone else note the irony of a paper that essentially comes to the defense of investor rationality, resting on less than perfectly efficient markets.

Suggested citation:

Ivkovich, Zoran, Sialm, Clemens and Weisbenner, Scott J., "Portfolio Concentration and the Performance of Individual Investors" (February 2005). http://ssrn.com/abstract=568156

What is the role of the Fed with respect to asset price bubbles?

Latest News and Financial Information | Reuters.com

There is always a debate as to the role of the Fed when it comes to asset "bubbles." For instance, the Fed was criticized by many after the internet bubble. What is the correct role? Hands off? Active interventionist?

Fed Governor Edward Gramlich gave his view to a "conference hosted at Princeton University." His view? Basically hands off:

"You've only got one funds' rate so you can't get into the business of targeting specific assets."

"Gramlich stressed that the Fed had a very specific task -- it is mandated by Congress to preserve price stability while seeking sustainable full employment -- and demanding that it tackle asset bubbles as well could undermine those goals. "If you worry about asset prices, that represents a trade-off with your primary objectives.""

That is true, but the counter argument can also be made. Namely that the role of the Fed is to assure stability in the Economy and that asset bubbles are often destabilizing. So the debate will continue to be waged.

A summary article on volatility forecasting

When I was looking at research-Finance.com,I stumbled upon this one by Andersen, Bollerslev, Christoffersen, and Diebold.

They provide a very interesting look at the volatility forecasting. The piece is largely a summary article that shows what has been done and the results. VERY good! It is part of a forthcoming Handbook of Economic Forecasting edited by Elliott, Granger, and Timmermann.

A warning: it is LONG! 114 pages.

The paper is also available through the UPenn site.

Suggested Citation
Andersen, Torben G., Bollerslev, Tim, Christoffersen, Peter and Diebold, Francis X., "Volatility Forecasting" (February 22, 2005). Penn Institute for Economic Research (PIER), Research Paper Series http://ssrn.com/abstract=678861

More Fuel for the Fire on social security reform

I hope you have been following the "discussion"--via comments at the end of my last blog entry on Social Security reform. The discussion is very interesting. My views have not been changed, but interesting discussion none the less.

Today I was reading what some others have to say about Social Security Reform.

Harvard's Robert Barro is against privatization but not for the normal reasons. He is opposed to anything that will make social security bigger (which is a very good point!).

A few quotes :

"The strongest points for personal accounts involve property rights and the freedom of choice. When people contribute to a personal account, property rights insulate benefits from future Congresses who can change the program as they wish. The rights also mean that, unlike the current program, the contributions are not a tax that discourages work. Personal
accounts also allow for differing preferences on which assets to hold, how much risk to take, and when to receive income. Forcing everyone into a one-size-fits-all plan is usually unwise."

* " From the perspective of the trust fund, returns look low because the fund's government bonds have paid less than stocks. But the premium on stocks is compensation for risk, as gauged by financial markets. Although the ability to hold stocks is a plus, there is no free lunch of assured higher returns."

* "An opposing myth is that the transition requires too much government borrowing. In fact, a debt-financed transition entails substitution of explicit liabilities (government bonds) for unfunded liabilities (future benefits in the present system). There are no substantial effects on interest rates, national saving, and the current-account imbalance."

*" A SERIOUS ANALYSIS STARTS with asking why we have Social Security. If we were not so used to it, we would find it odd for the government to collect money from young workers and give it to the old (mostly workers' parents). One rationale is that the government should help people who lack discipline to save for old age. I have never embraced this paternalistic view. It's true that society will inevitably provide welfare to the needy elderly. Knowing this, some people will save too little and rely on public support when old. Thus, there is reason to require workers to save for retirement. How much depends on what is viewed as a minimal standard of living....
Contributions that fund just the minimum cannot go into a meaningful personal account. People would opt for too much risk, knowing they would be bailed out if they fell short. Also, contributions that cover the minimum provide no individual return and, therefore, amount to a tax that discourages work."

* "Personal accounts have to supplement the minimum payout. But then why have a public program at all, rather than relying on individual choices on saving? I think there is no good reason to go beyond the minimum standard; that is why I view personal accounts as a mistake -- they enlarge a Social Security program that already promises too much."
Good Stuff!!!
Barro's Business Week Piece as PDF file

Over at Market Week, Thomas Saving (what a great name!) lays out some myths about social security and shows why something has to be done (for both SS and Medicare). I highly recommend reading it.

Saving's conclusion:

"People may have honest disagreements about the best way to move to a funded system (for example, whether we should have individual accounts or have government make the investments). But, there should be no disagreement about our need to move to a new system of finance as quickly as possible, and personal accounts is one way to do that, although not the only way."

Are Super Star CEOs bad for firm? It seem so.

In my MBA 610 class we now devote a bit more than a week to corporate governance. One of the lessons is that Super Star CEOs are rarely good for the long term prospects of the firm.

The NY Times has an interesting article that largely endorses this view: The New York Times Lo! A White Knight! So Why Isn't the Market Cheering?

Before getting to the article, let me suggest that at least some of these problems likely stem from CEO superstars trying to live up their own hype. To do so they are forced to take unwise gambles. Moreover, these CEOs often feel above the law and more important that both shareholders and their appointed Board of Directors.

Some quotes from NY Times Article:

* "Investors are often thrilled when well-known outsiders come in as white knights to run a company. But a growing body of evidence suggests that a company will perform better over the long run when it is led by a relatively anonymous insider"

* A "recent study helps to show why. The study, called "Governance and C.E.O. Turnover," was conducted by Ray Fisman and Matthew Rhodes-Kropf, associate professors of economics and finance at Columbia Business School, and Rakesh Khurana, an associate professor of organizational behavior at Harvard Business School. Their study has been circulating since last summer as an academic working paper; a version is at http://ssrn.com/abstract=656085.

Though the professors did not focus specifically on superstar or white-knight chief executives, they did study the pressures that sometimes lead companies' boards to hire them. Specifically, they were interested in the circumstances in which a board could resist shareholder demands to fire the chief because of disappointing performance."

* "From this study and other research, Professor Khurana concludes that when companies hire superstars, the result "more often than not is disappointment or even disaster." "

The New York Times > Business > Your Money > If I Only Had a Hedge Fund

An artcile on hedge funds that mentions the Counting Crows. It is a lock to get mentioned :)
The New York Times > Business > Your Money > If I Only Had a Hedge Fund: "15 years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. By contrast, assets in mutual funds grew at an impressive but much slower rate, to $8.1 trillion from $1 trillion, during the same period. The number of hedge fund firms has also grown - to 3,307 last year, up 74 percent from 1,903 in 1999. "

"In a way, hedge funds are to mutual funds what Evel Knievel was to weekend motorcyclists. Unlike mutual funds, which are restricted in the ways they can invest, hedge funds can use leverage, trade derivatives and bet that stocks will fall, a technique called shorting."

"A recent report published by Credit Suisse First Boston said that hedge funds were responsible for up to half of all activity in major markets, including the New York Stock Exchange and the London Stock Exchange"

USATODAY.com - Public cool about heart of Bush's Social Security plan

There are things that I just do not understand. From Yesterday's USA Today:

USATODAY.com - Public cool about heart of Bush's Social Security plan: "The heart of President Bush's plan for Social Security, allowing younger workers to create personal accounts in exchange for a lower guaranteed government benefit, is among the least popular elements with the public"

"Younger workers would have the option of investing a portion of their payroll taxes on their own and would receive a lower guaranteed government benefit when they retire. Supporters of the plan argue that earnings on the investments would make up the difference."

Huh? Obviously Social Security is in the news every hour, but somehow people are still not getting the message.

More important than when the money is going to run out (For instance, yesterday we heard that Social Security is probably going to run out of money by 2041), is how low of returns one gets from social security.

Michael Tanner of the Cato Institute writes the following:

"While "the term “rate of return” may be slightly misleading when applied to Social Security. Indeed, some observers object to the entire concept of applying rate-of-return analysis to Social Security....most economists attribute an “implicit” rate of return to Social Security, based on a comparison of a person’s contributions (taxes) and benefits. This rate of return can be summed up as the average interest rate that a person would have to earn on his or her contributions to pay for all of the benefits that he or she will receive from Social Security, or more technically, “the constant discount rate that equates the present discounted value of contributions
with the present discounted value of benefits.” It is important to note that this rate of return has nothing to do with the interest attributed to “assets” held by the Social Security Trust Fund."

The result of his analysis?

"We can assume that workers retiring today receive a rate of return of approximately 2 percent and that future retirees will receive even lower rates of return."

Yes I understand risk aversion, but wow. The people who are against reform must expect to be hit by the sky every time they go outside.

Now of course, this does not mean guaranteed. For instance recently the Christian Science Monitor reported the case of Stanley Logue a 1994 retiree who was getting more through social security than he would have had he invested on his own. Why? Timing. He invested when market went sideways or down. But as I tell people all the time, you can not manage to the exception. (indeed, a much more common "exception" can be seen by examining what happens when someone who has paid into the social security system and dies early.)

In a related note, Auburn's Jonathan Godbey (who has been described as a "financial genius"--yeah it was by his wife) recently gave his class a cool assignment. They had to compare how much they could expect under the current plan vs if they were allowed to invest 4% in private accounts. The results of course suggest that private accounts increase retirement income substantially. He will be updating this in the near future by examining it for each year of retirement to capture the magnitude of the Logue Exception.

So what will happen? I have no idea, but do not necessarily disagree with Tom Morgan (who many of you may hear on the radio) who published an interesting article on how he things the reform movement could play out. The short version of his view: higher taxes, lower payments, and a voluntary private account program.

Stay Tuned...

A Defense of Economics

Economics Wins, Psychology Loses, and Society Pays by Max Bazerman, Deepak Malhotra

The short version of the Bazerman and Malhotra chapter is that the authors believe that economics has come to dominate (to the exclusion of other fields) the social sciences and political arena. (Somewhat analogous to the idea that rational economics has dominated in finance to the detriment of psychology and behavioral finance).

The authors identify "five predominant myths, adapted from pervasive economic assumptions, which serve as guiding policy principles and serve to destroy value in society. These myths include:

1) Individuals have stable and consistent preferences
2) Individuals know their preferences and they pursue known preferences with volition
3) Individuals make decisions based on all of the evidence available to them
4) Free markets solve economic problems
5) Credible empirical evidence consists of outcome data, not of mechanism data"

While I have reservations about each of these, I will concede some truth in their views. For instance, Does psychology matter? Undoubtedly (see for instance their discussion of spending increases had the term "bonus" been used instead of "rebate" with respect to taxes).

However I disagree with much of the paper. Rather than being the norm, I would argue that it is only the rare close-minded financial economist who does not understand that other social sciences also have roles to play (even the most ardent of financial economists now concede some things to behavioral finance). That economics, and by extention finance, has become dominant is because it has shown it to be the best way we have of dealing with problems and limited resources.

Are there problems with economics/finance/free markets? Yes. Do some rights get trampled? Yes. Should we consider other models? Sure. Given enough time, we should consider all things, but given limited amounts of time and resources, we could do MUCH worse than relying predominantly on economic principles!

And in that spirit, I hope society grows more (and not less) economic in our thinking. That is not to say growth for growth sake. That is not even to say always growth--retrenchment can be value maximizing. But ideally growth through positive NPV investments. Where all costs and benefits are considered. Why? Because with a proper assigning of property rights (including environmental, intellectual etc), economics does work.

---

Suggested Citation

Bazerman, Max and Malhotra, Deepak K., "Economics Wins, Psychology Loses, and Society Pays" (2005). Harvard NOM Working Paper No. 05-07. http://ssrn.com/abstract=683200