Google and the Temptations of Being Cash-Rich - DealBook Blog - NYTimes.com

Several years ago Eric and crew at CyberLibris asked me for a list of my all time favorite finance papers. I could not find a link to it now but I do know that well in the top five was Michael Jensen's 1986 free cash flow paper. It was one of the first academic papers I read when I got to Rochester for my MBA and it immediately clicked. It later became the premise of my PHD dissertation and I use the ideas to this day in class.

In short, Jensen's Free Cash flow paper says that if firms have free cash flow (my dissertation and many other papers since have also looked at high levels of cash) tend to waste it by investing in negative NPV projects.

It appears that the analysts at Sanford C. Bernstein agree!

From the NY Times's DealBlog:

Google and the Temptations of Being Cash-Rich - DealBook Blog - NYTimes.com:

"Analysts at Sanford C. Bernstein are making their views on the subject unmistakably clear...(deleted stuff on Twitter)... said that Google and other successful Internet companies would generally be doing their investors a favor if they returned their cash to shareholders rather than using it to buy unprofitable start-ups.

The analysts argue that Internet companies have a bad track record when it comes to acquiring “pre-business-model” companies like Twitter, a popular microblogging service that has yet to produce profits — or even revenues. The Web is littered with examples of promising but ultimately value-destroying acquisitions, they wrote in a note to clients, citing deals like AOL’s $4.2 billion acquisition of Netscape and eBay’s $4.1 billion acquisition of Skype."

and later:

"It is worth noting that Google’s chief executive, Eric Schmidt, recently said his company doesn’t expect to be active in making acquisitions. In addition, Google paid for YouTube, the video-sharing service, with stock, not cash.

Even so, the analysts at Sanford Bernstein said they think Google should consider giving, say, $20 billion of its cash pile back to shareholders in a one-time dividend of about $60 a share."

Which fits the free cash flow story perfectly.

I guess it should be noted that the SIMM class that I teach does own a few shares of Google. Not sure how it is relevant , but I remember that as part of the SeekingAlpha agreement, I was supposed to list it.

Nissan removes cars from McAllister's Miss. lot - NFL - Yahoo! Sports

With the economy struggling, versions of this are playing out many times around the country, but given it is Deuce McAllister, I thought more would be interested in this specific case.

Nissan removes cars from McAllister's Miss. lot - NFL - Yahoo! Sports:

"Nissan began removing vehicles Tuesday from a dealership owned by former New Orleans Saints running back Deuce McAllister.

About 20 cars and trucks were loaded on tractor-trailers even as McAllister said in an interview that he is seeking investors to help pull the dealership out of bankruptcy....

McAllister filed for Chapter 11 bankruptcy protection last month after Nissan Motor Acceptance Corp. said in a federal civil suit that the free agent owed nearly $7 million, mostly in unsold vehicles still sitting on his lot.

The 30-year-old is the sole owner of the dealership, one of two he owns in Mississippi’s capital city."

Chapter 11 bankruptcy is for reorganization. From Wikipedia:

"Chapter 11 is a chapter of the United States Bankruptcy Code, which permits reorganization under the bankruptcy laws of the United States. Chapter 11 bankruptcy is available to any business, whether organized as a corporation or sole proprietorship, and to individuals, although it is most prominently used by corporate entities."

SSRN-So What Orders Do Informed Traders Use? Evidence from Quarterly Earnings Announcements by Hsiao-Fen Yang

I love when two ideas are in direct competition and are testable. For instance, suppose you have information that you want to trade on. If you trade too aggressively you will move the market (and if it is inside information get caught!). On the other hand, if you wait too long, the information is released to the public and your advantage is gone.

A new working paper by Hsiao-Fen Yang looks at this and finds evidence that seems to sugest that informed traders are sneaky at first, but as the information release date gets closer, they get more aggressive. Which is a really cool story.

Here is some from the abstract:

SSRN-So What Orders Do Informed Traders Use? Evidence from Quarterly Earnings Announcements by Hsiao-Fen Yang:

"Because informed traders expect their information advantage will disappear after the announcements, this information event provides a unique opportunity to test whether informed traders become more impatient and use more aggressive orders when the announcement is approaching. Our results show that when the information will be released soon but there is still enough time for the execution (from day -10 to day -6), informed investors use small orders and limit orders to trade stealthily and reduce price risk. Within five days right before the announcements, informed investors trade more aggressively. They start using large market orders to ensure the execution...."

Ok, so this is just an abstract, so it may or may not be a good paper, but I will take the chance given the author has done quite a bit of work in the market-microstructure field and it is a nice intuitive story. Unfortunately I have not seen the paper. I will email the author and update this link if I find a version online.

Nearly 97 percent of HSBC rights issue taken up - BusinessWeek

Just in time to serve as a perfect example of what we do in class is relevant, HSBC announced it had completed a rights issue.

(A rights issue is a way of selling new equity by giving existing shareholders the right to buy new shares at a reduced price. These rights are generally transferable which means they can be sold to someone else who will buy the new shares.)

From BusinessWeek:

"Stockholders have purchased nearly 97 percent of new shares offered under a rights issue, HSBC PLC said Sunday, raising nearly $18 billion (12 billion pounds) for the London-based bank."

And from the BBC:

"The $17.7bn (£12.5bn) by HSBC raised makes this the largest rights issue in UK corporate history.

The take-up was not a big surprise because the shares were being offered at 245p each, but were trading on the London Stock Exchange at 435p each"

And from the NY Times:

"HSBC said it expected to place the remaining 3.4 percent of the offering on Monday but any unsold shares would be acquired by its underwriters...."

We just covered rights issues in class, so this will be of special interest to my MBA students!

Strategies - Now the Long Run Looks Riskier, Too, for Investors - NYTimes.com

First from the NY Times: Strategies - Now the Long Run Looks Riskier, Too, for Investors - NYTimes.com:

"...despite downturns like the one we’ve endured recently, stocks over periods of 30 or more years have almost always outperformed other asset classes. And numerous studies have found that the stock market’s long-term returns have tended to fall within a surprisingly narrow range.

But those studies were based on the stock market’s past performance, which, famously, provides no guarantee of future performance. New research, using different statistical techniques aimed at capturing the uncertainty of future returns, suggests that the market may be much riskier than many investors have understood....

[later]

One example of such a force, Professor Stambaugh said, is global warming. Its impact on the economy over the next 12 months is likely to be quite small, he said. But expand the horizon to the next several decades, and the possible effects of global warming range from negligible to catastrophic.

[later]

Applying Bayesian techniques, the professors found that reversion to the mean isn’t powerful enough to overcome the growing uncertainty caused by other factors as the holding period grows...."

The new study, which began circulating last month as a working paper, is titled “Are Stocks Really Less Volatile in the Long Run?”"

The paper is by Lubos Pasto and Robert Stambaugh:

Abstract:

"Conventional wisdom views stocks as less volatile over long horizons than over short horizons due to mean reversion induced by return predictability. In contrast, we find stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. We decompose return variance into five components, which include mean reversion and various uncertainties faced by the investor. Although mean reversion makes a strong negative contribution to long-horizon variance, it is more than offset by the other components. Using a predictive system, we estimate annualized 30-year variance to be nearly 1.5 times the 1-year variance. "

Cite:
Pastor, Lubos and Stambaugh, Robert F.,Are Stocks Really Less Volatile in the Long Run?(February 17, 2009). Available at SSRN: http://ssrn.com/abstract=1136847

Selling forwards for sporting events | Blogs |

Felix Salmon writing for Reuters has a fascinating look at how the NCAA and other major sporting events could increase their profits based off a pricing model that relies on options and/or forward sales.

Felix Salmon » Blog Archive » Selling forwards for sporting events | Blogs |:

"Preethika Sainam of Indiana University, along with two colleagues from Chapel Hill, has an interesting paper suggesting that sports organizations shouldn’t sell tickets to big sporting events, like the finals of the Final Four, where the teams who will be playing are unknown. Instead, they say, they should sell options to buy tickets at a certain price once it’s known who’s going to be playing. This system, they say, will raise more money in ticket sales, will make fans happier, and will reduce scalping.

The interesting thing is that reading between the lines of the paper, it seems that selling options is actually the second-best solution to these problems. The best solution would be to replace some (but not all) of the tickets with team-specific forwards, which expire worthless if that team doesn’t make the finals. That would allow the “team-oriented” fans to buy forwards rather than tickets which they might not want if their team fails to make it to the finals; it would allow “game-oriented” fans to buy tickets to the finals just like they can right now; it would mean that many more tickets could be sold in total (for the final match-up, you can sell 32 times as many forwards as there are seats)...."

Here is the abstract of the actual paper Consumer Options: Theory and an Empirical Application to a Sports Market by Sainam, Balasubramanian, and Bayus:

"We introduce the concept of consumer options and empirically validate it in the context of event ticket pricing. We demonstrate that consumer options can protect consumers from the downside related to uncertain outcomes, and enhance seller profits by enabling superior market segmentation and increasing consumer willingness to pay. We examine ticket pricing in sports markets where there is uncertainty about the teams that will play in a final event (e.g., the NCAA Final Four basketball tournament). Fans who want to attend the game after knowing which teams will play are often disappointed because tickets typically sell out in advance. We propose that a fan can buy an option on a ticket before this uncertainty is resolved. Later she can decide about exercising the option. We present a simple analytical model of consumer options in this setting. We then empirically demonstrate that profits under options can exceed those from (a) advance selling, and (b) pricing after uncertainty is resolved. Our analysis and findings lay a foundation for future work on consumer options in marketing. "

Think of how many different things could be priced this way! For instance, not sure if you need a rental car or not, plane ticket, hotel room, and even if you want to attend one school or another. Or bandwidth, power, etc. (although correlations make some of these really messy) Wow. Exciting stuff!


Cite: Sainam, Preethika, Balasubramanian, Sridhar and Bayus, Barry L.,Consumer Options: Theory and an Empirical Application to a Sports Market(February 1, 2009). Available at SSRN: http://ssrn.com/abstract=1341763


HT to Lura_Forcum for the tweet that alerted me to this.

SSRN-The Actuarial Balance of the Pay-as-You-Go Pension System: 'American' Model versus 'Swedish' Model by Carlos Vidal-Meliá, María Del Carmen Boado-Penas

In whatever language you say it, transparency is good. Here it is on transparency in pension accounting.

SSRN-The Actuarial Balance of the Pay-as-You-Go Pension System: 'American' Model versus 'Swedish' Model by Carlos Vidal-Meliá, María Del Carmen Boado-Penas:

"The main conclusion reached is that making it mandatory for the actuarial balance to be drawn up every year would force politicians to be a lot more careful about what they say and encourage them to avoid the use of populism in pensions. Contributors and pensioners, on the other hand, would have a reliable way of measuring to what degree the promises made to them regarding payment of their pensions are actually kept."

Of course incentives matter in all things and politicians do not want transparency since they cannot make as many promises in its presence, so reform has been slow in coming.

Note: This paper is in Spanish--if you are like me and need help with translation, I used Google's translation. It was far from perfect (Not only did some sentences not make sense, but also you have to copy and paste about a million times), but worked.

Note to self: relearn Spanish!
Here is a link to it.

SSRN-Chinese Bond Markets - An Introduction by Index and Portfolio Services, Standard & Poor's

Standard and Poor's has a very short but informative primer out on the Chinese Bond market. It is full of things I sure did not know about the bond market.

SSRN-Chinese Bond Markets - An Introduction by Index and Portfolio Services, Standard & Poor's:

"While foreign investors have flocked to Chinese equities because of performance and correlation considerations, there is relatively less awareness of Chinese bond markets. This paper serves as an introduction to structure, trading venues, investor base and performance of Chinese bond markets for outside investors.

After more than a quarter century of development, Chinese bond markets have evolved into a RMB 15 trillion (more than USD 2 trillion) market across a broad variety of credit, maturity and investor profiles.

The market has a multi-layered structure, comprised of the national interbank market, the exchange market and bank counters, with the interbank market being the dominant trading venue.

Foreign institutional investors can invest in Chinese bonds by seeking regulator approval for QFII quota or access to the interbank market....

Over the five years ending 2008, the Chinese bonds in aggregate returned 8.1% annually in USD terms as measured by S&P/CITIC Composite Bond Index, a rate higher than those of U.S. and European bonds. RMB appreciation was a key return"

Cite:
Standard & Poor's, Index and Portfolio Services, ,Chinese Bond Markets - An Introduction(March 31, 2009). Available at SSRN: http://ssrn.com/abstract=1371129

Harvard Begins Case Study as Tainted MBAs Reveal Damaged Brand - Bloomberg.com

Interesting. My classes sure have changed. I would imagine most professors have changed what they are teaching. It would be fun to see the case study that results and their changes.

Harvard Begins Case Study as Tainted MBAs Reveal Damaged Brand - Bloomberg.com:

"Harvard Business School, stung by criticism that it hasn’t prepared alumni to cope with the economic meltdown, will dissect its performance using a practice it employs to examine corporations in crisis.

A task force....is writing a case study to scrutinize whether the school is failing to teach students to understand and manage risk in the current environment, according to Paul Healy, co-chair of the panel....Harvard Business School’s 219 professors will tackle the case...and may use the discussion to propose curriculum changes."

Subprime Suit Accuses KPMG of Negligence - Accounting - CFO.com

Well we all knew that lawsuits would begin soon. Here we go:

Subprime Suit Accuses KPMG of Negligence - Accounting - CFO.com:

"Two complaints filed in federal courts yesterday claim that KPMG auditors were complicit in allowing 'aggressive accounting' to occur under their watch at New Century Financial, the mortgage lender that collapsed two years ago at the beginning of the subprime-mortgage mess.

The plaintiff, a New Century trustee, alleges that misstated financial reports were filed with the audit firm's rubber stamp because of its partners' fears of losing the lender's business. 'KPMG acted as a cheerleader for management, not the public interest,' one of the complaints says. The trustee further accuses the firm of 'reckless and grossly negligent audits.'

AND LATER

"In the new lawsuit, KPMG LLP is accused of not giving credence to lower-level employees' concerns about their client's accounting flaws. In 2005, for instance, a partner was said to have "silenced" one of the firm's specialists who had questioned New Century's "incorrect accounting practice." The partner allegedly said, "I am very disappointed we are still discussing this.... The client thinks we are done. All we are going to do is piss everybody off." Dan Ginsburg, KPMG LLP spokesman, says any claims that the firm gave in to its client's demands "is unsupportable."

FASB Eases Fair-Value Rules Amid Lawmaker Pressure (Update1) - Bloomberg.com

FASB Eases Fair-Value Rules Amid Lawmaker Pressure (Update1) - Bloomberg.com:

"The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value rules....The changes to so-called mark-to-market accounting allow companies to use “significant” judgment when gauging the price of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ writedowns and boost their first-quarter net income by 20 percent or more"

Former SEC chairperson Arthur Levitt who "along with former SEC head William Donaldson, of the Investors’ Working Group, a non-partisan panel formed to recommend improvements to regulation of U.S. financial markets. " disagreed with the decision:

"Fair-value “provides the kind of transparency essential to restoring public confidence in U.S. markets,” and "The group is deeply concerned about the apparent FASB succumbing to political pressures, which prevent U.S. investors from understanding the true obligations of U.S. financial institutions"

What is at stake? Forgetting cynicism, we can assume that both sides want true values reflected. The difference is in what is "true". Levitt and others believe that market prices should be used while the banks believe that markets are not giving "fair values" right now and that their own models give a truer value.

"Wells Fargo and other banks argue the rule doesn’t make sense when trading has dried up because it forces companies to write down assets to fire-sale prices.

By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB’s changes could raise bank industry earnings by 20 percent, according to Robert Willens, a former managing director at Lehman Brothers Holdings Inc. who runs his own tax and accounting advisory firm in New York."

Neither market values nor valuation models are always going to be right, but I have to side with Levitt and say that the objective market values are better.

Why? Because those making the subjective valuations may have an incentive to inflate the values. Consider this example. In my life outside of academia I help out at my family's grocery stores. What if rather than writing down old lettuce, I keep them on the books because I want to keep earnings up (at least temporarily) so that I get a bonus, can cash out stock options, or the like. The lettuce is still bad, whether I say it is good or not. But to the outside investor, they can no longer tell.

UPDATE:

From CFO.com the IASB joined in the criticism of FASB:

" "As distasteful as it is, we've got to recognise that there is a crisis on and we can't totally ignore what another standard-setter is doing," said a board member at the meeting in London. But other members, most notably James Leisenring, argued that FASB was proposing to allow companies to "ignore" the traded price of a financial instrument in favour of using internal models.

In the end, the IASB issued a "request for views" about FASB's proposals. This rarely used document is unusually broad and asks parties what they think of the proposals, with no formal implications for what the IASB's next steps should be. The IASB's document is read as a thinly veiled critique of how FASB's hand was forced by US politicians. It cautions that "attempting accelerated efforts in complex areas" can have "unintended consequences and undermine investor confidence in financial reporting.""

Airlines Return to Hedging - WSJ.com

According to the WSJ, airlines are making a switch from futures to options for their hedging programs.

Airlines Return to Hedging - WSJ.com:

"..oil prices are starting to rebound, creating a quandary for the industry. If the airlines dive back into hedging, they could end up overpaying once again should oil prices fall back. Remaining unhedged would leave airlines exposed should the recent rally extend into a price spike.

The answer, some airlines say, is to hedge their bets on how to hedge. Carriers are relying increasingly on instruments that reduce the burden of rising oil prices, but leave open the option of purchasing fuel at market rates should costs fall back. These derivatives have greater upfront costs, but airlines are unlikely to see a repeat of the massive charges they reported in their fourth quarters from hedging programs gone wrong."

and later

" The airline is using a mechanism known as a call option, which grants it the right to buy oil futures at $60 a barrel, even if their value has risen above that level. The options are pricier than other hedging instruments, but still allow an airline to take advantage of cheaper fuel when oil prices fall.

Excusing the article appears it was written for an introductory finance class, it is interesting to see the switch to options. It is surprising that futures were used as much as they were when they create an obligation to lose if prices move against your hedge. Or as you learn in any finance class: options hedge the moves against you while allowing you to participate in moves that are in your favor. The disadvantage is that they often are not as liquid and have higher transaction costs.

SSRN-What Do Subprime Securitization Contracts Actually Say About Loan Modification? Preliminary Results and Implications by John Hunt

Interesting! John Hunt reviews some actual contracts and finds they rarely strictly forbid loan modifications.

SSRN-What Do Subprime Securitization Contracts Actually Say About Loan Modification? Preliminary Results and Implications by John Hunt:

"A review of pooling and servicing agreements from large subprime securitization programs in 2006 reveals that about 10% of the contract ban loan modifications altogether. The other 90% do not seem to forbid win-win loan modifications (defined as modifications that benefit the borrower and increase the present value of cash flows to the trust), although their terms are open-ended enough that reluctance to make such modifications is understandable. If the subprime universe as a whole looks similar to the contracts we have reviewed to date, mass clarification of contracts rather than mass abrogation either through special legislation or through the creation of a special bankruptcy process may be appropriate."

That said, wouldn't it sort be assumed that you can't modify it, but it is not in writing, so ???

SSRN-Peer Firms in Relative Performance Evaluation by Ana Albuquerque

Financial theory suggests that CEO compensation should be based on relative performance.

Why? It captures what financeprofessors like to call external shocks (for the rest of you this means that things that are beyond the control of manager). For instance if you are paid by stock, for better or worse you are at least partially at the mercy of the stock market. So essentially the peer group is a control group.

Surprisingly the empirical literature has found mixed results when examining how well this works. That seemingly has changed with a new paper by Ana Albuquerque. She suggests the the reason that previous researchers have used the wrong peer groups.

SSRN-Peer Firms in Relative Performance Evaluation by Ana Albuquerque:

From the abstract:

"External shocks and flexibility in responding to the shocks are functions of, for example, the firm's technology, the complexity of the organization, and the ability to access external credit, which depend on firm size. When peers are composed of similar industry-size firms, evidence is consistent with the use of RPE in CEO compensation."

A later look in:

"...difficulty in defining the ideal peer group. Such a group should include firms that are similar along several characteristics (e.g., industry, size, diversification, and financial constraints). Yet considering all such characteristics simultaneously is not practical because it could result in peer groups composed of too few firms, which would be too noisy to filter external shocks. In this paper, I show that industry and firm size capture many of these characteristics. When peer groups consist of firms within the same industry and size quartile, my empirical results show systematic evidence supporting RPE usage in CEO pay."

and to compare this to previous work in the field:

"To compare with previous studies,I test whether RPE is used when measuring peer performance with two common peer group definitions, namely, the S&P 500 index and firms within the same industry. I fail to find consistent evidence of RPE usage with either peer definition"

Good stuff. Interesting.

Cite:
Albuquerque, Ana M.,Peer Firms in Relative Performance Evaluation(March 26, 2009). Available at SSRN: http://ssrn.com/abstract=1368893