Corporate Investment and Asset Price Dynamics: Implications for SEO Event Studies and Long-Run Performance by Murray Carlson, Adlai Fisher, Ronal

Using option theory to understand and explain firm and investor behavior often yields important insight. This is no exception.

Carlson, Fisher, and Giammarino (CFG) use real option analysis (real options are essentially the application of option theory to “real” assets) to investigate the stock behavior around seasoned equity offers (SEO). Many researchers (probably most notably Ritter 2003) have shown that prior to a SEO stock prices rise, then fall on the announcement, and then underperform over the following period.

Potential explanations to this include market timing and inefficiency stories that have managers selling overpriced shares to investors who willingly buy the shares but at only a partial discount. The real option view allows us to add a more rational explanation to these behavioral models.

The very quick explanation is that firms have options on growth (i.e growth options). These options are more volatile than both the firms’ assets as well as the assets that make up the growth opportunities. So, when the firm uses the proceeds of the SEO to expand (which is to say to convert growth options into assets in place), the value of the firms’s equity drops.

In the authors’ words:

“Equity issues are associated with firm expansions. When firms invest, they convert growth options to assets in place. Even when the new assets are risky, they will be less risky than the options they replace. Although both size and book-to-market effects are present in our model, standard matching procedures fail to capture the dynamics of risk and expected return.”

How cool is that?!

And yes this is similar to the real option papers that try to explain the internet bubble away.

Cite:
Carlson, Murray D., Fisher, Adlai J. and Giammarino, Ron, "Corporate Investment and Asset Price Dynamics: Implications for SEO Event Studies and Long-Run Performance" (December 5, 2004). 7th Annual Texas Finance Festival Paper. http://ssrn.com/abstract=562942

FTR I stumbled upon this paper while researching Real options for my advanced corporate finance class. I feel bad I had missed it for so long. And yes I will have to be redoing my notes for the umpteenth time. :)

How Informative are Analyst Recommendations and Insider Trades? by Jim Hsieh, Lilian Ng, Qinghai Wang

Mixed signals. They happen all the time in and out of finance. Take for instance the starting pitcher saying he can go another inning while wearily dragging himself onto the field, or the spouse who is crying while saying things are fine, or the CEO selling shares while stock analysts write ringing endorsements.

While Hsieh, NG, and Wang may not be able to help you interpret the mixed signals on the field or at home, they do look at this issue with respect to analyst stock recommendations and insider trades. They find that "insider trading is informative when signaling positive information, and analyst recommendations are informative when conveying negative information...."

SSRN-How Informative are Analyst Recommendations and Insider Trades? by Jim Hsieh, Lilian Ng, Qinghai Wang:

In one of the best abstracts I have seen in a long time, the authors succiently summarize their paper:

"This study jointly evaluates the informativeness of insider trades and analyst recommendations. We show that the two activities often generate contradictory signals. Insiders in aggregate buy more shares when their firm's stock is unfavorably recommended or downgraded by analysts than when it is favorably recommended or upgraded. This result is robust to various controls such as varying degrees of analyst coverage, firm size, book-to-market ratios, and stock price momentum. We find that analyst recommendations affect insider trading decisions, but not vice versa. Our further analysis shows that insider trading is informative when signaling positive information, and analyst recommendations are informative when conveying negative information. The overall results imply that corporate insiders and financial analysts do not substitute each other's informational role in the financial market."

Wasn't that a great abstract?

A few points worth mentioning:

* "Using data on insider trading and analyst recommendations from 1994 through 2003, we
show that insider trades and analyst recommendations produce contradictory informational
signals: insiders trade against the recommendations from financial analysts."

* It is surprising that insider trading does not impact analyst recommendations. I am not totally convinced.

And finally the bombshell:

"...analysis shows that insider trades are informative only when insiders are actively buying their company’s stock, and that analyst recommendations hold investment value only when they issue downgrade recommendations on stocks with no insider trading."

So ignore insider sells and analyst buy recommendations.

Definitely worth reading!

Cite:
Hsieh, Jim, Ng, Lilian K. and Wang, Qinghai, "How Informative are Analyst Recommendations and Insider Trades?" (April 12, 2005). AFA 2006 Boston Meetings Paper http://ssrn.com/abstract=687584

Financial Advice-KISS

I was asked recently by FreeMoneyFinance for a brief piece on the best financial advice possible. Unfortuntately I was too busy at the time to do it, but FMF was nice enough to run it anyways. The following is what I wrote.

KISS-Keep It Simple Stupid.

Oftentimes financeprofessors tend to make things too complicated. Such is the often the case when it comes to investing. Sure, we might be able to better with derivatives and complex investment schemes, but these plans probably scare off as many people as they help.

So the best financial advice I could give someone is to let compounding work for them. That is, save as much as you can as often as you can for as long as you can at as of high of rate as you can without taking major risks and start as soon as possible.

To implement this idea, I tell my friends and students to set up automatic investment programs whereby money is automatically invested for both your retirement plans as well as well as savings outside of retirement plans for “life expenses”. It is important to do this because it takes the emotion out of your investment decisions and also you are much more apt to stick to the investment program. Moreover, if you set aside the money prior to actually having the money, you will never miss it.

This savings plan should be examined annually to make sure you are still setting aside as much as you can. For instance, if you earned a pay raise or get a bonus, make sure you save more. Also if you do need (and I stress need) to take money out of the account,as soon as possible increase your payments to make up for the withdrawl.

As for what to invest in, make sure you are diversified and take the view that the basket that counts more than the eggs in the basket. Thus, worry more that you invest in the right class of securities (equity, fixed income, etc.) than what specific securities you hold within each class.

A final important bit of advice: watch transaction costs and taxes. They will destroy your returns. While your mileage may vary, for me this means using tax-advantaged accounts and investing largely in index funds and ETFs that both lower transaction costs and the tax bite of frequent trading.

So nothing earth shattering, but I hope useful.

-Political Connections and Corporate Bailouts by Mara Faccio, Ronald Masulis, John McConnell

SSRN-Political Connections and Corporate Bailouts by Mara Faccio, Ronald Masulis, John McConnell:

Faccio, Masulis, and McConnell report that politically connected firms are more apt to receive government bailouts. This fits with prior evidence that leverage ratios at politically connected firms are higher. Thus, it may be inferred that lenders are more apt to make loans if they feel that the government will bail the firm out if things go bad.

While not surprising, it is VERY interesting.

A look in:

The paper is a "systematic examination of the link between political connections and
corporate bailouts. To do so, we study 450 politically-connected firms in 35 countries over the six-year period 1997-2002 along with a set of matching peer firms."

On why firms with connections have higher leverage:

"The anecdotal and empirical evidence that politically-connected firms make greater use of leverage is subject to a number of possible interpretations. One possibility is that lenders are irrational. A second is that they are coerced into making poor loans to politically-connected enterprises. A third is that lenders receive offsetting government benefits for making such loans. Yet another possibility is that lenders factor into their lending decisions the likelihood that borrowers will be bailed out when they encounter economic distress and, thus, lend more to politically-connected firms who are, in turn, more likely to be bailed out than their nonconnectedpeers."

"The evidence that we present is consistent with the last interpretation: politically-connected firms do borrow more than non-connected firms...our evidence indicates that lenders are willing to lend more to connected borrowers because they can reasonably anticipate a future bailout of troubled loans...."

BUT

"the data do not rule out the possibilities that lenders may also sometimes be pressured into making weak loans and/or that lenders may receive benefits in other forms."

See, I told you it was interesting!

Cite:
Faccio, Mara, Masulis, Ronald W. and McConnell, John J., "Political Connections and Corporate Bailouts" (March 1, 2005). AFA 2006 Boston Meetings Paper http://ssrn.com/abstract=676905

BTW while this has a March date, it appears to have been just updated on Sept 16.

Financial Fruition: Crappy TV -- Jim Cramer's Mad Money -- Let's Turn It OFF!

Financial Fruition has a pretty interesting article on Jim Cramer of CNBC. Cramer probably will not be sending FF a Chirstmas card anytime soon:


Some highlights:

** "Jim Cramer and the ill effects of active trading and preaching to to a world-wide audience. "

** "Yes, Cramer says he is just giving advice to those that have side money and want to dabble in the market, but does he know if that person's portfolio is already overweighted in the sector that he is recommending a buy of a certain stock in that same sector?"

** "One thing I don't think is reflected in Jim's return at the above link, is the commission charges for executed trades, or the short term capital gains one would have to incur on a winning pick"

My take on Cramer? He is really smart BUT mainly a showman and I would be VERY VERY hesitant to take any of his advice. But that said, he is occassionally fun to watch, just don't fall into his short term trading trap.

Is It Better to Buy or Rent? - New York Times

Is It Better to Buy or Rent? - New York Times: "But renting might deserve another look right now. After five years in which rents have barely budged while house prices in New York, Washington, Los Angeles and elsewhere have doubled, renting has become a surprisingly smart option for many people who never would have considered it before"

Something I have been saying for quite a while. Renting is also a whole lot easier. Not saying it is always right, but it is also not always wrong!

(PS the link was wrong originally, sorry!)

HoustonChronicle.com - Cash in demand, but supply short

HoustonChronicle.com - Cash in demand, but supply short

"Cash-hungry residents who had to deal with Hurricane Rita also drained automatic teller machines throughout the city.

Machines at some of Chase's 37 Houston branches, which were open for part of Thursday, ran out of cash, spokesman Greg Hassell said. He wasn't sure how many.

'We weren't able to get cash in because of the roadways, and there was very heavy demand,' he said. 'There were some cash shortages.'"

After disasters it has become standard practice for the Fed to increase liquidity (see post 9-11 for textbook response), but it would be interesting to see what the preparation for hurricanes at the Fed is. Or at local banks even. Both the main Federal Reserve page and that of the Atlanta Fed have comments on the hurricanes but neither is very specific. The Dallas Fed page actually is much more informative in this regard but sort of dry for class use.

If anyone has a good contact at either Fed or a major bank in path of Hurricanes who would like to be interviewed for a podcast (and blog entry) please email me. I think it could be very informative and a great way to use current events in a Money and Banking course.

SSRN-Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards by James Linck, Jeffry Netter, Tina Yang

SSRN-Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards by James Linck, Jeffry Netter, Tina Yang: "Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards"

Using firms in the Disclosure database, Linck, Netter, and Yang report that the Sarbanes-Oxley Act has increased the size of boards and has created more committees within boards. They also provide almost mind blowing evidence that the costs of boards--and more specifically the cost of compliance with the Sarbanes-Oxley Act (SOX)-- is significantly higher for small firms.

A very short look at some highlights:

"...although SOX does not explicitly prohibit unitary leadership (same person holds the two titles of the CEO and the Chairman of the Board), we see a distinct trend of firms moving away from this consolidated leadership structure..."

"the documented board changes are most significant for firms that are targeted by SOX – firms that originally do not have majority independent boards or firms that do not have completely independent audit committees."

"...small firms paid $5.91 to non-employee directors on every $1,000 in sales in the pre-SOX period, which increased to $9.76 on every $1000 in sales in the post-SOX period. In contrast, large firms incurred 13 cents in director cash compensation per $1,000 in sales in the Pre-SOXperiod, which increased only to 15 cents in the Post-SOX period."

Interesting stuff!

Cite:
Linck, James S., Netter, Jeffry M. and Yang, Tina, "Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards" (March 15, 2005). AFA 2006 Boston Meetings Paper http://ssrn.com/abstract=687496

SSRN-Brand New Deal: The Google IPO and the Branding Effect of Corporate Deal Structures by Victor Fleischer

Brand New Deal: The Google IPO and the Branding Effect of Corporate Deal Structures

Fleischer provides us with a series of case studies that shows that firms use contract design to signal various traits about the firm to stakeholders.

In the author's own words:

"This Article claims that the legal infrastructure of deals sometimes has a branding effect - that is, an effect on the brand image of the company. Deal structure affects the atmospherics of the brand. "

Or to put it another way: firms draw up contracts both for the traditional legal and incentive reasons generally mentioned in economics and finance but also for marketing (or branding) reasons. Which, while obvious, is often missed.

For instance, Fleischer uses the examples of the Google IPO and the Ben and Jerry's IPO. In each of these cases, the firm significantly altered the traditional IPO process. Why did they do so? One explanation is this branding story: the firms wanted to stand out as different. The IPO process was just one other way that they could signal this message to all stakeholders.

A few look-ins:

"From a traditional corporate finance perspective, the goal of a properly structured IPO is to manage the information asymmetry between the issuer and potential buyers in order to raise the most amount of money possible per share of stock sold. From this perspective, the success of the Google deal is questionable. Few would call the deal elegant or efficient. But this is not really what the Google IPO structure was about, or at least it is not the full story. When Google structured its IPO as an auction, it reinforced Google’sidentity as an innovative, egalitarian, playful, trustworthy company."

"Similarly, the Ben & Jerry’s deal structure may not have been terribly efficient.
By selling its stock only to Vermont residents, the company saved a few thousand dollars in legal and accounting fees. On the other hand, the geographic restriction artificially limited demand for the stock, and the offering price might have been higher if the offering had not been geographically limited.11 But without considering consumers, this sort of cost-benefit analysis fails to capture the essence of the deal. The offering was not just about selling stock and raising capital. It was also about selling ice cream. Selling stock to Vermonters helped build the brand image of the company."

and later:

"What can we learn from these case studies? Deal structure sometimes allows us to peer through the gossamer corporate veil and spy the values of the company’s founders and managers. Unusual deal structures, in particular, tend to anthropomorphize the firm. Google is not just a network of connected contracts;18 it is playful and innovative. Ben & Jerry’s is not just a manufacturer of a dessert product; it is a companion. For some products, consumers seek a personal bond. We crave more than mere product functionality. Deal structure serves as a specialized advertising medium, providing early adopters with quality assurance or enhancing the expressive value of the purchasingdecision"

This idea fits in well with the Demers and Lewellen that find that web hits are higher following underpriced IPOs.

Definitely recommended. The examples will make great class material! And its a fun paper too! Indeed one of the more fun reads I have had in a while (which either says something about me or the paper or both ;) )


Cite:
Fleischer, Victor, "Brand New Deal: The Google IPO and the Branding Effect of Corporate Deal Structures" (September 7, 2005). UCLA School of Law, Law-Econ Research Paper No. 05-18 http://ssrn.com/abstract=790928

How the BBC, Fortune and the New York Times went overboard claiming that the prediction markets had foreseen the name of the new pope!

This deserves another look. Hopefully this afternoon. But for now I at least wanted to point the article out to you.

Super Short version: The bettering markets (decision markets) may not have done as well in predicting the pope as the NY Times and others suggested.

From ChrisMasse.com

"The questions I pose today to Enterprise Commanders are these:

* How did the prediction markets at TradeSports/InTrade fare with anticipating Joseph Ratzinger as the new pope?
* Was it really "another triumph" [sic] for the prediction markets, as the Beeb trumpeted (and as Fortune and the New York Times echoed)?"
* What are the lessons that we can draw from this string of media failures?
o Are journalists (and bloggers) just stenographers, republishing Press releases from the exchanges?"

India's MBA Gold Rush

India's MBA Gold Rush: "To get an edge in the country's exploding economy, more Indian students are seeking business degrees -- both abroad and at home "

Given that one of my classes has an extra credit assignment of reading "The World is Flat" I really could not skip this one!

Remember, there is a great deal of competition from all corners of the earth! Study hard!

Emotionless Trading

Sorry, I liked the title Emotionless Trading better than Yahoo's version:
"Psychopaths could be best financial traders?"


Not sure what to say about this one. Just that it goes to show emotions should not play a roll in investment decisions.

Psychopaths to rule fin markets?: "A team of US scientists has found the emotionally impaired are more willing to gamble for high stakes and that people with brain damage may make good financial decisions, the Times newspaper reported Monday.

In a study of investors' behavior 41 people with normal IQs were asked to play a simple investment game. Fifteen of the group had suffered lesions on the areas of the brain that affect emotions.

The result was those with brain damage outperformed those without.

The scientists found emotions led some of the group to avoid risks even when the potential benefits far outweighed the losses, a phenomenon known as myopic loss aversion."


Thanks to Dave and Paul Harvey for pointing this one out to me!

Kimmunications: Investment Return Doesn't Mean Diddly

Even when the stock market goes up, investors may lose out if they try to time the market. The extent to which market timing occurs is debateable but no doubt substantial. That is the gist of a recent blog entry over at Kimmunications.

Kimmunications cites a Dalbar study that finds individual investors lose a great deal as a result of this attempt to time the market.

"over the 19 year period 1984 to 2002, the S&P 500 was up an average of 12.9%. U.S. stock mutual funds had a return over the same period of only 9.6%. That is the investment return of U.S. equity mutual funds. But the stock mutual fund investor had a return of only 2.7%!"

Without seeing more of the study, I have always had by questions on how investors could do that poorly (I would have to guess that many investors got in right at the top), but unfortunatley the paper is not available online (I did email them for a copy).

That said, the idea is sound and I absolutely love the figure that shows that actual stock picking makes up only a small portion of overall returns---it will be an excellent teaching tool!

Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments by Panagiotis Andrikopoulos

It is about the time of the semester when many finance classes turn their attention to market efficiency. Thus, it is perfect timing for Andrikopoulous' refresher comparing and contrasting Modern Fiance and Behavioural Finance.

SSRN-Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments by Panagiotis Andrikopoulos:

A quick look in:

• "Modern Finance has dominated the area of financial economics for at least four decades. Based on a set of strong but highly unrealistic assumptions its advocates have produced a range of very influential theories and models."
• "The importance of these two psychological biases in the under- and overreaction hypotheses is that investors under conservatism will only partially evaluate new publicly available information, or even disregard it altogether if it is not in favour of their beliefs"
• "Under the representativeness heuristic, investors will consider a series of positive company performances as representative of a continuous growth potential, and ignore the possibility that this performance is of a random nature."
• "Overreaction and under-reaction to new information may be viewed as a combination of three distinct inefficiencies; firstly, the inability of investment players to correctly distinguish between the length of the short-run and the long-run...; secondly, the excessive optimism of all investment agents due to biased self-attribution, and thirdly, the influence that one investment group has on another."
  

Of course, not everyone believes this new Behavioural School of thought. Again from the paper:

"Soon after the first empirical papers on behavioural finance were published, their claims came in for considerable criticism from supporters of the modern finance paradigm."

"important counter-argument disputes the existence of certain regularities and argues for the existence of research biases and other methodological shortcomings in behavioural finance studies. More commonly, the evidence on the existence of pricing anomalies is accepted but in that case, the most important response concerns the existence of additional risk factors, e.g. value premium can be explained as compensation for bearing additional systematic risk."

In this light of continually counter-punching against evidence suggesting rationality does not dominate

"It is also claimed that the positive contributions of modern finance are at an end and that its energies are now devoted to protecting itself in various ad hoc ways from the threat posed by the vast and growing anomalies literature. The simplifying models of modern finance, under this view, should be regarded as merely rough first approximations to how markets really behave, and that they stand in need of substantial revision and extension."

Andrikopoulos concludes:

"Nevertheless, the rational expectations model and the efficient markets model can never become obsolete, since they represent an ideal market. Should the behavioural finance revolution succeed, its applications in practice will simply move real markets closer to the ideal of semi-strong market efficiency."

Very nice. I like the perspective it gives even though at times I thought he made the division stronger than it generally appears to be.

My view? Probably be that modern finance is a very good first approximation and more often than not, the correct view. That said, I will concede (and indeed stress) that markets are far from perfect and behavioural finance is rightly here to stay for it does add to our understanding and (as Andrikopoulos points out) most assuredly moves markets closer to the ideal held by modern finance.


Cite:
Andrikopoulos, Panagiotis, "Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments" (June 2005). http://ssrn.com/abstract=746204