Showing papers in "Journal of Finance in 2009"
TL;DR: The authors investigated how the cash holdings of U.S. firms have evolved since 1980 and whether this evolution can be explained by changes in known determinants of cash holdings and found no consistent evidence that agency conflicts contribute to the increase.
Abstract: The average cash-to-assets ratio for U.S. industrial firms more than doubles from 1980 to 2006. A measure of the economic importance of this increase is that at the end of the sample period, the average firm can retire all debt obligations with its cash holdings. Cash ratios increase because firms’ cash flows become riskier. In addition, firms change: They hold fewer inventories and receivables and are increasingly R&D intensive. While the precautionary motive for cash holdings plays an important role in explaining the increase in cash ratios, we find no consistent evidence that agency conflicts contribute to the increase. CONSIDERABLE MEDIA ATTENTION has been devoted to the increase in cash holdings of U.S. firms. For instance, a recent article in The Wall Street Journal states that “The piles of cash and stockpile of repurchased shares at [big U.S. companies] have hit record levels.” 1 In this paper, we investigate how the cash holdings of U.S. firms have evolved since 1980 and whether this evolution can be explained by changes in known determinants of cash holdings. We document a secular increase in the cash holdings of the typical firm from 1980 to 2006. In a regression of the average cash-to-assets ratio on a constant and time, time has a significantly positive coefficient, implying that the average cash-to-assets ratio (the cash ratio) has increased by 0.46% per year. Another way to see this evolution is that the average cash ratio more than doubles over our sample period, from 10.5% in 1980 to 23.2% in 2006. Everything else equal, following Jensen (1986), we would expect firms with agency problems to accumulate cash if they do not have good investment opportunities and their management does not want to return cash to shareholders. In the absence of agency problems, improvements in information and financial
1,829 citations
TL;DR: In this paper, the authors compare the response to earnings announcements on Friday, when investor inattention is more likely, to the response on other weekdays, and support explanations of post-earnings announcement drift based on underreaction to information caused by limited attention.
Abstract: Does limited attention among investors affect stock returns? We compare the response to earnings announcements on Friday, when investor inattention is more likely, to the response on other weekdays. If inattention influences stock prices, we should observe less immediate response and more drift for Friday announcements. Indeed, Friday announcements have a 15% lower immediate response and a 70% higher delayed response. A portfolio investing in differential Friday drift earns substantial abnormal returns. In addition, trading volume is 8% lower around Friday announcements. These findings support explanations of post-earnings announcement drift based on underreaction to information caused by limited attention.
1,440 citations
TL;DR: In this article, the authors estimate dynamic R&D models for high-tech firms and find significant effects of cash flow and external equity for young, but not mature, firms.
Abstract: The financing of R&D provides a potentially important channel to link finance and economic growth, but there is no direct evidence that financial effects are large enough to impact aggregate R&D. U.S. firms finance R&D from volatile sources: cash flow and stock issues. We estimate dynamic R&D models for high-tech firms and find significant effects of cash flow and external equity for young, but not mature, firms. The financial coefficients for young firms are large enough that finance supply shifts can explain most of the dramatic 1990s R&D boom, which implies a significant connection between finance, innovation, and growth.
1,420 citations
TL;DR: The authors investigated the cross-sectional relation between media coverage and expected stock returns and found that stocks with no media coverage earn higher returns than stocks with high media coverage even after controlling for well-known risk factors.
Abstract: By reaching a broad population of investors, mass media can alleviate informational frictions and affect security pricing even if it does not supply genuine news. We investigate this hypothesis by studying the cross-sectional relation between media coverage and expected stock returns. We find that stocks with no media coverage earn higher returns than stocks with high media coverage even after controlling for well-known risk factors. These results are more pronounced among small stocks and stocks with high individual ownership, low analyst following, and high idiosyncratic volatility. Our findings suggest that the breadth of information dissemination affects stock returns.
1,083 citations
TL;DR: In this article, the authors proposed a new approach to estimate the effective cost of trading and the common variation in this cost, which is then used in conventional asset pricing specifications with a view to ascertaining the role of trading costs as a characteristic in explaining stock returns.
Abstract: The effective cost of trading is usually estimated from transaction-level data. This study proposes a Gibbs estimate that is based on daily closing prices. In a validation sample, the daily Gibbs estimate achieves a correlation of 0.965 with the transactionlevel estimate. When the Gibbs estimates are incorporated into asset pricing specifications over a long historical sample (1926 to 2006), the results suggest that effective cost (as a characteristic) is positively related to stock returns. The relation is strongest in January, but it appears to be distinct from size effects. INVESTIGATIONS INTO THE ROLE of liquidity and transaction costs in asset pricing must generally confront the fact that while many asset pricing tests make use of U.S. equity returns from 1926 onward, the high-frequency data used to estimate trading costs are usually not available prior to 1983. Accordingly, most studies either limit the sample to the post-1983 period of common coverage or use the longer historical sample with liquidity proxies estimated from daily data. This paper falls into the latter group. Specifically, I propose a new approach to estimating the effective cost of trading and the common variation in this cost. These estimates are then used in conventional asset pricing specifications with a view to ascertaining the role of trading costs as a characteristic in explaining
1,022 citations
TL;DR: In this article, the propensity to gamble and investment decisions are correlated, and individual investors prefer stocks with lottery features, and like lottery demand, the demand for lottery-type stocks increases during economic downturns.
Abstract: This study shows that the propensity to gamble and investment decisions are correlated. At the aggregate level, individual investors prefer stocks with lottery features, and like lottery demand, the demand for lottery-type stocks increases during economic downturns. In the cross-section, socioeconomic factors that induce greater expenditure in lotteries are associated with greater investment in lottery-type stocks. Further, lottery investment levels are higher in regions with favorable lottery environments. Because lottery-type stocks underperform, gambling-related underperformance is greater among low-income investors who excessively overweight lottery-type stocks. These results indicate that state lotteries and lottery-type stocks attract very similar socioeconomic clienteles.
951 citations
TL;DR: In this article, the authors focus on the competition for investor attention between a firm's earnings announcements and the earnings announcements of other firms and find that negative news has a stronger effect on firms that receive positive than negative earnings surprises.
Abstract: Psychological evidence indicates that it is hard to process multiple stimuli and perform multiple tasks at the same time. This paper tests the INVESTOR DISTRACTION HYPOTHESIS, which holds that the arrival of extraneous news causes trading and market prices to react sluggishly to relevant news about a firm. Our test focuses on the competition for investor attention between a firm's earnings announcements and the earnings announcements of other firms. We find that the immediate stock price and volume reaction to a firm's earnings
surprise is weaker, and post-earnings announcement drift is stronger, when a greater number of earnings announcements by other firms are made on the same day. Distracting news has a stronger effect on firms that receive positive than negative earnings surprises. Industry-unrelated news has a stronger distracting effect than related news. A trading strategy that exploits post-earnings announcement drift is unprofitable for announcements made on days with little competing news.
854 citations
TL;DR: In this article, the authors examine whether differences in legal protection affect the size, maturity, and inter-rate spread on loans to borrowers in 48 countries and show that variation in enforceability of contracts matters a great deal more to how loans are structured and how they are priced.
Abstract: We examine whether differences in legal protection affect the size, maturity, and inter est rate spread on loans to borrowers in 48 countries. Results show that banks respond to poor enforceability of contracts by reducing loan amounts, shortening loan maturi ties, and increasing loan spreads. These effects are both statistically significant and economically large. While stronger creditor rights reduce spreads, they do not seem to matter for loan size and maturity. Overall, we show that variation in enforceability of contracts matters a great deal more to how loans are structured and how they are priced. THE EXTENT TO WHICH PROPERTY RIGHTS are protected in a country is an impor tant consideration in determining what loans are offered to firms, how these loans are structured, and how they are priced. Property rights protection af fects a lender's incentives to monitor and its ability to recontract. Declining credit quality often results in lenders raising interest rates, demanding more collateral, shortening loan maturity, and further restricting future activities. This recontracting is costly when property rights are poorly enforced. Poor en forcement lowers recovery rates and increases the time spent in repossessing collateral following default.' In addition to enforcement, the legal rights that lenders have in reorgani zation and liquidation procedures are also important. Differences in creditor rights matter to loan contracting because laws determine who controls the in solvency process and who has rights to the property of a bankrupt firm. How do differences in creditor rights and contract enforceability affect the amount banks lend to firms, the maturity of the loans they make, and the interest rate spreads they charge? Are laws and enforcement equally important to the loan
695 citations
TL;DR: Recently, this article showed that exponential growth bias can explain two stylized facts in household finance: the tendency to underestimate an interest rate given other loan terms, and the propensity to underestimate a future value given other investment terms.
Abstract: Exponential growth bias is the pervasive tendency to linearize exponential functions when assessing them intuitively. We show that exponential growth bias can explain two stylized facts in household finance: the tendency to underestimate an interest rate given other loan terms, and the tendency to underestimate a future value given other investment terms. Bias matters empirically: More-biased households borrow more, save less, favor shorter maturities, and use and benefit more from financial advice, conditional on a rich set of household characteristics. There is little evidence that our measure of exponential growth bias merely proxies for broader financial sophistication. WHAT DRIVES HOUSEHOLD financial decisions? The canonical economic model assumes that consumers choose to consume, borrow, or save based on their preferences, their expectations, and the costs and benefits of borrowing and saving. A growing body of work applies insights from psychology to enrich specifications of three of the model’s key pieces: preferences, expectations, and problem-solving conditional on parameter values. 1 In this paper, we bring psychological evidence to bear on a fourth specification issue: How consumers perceive the costs and benefits of borrowing and saving. We begin by tying together existing and new evidence on these cost perceptions to show that most consumers err systematically when given information commonly available in the market. On the saving side, consumers display future value bias: a systematic tendency to underestimate a future value given
672 citations
TL;DR: The authors analyzes how blockholders can exert governance even if they cannot intervene in a firm's operations, by trading on private information (following the “Wall Street Rule”), they cause prices to reflect fundamental value rather than current earnings.
Abstract: This paper analyzes how blockholders can exert governance even if they cannot intervene in a firm’s operations. Blockholders have strong incentives to monitor the firm’s fundamental value because they can sell their stakes upon negative information. By trading on private information (following the “Wall Street Rule”), they cause prices to reflect fundamental value rather than current earnings. This in turn encourages managers to invest for long-run growth rather than short-term profits. Contrary to the view that the U.S.’s liquid markets and transient shareholders exacerbate myopia, I show that they can encourage investment by impounding its effects into prices. The nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms—the kinds of investment most penalized by the U.S. [capital allocation] system. —Porter (1992) THIS PAPER ANALYZES how outside blockholders can induce managers to undertake efficient real investment through their informed trading of the firm’s shares. By gathering information about a firm’s fundamental value and impounding it into prices, they encourage managers to undertake investment that increases long-run value even if it reduces interim profits. The model therefore addresses two broad issues. First, it introduces a potential solution to managerial myopia. Second, it demonstrates that shareholders can add significant value even if they cannot intervene in a firm’s operations. This may explain the prevalence in the
656 citations
TL;DR: In this paper, the authors examine recent confrontational activism campaigns by hedge funds and other private investors and examine the determinants, methods, and consequences of hedge fund managers who undertake confrontational activist campaigns.
Abstract: We examine recent confrontational activism campaigns by hedge funds and other private investors. The main parallels between the groups are a significantly positive market reaction for the target firm around the initial Schedule 13D filing date, significantly positive returns over the subsequent year, and the activist’s high success rate in achieving its original objective. Further, both activists frequently gain board representation through real or threatened proxy solicitations. Two major differences are that hedge funds target more profitable firms than other activists, and hedge funds address cash flow agency costs whereas other private investors change the target’s investment strategies. IN THIS PAPER, WE EXAMINE RECENT aggressive campaigns by entrepreneurial shareholder activists. In the spirit of Pound (1992), we define an entrepreneurial activist as an investor who buys a large stake in a publicly held corporation with the intention to bring about change and thereby realize a profit on the investment. We conduct our analyses on two samples of entrepreneurial activists. The common feature to both groups is that the investor is relatively free from the regulatory controls of the Securities Act of 1933, the Securities Exchange Act of 1934, and most notably the Investment Company Act of 1940. The first sample consists of 151 hedge fund activist campaigns conducted primarily between 2003 and 2005. Hedge fund activism has received widespread attention, both in the popular press and by legal and financial scholars. 1 Our paper complements and extends this research by examining the determinants, methods, and consequences of hedge fund managers who undertake confrontational activist
TL;DR: The authors found that private firms rely almost exclusively on debt financing, have higher leverage ratios, and tend to avoid external capital markets, leading to a greater sensitivity of their capital structures to fluctuations in performance.
Abstract: Based upon a large data set of public and private firms in the United Kingdom, I find that compared to their public counterparts, private firms rely almost exclusively on debt financing, have higher leverage ratios, and tend to avoid external capital markets, leading to a greater sensitivity of their capital structures to fluctuations in performance. I argue that these differences are due to private equity being more costly than public equity. I further examine the private firms subsample to show that private equity is more costly than its public counterpart due to information asymmetry and the desire to maintain control.
TL;DR: In this paper, the authors model investors, endowed with a small home information advantage, who choose what information to learn before they invest, and find that even when home investors can learn what foreigners know, they choose not to: Investors profit more from knowing information others do not know.
Abstract: Many argue that home bias arises because home investors can predict home asset payoffs more accurately than foreigners can. But why does global information access not eliminate this asymmetry? We model investors, endowed with a small home information advantage, who choose what information to learn before they invest. Surprisingly, even when home investors can learn what foreigners know, they choose not to: Investors profit more from knowing information others do not know. Learning amplifies information asymmetry. The model matches patterns of local and industry bias, foreign investments, portfolio outperformance, and asset prices. Finally, we propose new avenues for empirical research.
TL;DR: This paper examined international stock return comovements using country-industry and country-style portfolios as the base portfolios and established that parsimonious risk-based factor models capture the data covariance structure better than the popular Heston-Rouwenhorst (1994) model.
Abstract: We examine international stock return comovements using country-industry and country-style portfolios as the base portfolios. We first establish that parsimonious risk-based factor models capture the data covariance structure better than the popular Heston‐Rouwenhorst (1994) model. We then establish the following stylized facts regarding stock return comovements. First, there is no evidence for an upward trend in return correlations, except for the European stock markets. Second, the increasing importance of industry factors relative to country factors was a short-lived phenomenon. Third, large growth stocks are more correlated across countries than are small value stocks, and the difference has increased over time.
TL;DR: This paper analyzed the role that two psychological attributes (sensation seeking and overconfidence) play in the tendency of investors to trade stocks and found that overconfident investors and those investors most prone to sensation seeking trade more frequently.
Abstract: This study analyzes the role that two psychological attributes—sensation seeking and overconfidence—play in the tendency of investors to trade stocks. Equity trading data from Finland are combined with data from investor tax filings, driving records, and mandatory psychological profiles. We use these data, obtained from a large population, to construct measures of overconfidence and sensation seeking tendencies. Controlling for a host of variables, including wealth, income, age, number of stocks owned, marital status, and occupation, we find that overconfident investors and those investors most prone to sensation seeking trade more frequently. RECENTLY, EMPIRICISTS HAVE BEGUN to study and document that behavioral attributes influence trading volume. 1 This evidence is compelling but it is difficult to conclusively argue that particular traits influence trading without better data. Much of the data used in the past to establish a connection between behavioral attributes and trading are experimental or aggregated across individuals. When actual trades are studied at the individual level, the results come from self-reported surveys, sometimes combined with brokerage trading
TL;DR: In this article, the authors investigate whether prospect theory preferences can predict the disposition effect in individual investor trading and find that the realized gain/loss model predicts a disposition effect more reliably than the annual gains and losses.
Abstract: We investigate whether prospect theory preferences can predict a disposition effect. We consider two implementations of prospect theory: in one case, preferences are defined over annual gains and losses; in the other, they are defined over realized gains and losses. Surprisingly, the annual gain/loss model often fails to predict a disposition effect. The realized gain/loss model, however, predicts a disposition effect more reliably. Utility from realized gains and losses may therefore be a useful way of thinking about certain aspects of individual investor trading. ONE OF THE MOST ROBUST FACTS ABOUT THE TRADING of individual investors is the “disposition effect”: when an individual investor sells a stock in his portfolio, he has a greater propensity to sell a stock that has gone up in value since purchase than one that has gone down. The effect has been documented in all the available large databases of individual investor trading activity and has been linked to important pricing phenomena such as post-earnings announcement drift and stock-level momentum. Disposition effects have also been uncovered in other settings—in the real estate market, for example, and in the exercise of executive stock options. 1 While the disposition effect is a fundamental feature of trading, its underlying cause remains unclear. Why do individual investors have a greater propensity to
TL;DR: The authors showed that the probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors.
Abstract: This paper shows that the probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and CDO default losses are typically measured for economic-capital and rating purposes, our empirical results indicate that conventionally based estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public non-financial firms existing between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm-by-firm default probabilities.
TL;DR: In this article, the authors show that the intertemporal trade-offs between interest income taxation and the cost of external finance determine optimal savings, and they also find that income uncertainty affects saving more than do external finance constraints.
Abstract: Why do corporations accumulate liquid assets? We show theoretically that intertemporal trade-offs between interest income taxation and the cost of external finance determine optimal savings. Intriguingly, we find that, controlling for Tobin's q, saving and cash flow are negatively related because firms lower cash reserves to invest after receiving positive cash-flow shocks, and vice versa. Consistent with theory, we estimate negative propensities to save out of cash flow. We also find that income uncertainty affects saving more than do external finance constraints. Therefore, contrary to previous evidence, saving propensities reflect too many forces to be used to measure external finance constraints.
TL;DR: This article examined the role of managerial incentives and discretion in the performance of hedge funds and found that hedge funds with greater managerial incentives as proxied by delta of option-like incentive fee contract, managerial ownership, and high-water mark provision are associated with superior performance.
Abstract: Using a comprehensive database of hedge funds, we examine the role of managerial incentives and discretion in the performance of hedge funds. We find that hedge funds with greater managerial incentives as proxied by delta of option-like incentive fee contract, managerial ownership, and high-water mark provision are associated with superior performance. Incentive fees have no explanatory power for future returns. We also find that funds with higher degree of managerial discretion, proxied by longer lockup, notice, and redemption periods, are associated with superior performance. Our results are robust to various alternate specifications including using alternative performance measures, allowing for nonlinearity for managerial discretion, using different econometric specifications, and controlling for different data-related biases.
TL;DR: This article studied the impact of algorithmic trading in the foreign exchange market using a long time series of high-frequency data that identify computer-generated trading activity and found that the reduction in arbitrage opportunities is associated primarily with computers taking liquidity.
Abstract: We study the impact of algorithmic trading (AT) in the foreign exchange market using a long time series of high-frequency data that identify computer-generated trading activity. We find that AT causes an improvement in two measures of price efficiency: the frequency of triangular arbitrage opportunities and the autocorrelation of high-frequency returns. We show that the reduction in arbitrage opportunities is associated primarily with computers taking liquidity. This result is consistent with the view that AT improves informational efficiency by speeding up price discovery, but that it may also impose higher adverse selection costs on slower traders. In contrast, the reduction in the autocorrelation of returns owes more to the algorithmic provision of liquidity. We also find evidence consistent with the strategies of algorithmic traders being highly correlated. This correlation, however, does not appear to cause a degradation in market quality, at least not on average.
TL;DR: This paper found that the new board requirements affected CEO compensation decisions and that the decrease in compensation was particularly pronounced in the subset of affected firms having no outside blockholder on the board and in affected firms with low concentration of institutional investors.
Abstract: In response to corporate scandals in 2001 and 2002, major US stock exchanges issued new board requirements to enhance board oversight We find a significant decrease in CEO compensation for firms that were more affected by these requirements, compared with firms that were less affected, taking into account unobservable firm effects, time-varying industry effects, size, and performance The decrease in compensation is particularly pronounced in the subset of affected firms with no outside blockholder on the board and in affected firms with low concentration of institutional investors Our results suggest that the new board requirements affected CEO compensation decisions
TL;DR: In this paper, the authors exploit the inability of Fannie Mae and Freddie Mac to purchase jumbo mortgages to identify an exogenous change in liquidity and find that the volume of jumbo mortgage originations relative to nonjumbo originations increases with bank holdings of liquid assets and decreases with bank deposit costs.
Abstract: Low-cost deposits and increased balance sheet liquidity raise banks' supply of illiquid loans more than loans easily sold or securitized. We exploit the inability of Fannie Mae and Freddie Mac to purchase jumbo mortgages to identify an exogenous change in liquidity. The volume ofjumbo mortgage originations relative to nonjumbo origina tions increases with bank holdings of liquid assets and decreases with bank deposit costs. This result suggests that the increasing depth of the mortgage secondary mar ket fostered by securitization has reduced the effect of lender's financial condition on credit supply. LIQUIDITY TRANSFORMATION-THE FUNDING OF ILLIQUID LOANS with liquid deposits has been viewed as a fundamental role of banks. Diamond and Dybvig (1983), for example, argue that banks improve welfare by allowing depositors to diversify liquidity risk while investing in high return but illiquid projects. In recent years, however, securitization has changed the way banks provide liquidity.' While real projects remain illiquid, loans have become more liquid because banks often securitize them, replacing deposits with bonds as a source of finance. Today, more than 60% of outstanding mortgages are securitized. As loans have become more liquid, credit supply has become less sensitive to changes in bank's financial condition. For example, a bank has the option to finance a liquid loan either with deposits or, via securitization, with funds from capital markets. Liquidity provides a substitute source of finance for loan origination because the originator need not hold the loan. In contrast, illiquid loans must be held and thus funded by the originating lender. An increase in the originator's costs of deposits (e.g., from tight monetary policy) could thus restrict the supply of illiquid loans. Many financial assets have been securitized in recent years, with the growth of structured products such as collateralized debt obligations (CDOs),
TL;DR: This paper found that the negative relation between fees and performance is robust and can be explained as the outcome of strategic fee-setting by mutual funds in the presence of investors with different degrees of sensitivity to performance.
Abstract: Gruber (1996) drew attention to the puzzle that investors buy actively managed equity mutual funds, even though on average such funds underperform index funds. We uncover another puzzling fact about the market for equity mutual funds: Funds with worse before-fee performance charge higher fees. This negative relation between fees and performance is robust and can be explained as the outcome of strategic fee-setting by mutual funds in the presence of investors with different degrees of sensitivity to performance. We also find some evidence that better fund governance may bring fees more in line with performance.
TL;DR: In this article, the authors show that incentive conflicts between firms and their creditors have a large impact on corporate debt policy and that the effect of creditor actions on debt policy is strongest when the borrower's alternative sources of finance are costly.
Abstract: We show that incentive conflicts between firms and their creditors have a large impact on corporate debt policy. Net debt issuing activity experiences a sharp and persistent decline following debt covenant violations, when creditors use their acceleration and termination rights to increase interest rates and reduce the availability of credit. The effect of creditor actions on debt policy is strongest when the borrower’s alternative sources of finance are costly. In addition, despite the less favorable terms offered by existing creditors, borrowers rarely switch lenders following a violation. A FUNDAMENTAL QUESTION IN FINANCIAL ECONOMICS is: How do firms choose their financial policies? Extant empirical research on this question has focused primarily on the presence of taxes and bankruptcy costs (e.g., Scott (1976)), information asymmetry (e.g., Myers and Majluf (1984)), and more recently, market timing behavior (e.g., Baker and Wurgler (2002)). However, beginning with Jensen and Meckling (1976), a large body of theoretical research examines how incentive conflicts between managers and external investors affect corporate financial policies. In particular, theoretical research on financial contracting shows that in the presence of incentive conflicts, optimal debt contracts will allocate certain rights to creditors after negative performance in order to help firms secure financing ex ante (e.g., Aghion and Bolton (1992) and Dewatripont and Tirole
TL;DR: In this paper, the authors examined the performance consequences of cutting discretionary expenditures and managing accruals to exceed analyst forecasts and found that firms that just beat analyst forecasts with low quality earnings exhibit a short-term stock price benefit relative to firms that miss forecasts with high quality earnings.
Abstract: This paper examines the performance consequences of cutting discretionary expenditures and managing accruals to exceed analyst forecasts. We show that firms that just beat analyst forecasts with low quality earnings exhibit a short-term stock price benefit relative to firms that miss forecasts with high quality earnings. This trend, however, reverses over a 3-year horizon. Additionally, firms reducing discretionary expenditures to beat forecasts have significantly greater equity issuances and insider selling in the following year, consistent with managers understanding the myopic nature of their actions. Our results confirm survey evidence suggesting managers engage in myopic behavior to beat benchmarks. THERE IS GROWING EVIDENCE that managers are willing to sacrifice economic value to meet short-run earnings objectives. For example, Graham, Harvey, and Rajagopal (2005) report that a majority of managers would forgo a project with positive net present value (NPV) if the project would cause them to fall short of the current quarter consensus forecast. When asked what actions they might take in order to meet an earnings target, approximately 80% suggest they would decrease discretionary spending, including R&D and advertising expense. This survey evidence is consistent with other research on myopic behavior and real earnings management (e.g., Baber, Fairfield, and Haggard (1991), Bhojraj and Libby (2005), Roychowdhury (2006)). Jensen (2005) attributes this behavior in part to the agency costs of overvalued equity, noting that “when numbers are manipulated to tell the market what they want to hear ... and when real operating decisions that would maximize value are compromised to meet market expectations, real long-term value is being destroyed” (p. 8). In this paper, we provide evidence on the short- and long-term price and profitability
TL;DR: This paper examined how divergence between insider voting and cash flow rights affects managerial extraction of private benefits of control, and found that corporate cash holdings are worth less to outside shareholders, CEOs receive higher compensation, managers make shareholder value-destroying acquisitions more often, and capital expenditures contribute less to shareholder value.
Abstract: Using a sample of U.S. dual-class companies, we examine how divergence between insider voting and cash flow rights affects managerial extraction of private benefits of control. We find that as this divergence widens, corporate cash holdings are worth less to outside shareholders, CEOs receive higher compensation, managers make shareholder value-destroying acquisitions more often, and capital expenditures contribute less to shareholder value. These findings support the agency hypothesis that managers with greater excess control rights over cash flow rights are more prone to pursue private benefits at shareholders’ expense, and help explain why firm value is decreasing in insider excess control rights. THE SEPARATION OF OWNERSHIP and control has long been recognized as the source of the agency problem between managers and shareholders at public corporations (Berle and Means (1932), Jensen and Meckling (1976)), and its shareholder-value ramification has been the subject of an extensive literature. 1 While most of this research focuses on firms in which voting or control rights and cash flow rights are largely aligned, recently some researchers have started to examine companies with alternative ownership schemes such as cross-holding, pyramidal, and dual-class structures. These alternative ownership arrangements, which are common in much of the world, often result in a significant divergence between insider voting rights and cash flow rights. This divergence aggravates the agency conflicts between managers and shareholders, since insiders controlling disproportionally more voting rights than cash flow rights bear a smaller proportion of the financial consequences of their decisions while
TL;DR: In this article, the authors show that long-run stockholder consumption risk better captures cross-sectional variation in average asset returns than aggregate or non-stockholders consumption risk, and implies more plausible risk aversion estimates.
Abstract: We provide new evidence on the success of long-run risks in asset pricing by focusing on the risks borne by stockholders. Exploiting microlevel household consumption data, we show that long-run stockholder consumption risk better captures cross-sectional variation in average asset returns than aggregate or nonstockholder consumption risk, and implies more plausible risk aversion estimates. We find that risk aversion around 10 can match observed risk premia for the wealthiest stockholders across sets of test assets that include the 25 Fama and French portfolios, the market portfolio, bond portfolios, and the entire cross-section of stocks. A CORNERSTONE OF ASSET PRICING THEORY, the consumption Capital Asset Pricing Model (CCAPM) focuses on consumption risk as the key determinant of equilibrium asset prices. Recent studies find success using long-run aggregate consumption risk to capture cross-sectional and aggregate stock returns (Parker (2001), Bansal and Yaron (2004), Parker and Julliard (2005), Bansal, Dittmar, and Lundblad (2005), Hansen, Heaton, and Li (2008)). 1 The em
TL;DR: In this article, the authors highlight the importance of interaction among management, labor, and investors in shaping corporate governance and find that strong union laws protect not only workers but also underperforming managers.
Abstract: Our results highlight the importance of interaction among management, labor, and investors in shaping corporate governance. We find that strong union laws protect not only workers but also underperforming managers. Weak investor protection combined with strong union laws are conducive to worker–management alliances, wherein poorly performing firms sell assets to prevent large-scale layoffs, garnering worker support to retain management. Asset sales in weak investor protection countries lead to further deteriorating performance, whereas in strong investor protection countries they improve performance and lead to more layoffs. Strong union laws are less effective in preventing layoffs when financial leverage is high.
TL;DR: In this paper, the authors investigate how a foreign firm's decision to cross-list on a U.S. stock exchange is related to the consumption of private benefits of control by its controlling shareholders.
Abstract: This paper investigates how a foreign firm's decision to cross-list on a U.S. stock exchange is related to the consumption of private benefits of control by its controlling shareholders. Theory has proposed that when private benefits are high, controlling shareholders are less likely to choose to cross-list in the United States because of constraints on the consumption of private benefits resulting from such listings. Using several proxies for private benefits related to the control and cash flow ownership rights of controlling shareholders, we find support for this hypothesis with a sample of more than 4,000 firms from 31 countries.
TL;DR: In this paper, the authors consider two complicating factors, namely crowding and leverage, which may increase the likelihood of a severe crash in the stock market, and suggest that capital regulation may be helpful in dealing with the latter problem.
Abstract: Stock-market trading is increasingly dominated by sophisticated professionals, as opposed to individual investors. Will this trend ultimately lead to greater market efficiency? I consider two complicating factors. The first is crowding—the fact that, for a wide range of “unanchored” strategies, an arbitrageur cannot know how many of his peers are simultaneously entering the same trade. The second is leverage— when an arbitrageur chooses a privately optimal leverage ratio, he may create a firesale externality that raises the likelihood of a severe crash. In some cases, capital regulation may be helpful in dealing with the latter problem. IN THE LAST 20 YEARS or so, there have been profound changes in the way that money is managed. One indicator of these changes is the rapid growth of the hedge fund industry, whose assets on a global basis have gone from $39 billion at year-end 1990 to $1.93 trillion as of the second quarter of 2008. 1 Hedge funds are commonly thought of as the prototypical sophisticated investors, for a couple of reasons. First, many of their investment strategies are based on extensive quantitative modeling, much of which has its roots in academic research in finance. 2 Second, hedge funds often implement these strategies in an aggressively leveraged fashion. The growth of hedge funds is part of a broader trend toward professional asset management. French (2008) documents that, in the stock market, individual investors have been largely supplanted by institutions. Direct individual ownership of U.S. equities, which was 47.9% in 1980, fell to 21.5% by 2007. At