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Thursday, August 26, 2004

The Politics of Internal Capital Markets

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

With such an important finding, there are of course many potential explanations as to why the discount exists. A far from complete list includes:

Poor managerial incentives
Poor Monitoring and a lack of transparency (hard to tell who is doing what, so why not shirk)
Inefficient internal capital markets (so money is wasted through misallocation)
A lack of loyalty on mangers' and employees' behalves---this would lead to reduced performance and higher expenses.

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

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

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

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

In their words:

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

and the findings?

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

VERY INTERESTING!!!!

http://207.36.165.114/NewOrleans/Papers/1101756.pdf

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

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

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

Short Version :

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

Longer review:

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

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

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

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

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

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

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

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

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

NOTE: While the paper is forthcoming, the JFR only lists abstracts. A previous version of this paper was presented at last year's FMA conference. A copy of that paper is available here.
http://207.36.165.114/Denver/Papers/MarketStructureandtradingvolume.pdf

Demand for NYSE seats is down

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

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

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

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

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

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

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

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

What caused the NYSE's governance problems?

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

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

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

Sources:
http://www.forbes.com/technology/feeds/ap/2004/08/25/ap1518701.html
http://newsobserver.com/24hour/business/story/1599524p-9241399c.html

Wednesday, August 25, 2004

Cyberlibris blog: Finance at its best by two academic heavyweights

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

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

YOU HAVE TO WATCH THEM! THEY ARE SIMPLY THAT GOOD!!!

You will learn a ton!!!

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

WOW, WOW, WOW, WOW

Watch them both, you will not be disappointed!

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

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

http://cyberlibris.typepad.com/blog/2004/08/finance_at_its_.html

Tuesday, August 24, 2004

Google ranked last in corporate governance?!

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

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2004/08/24/BUGBU8D46M1.DTL

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

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

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

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

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

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

Sources:

Friday, August 20, 2004

China considers buying Russian oil firm

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

Wow, this is an interesting story.

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

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

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

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

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

Sources:
http://business.timesonline.co.uk/article/0,,8209-1224574,00.html
http://www.sptimes.ru/archive/times/996/news/b_13306.htm

Goldman Sachs to build near ground zero

New York Post Online Edition%3A business

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

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

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

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

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

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

Jay Ritter on Google's IPO

Lessons of Google's Dutch auction

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

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

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

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

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

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

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

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

Sources:

Thursday, August 19, 2004

SEC Vote Prohibits Mutual Funds From Directed Brokerage

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

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

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

The incentive payments are often hidden from investors and can taint brokers' advice, officials said at yesterday's meeting."
http://www.nytimes.com/2004/08/19/business/19sec.html

A definite step in the right direction!

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

Sources:
http://www.boston.com/business/articles/2004/08/19/sec_tells_funds_to_end_perks/ http://www.washingtonpost.com/wp-dyn/articles/A13799-2004Aug18.html
http://www.nytimes.com/2004/08/19/business/19sec.html

Just in time for class, another CAPM Review :)

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

Some of the high points:

The review of the existing CAPM literature is excellent and laid out in an easy to follow format. From the Capital Market Line to the work of Sharpe and Lintner, the paper describes the "whys", the "hows", and even the "why nots" of the CAPM.
Unlike most textbooks, the author takes seriously the problems with non-normal returns. For instance:
"Many researchers investigated the validity of the CAPM in the presence of higher-order co-moments and their effects on asset prices. In particular, the effect of skewness on asset pricing models was investigated extensively. For example, Kraus and Litzenberger (1976), Friend and Westerfield (1980), Sears and Wei (1985) and Faff, Ho and Zhang (1998), among others extended the CAPM to incorporate skewness in asset valuation models and provided mixed
results....Investors are generally compensated for taking high risk as measured by high systematic variance and systematic kurtosis. Investors also forego the expected returns for taking the benefit of a positively skewed market. It also has been documented that skewness and kurtosis cannot be diversified away by increasing the size of portfolios (Arditti, 1971). "
The author concludes that the assumptions (especially of normality) are important, but even when the problems of assumptions are adjusted for, CAPM still has very mixed results.

As a note, given Fama and French's CAPM review (See April's FinanceProfessor Newsletter, and June's FP Blog Archive ), I do feel a bit sorry for Galagedera, but it none-the-less is a very well done article and it is easy enough for upper level undergraduates to grasp with little problem. (Which is a hint to all of my students ;) )

Sources:
http://econwpa.wustl.edu/eps/fin/papers/0406/0406010.pdf
http://lists.topica.com/lists/FinanceProfessor/read/message.html?mid=1716457251&sort=d&start=88
http://gsbwww.uchicago.edu/fac/finance/papers/capm%202004.pdf
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=440920

Wednesday, August 18, 2004

The trials and tribulations of the Google IPO

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

Friday-- we learned that Google's founders had done an interview in playboy. This caused some problems as many feared it would violate the SEC's Quiet Period. Interestingly, the interview was done before the firm had filed for its IPO, but the publication came out after the filing and during the quiet period.
http://www.cnn.com/2004/TECH/08/13/google.playboy.reut/

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

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

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

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

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

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

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

Sources:
http://www.nytimes.com/2004/08/18/technology/18CND-GOOGLE.html
http://www.cnn.com/2004/TECH/08/13/google.playboy.reut/
http://quote.bloomberg.com/apps/news?pid=10000006&sid=a4yq5qGfOls8&refer=home
http://www.out-law.com/php/page.php?page_id=googlesplayboybo1092661998&area=news
http://www.searchenginejournal.com/index.php?p=784
http://www.businessweek.com/technology/content/aug2004/tc2004089_9615_tc024.htm

Tuesday, August 17, 2004

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

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

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

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

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

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

“Fama and French (2002) note that firms' debt ratios adjust slowly towards their targets. That is, firms appear to take a long time to return their leverage to its long-run mean or, loosely speaking, optimal level. Baker and Wurgler (2002) document that historical efforts to time equity issuances with high market valuations have a persistent impact on corporate capital structures. This fact leads them to conclude that capital structures are the cumulative outcome of historical market timing efforts, rather than the result of a dynamic optimizing strategy. Finally, Welch (2004) finds that equity price shocks have a long-lasting effect on corporate capital structures as well. He concludes that stock returns are the primary determinant of capital structure changes and corporate motives for net issuing activity are largely a mystery.”
[A problem with] “Most empirical tests, however, [is that they] implicitly assume that this rebalancing is costless. In the absence of adjustment costs, firms can continuously rebalance their capital structures towards an optimal level of leverage. However, in the presence of such costs, it may be suboptimal to respond immediately to capital structure shocks.”

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

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

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

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

Overall a very good and important article!

Cite:

Leary , Mark and Roberts, Michael R., "Do Firms Rebalance Their Capital Structures?" (June 7, 2004). 14th Annual Utah Winter Finance Conference; Tuck Contemporary Corporate Finance Issues III Conference Paper. http://ssrn.com/abstract=571002

New Newsletter is online!

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

Here is a link to the newsletter
http://lists.topica.com/lists/FinanceProfessor/read/message.html?mid=1717368295&sort=d&start=88

and a link to subscribe to it if you do not already.
http://lb.bcentral.com/ex/manage/subscriberprefs.aspx?customerid=11418

Of course all of this is also available at FinanceProfessor.com

Have fun!