Debt Crisis Looming? Yes, Corporate Debt Expanded but Don’t Panic Over the Prospect of Bbb Downgrades

Debt Crisis Looming? Yes, Corporate Debt Expanded but Don’t Panic Over the Prospect of Bbb Downgrades

In our sixth article from the (JACF Spring/Summer issue)Martin Fridson’s piece examines how the popular press often tends towards sensationalism and, unfortunately, the supposedly more sober financial press is not always better. It is true that many American companies have taken the opportunity to borrow large sums during recent years when interest rates were close to their all-time lows. This has also led some media commenters to predict a large number of marginally investment grade debt issues (e.g. BBB rated on the S&P rating scale) will be downgraded to less-than-investment-grade status–or to “junk”–as such bonds are commonly known.

Veteran fixed income analyst Martin Fridson takes stock of the situation in mid-2018. While emphasizing that a bear market is inevitable someday, he advises investors not to panic now. Despite the more apocalyptic scenarios offered by financial commentators making dubious connections between today’s corporate bond market and possible future high-yield events, the aggregate numbers do not add up to an end-of-civilization-as-we-know-it story. Some of the numbers mentioned in financial commentary are at least slightly misleading.

The present market lacks the sort of structural weaknesses likely to trigger a major bear cycle in fixed income securities, such as overleveraged buyouts and early-stage telecoms. While there are some questionable issuers in the market, these are isolated cases, rather than representatives of a vast segment of today’s high-yield universe.

Authored by Martin Fridson, Lehmann Livian Fridson Advisors.

“Big Data” Analysis: Putting the Data Cart before the Modeling Horse?

“Big Data” Analysis: Putting the Data Cart before the Modeling Horse?

In our fifth article from the (JACF Spring/Summer issue) the authors discuss the statistical analysis of very large data sets, so-called Big Data or Data Analytics, and how they have become enormously popular in Statistical Analysis and Operations Research. In some cases, such as research into the buying habits of online consumers, the results have come quickly and been very significant. Analysis of other data sets, however, is questionable. For example, time-series based statistical analysis, often under the descriptive envelope of “neural networks” and “data mining,” of stock market and futures prices, sometimes in combination with historical accounting figures such as earnings and cash flows.

The appeal is understandable given the availability of share price data and cheap computer processing power. Nevertheless, the notion that historical data form some sort of repeatable pattern over time, and that complex time series or neural network techniques can be then be used to forecast future prices is hard to justify.

Economic modeling necessarily needs to factor in human behavior, unlike modeling in the pure sciences. The authors cite Lancaster University Professor Michael Pidd who summarizes six relevant principles:

    1. Model simple, think complicated
    2. Be parsimonious, start small and add
    3. Divide and conquer, avoid mega models
    4. Use metaphors, analogies and similarities
    5. Do not fall in love with data
    6. Model building may feel like muddling through.

Economic modeling must recognize three key components:

    (i) the incorporation of human cognitive understanding and experience of the underlying systems,
    (ii) the use of data to validate emerging models, and
    (iii) the role of mathematics to ensure internal coherence and logic.

Decision-makers ought to be very skeptical of models which skimp on any one of these three components. The authors emphasize that, rather than Big Data adding value, per se, people add value by creating models that use it.

Authored by Graham D Barr, Theodor J. Stewart & Brian S. Kantor, University of Cape Town

Building a Bridge between Marketing and Finance

How advances in behavioral science and financial analytics offer an effective way to bridge this gap between marketing and finance.

Our fourth article from the (JACF Spring/Summer issue) discusses how finance executives are often frustrated by spending proposals from their marketing colleagues but cannot seem to be able to quantify the putative benefits. Similarly, the marketing staff is frustrated by the finance team’s inability to convert soft marketing metrics, such as “awareness” and “customer satisfaction” into financial forecasts. The challenge is that neither marketers nor finance executives have been able to articulate a single analytical framework which both explains how and why brands come to flourish or flounder and how brand growth contributes to the business’s short and long term bottom line.

Lacking an effective way to do this now, most managers default to using the hard data they do have, namely how marketing investment is likely to impact sales this quarter and next. This reinforces the widespread focus on quarterly EPS and reduces the perceived value of the marketing department to their ability to hit three month sales targets. This degraded view of marketing’s contribution and the inability to link “soft” marketing metrics to longer term financial returns impedes building long-term brand value. This article focuses on how advances in behavioral science and financial analytics offer an effective way to bridge this gap between marketing and finance.

Building that bridge requires better measures of brand health and financial performance to allocate capital and marketing resources. Undoubtedly, brand building is both an art and a science. But, the finance people can develop an evidence-based framework explaining how some of the “softer” investments such as brand building, contribute to the value of the firm.

Authored by Ryan Barker, BERA Brand Management, and Greg Milano, Fortuna Advisors

The ESG Integration Paradox

The ESG Integration Paradox

Our third article from the JACF Spring/Summer issue is by Michael Cappucci.

Today, most investment managers have something to say about environmental, social and governance (ESG) issues, and written ESG policies are ubiquitous.

Today, most investment managers have something to say about environmental, social and governance (ESG) issues, and written ESG policies are ubiquitous.

Yet, a written policy is not a reliable indicator of a firm’s commitment. Actual ESG incorporation practices vary greatly, with most investment managers falling well short of full integration. Only a few firms seem to be using ESG factors to deliver alpha, hence, the paradox. If not implemented wholeheartedly, responsible investing can lead to lower financial returns. So, why have so few investment managers gone all the way?

The paradox involves a “valley” of lower returns where portfolios first absorb the costs of ESG integration before the promised benefits materialize. In the early days of ethical investing, the focus was on using negative screens to exclude certain companies for moral or ethical reasons but lower financial returns are inherent to exclusionary screening.

Hard exclusions force managers to tradeoff certain risks for others. So, for example, if the market discounts tobacco stock prices to account for changing consumer behavior, eventually tobacco stock prices become attractive again as, indeed, has been the case over the last two decades. Exclusionary screening alone is a self-limiting strategy.

By contrast, ESG strategies range from active ownership and engagement, to positive screening (selecting for certain attributes), to relative weighting (sometimes called “best-in-class selection”), to risk factor investing, to full integration.

Because the relationship between an asset manager’s ESG efforts and its risk-adjusted performance is not classically linear, asset owners should look for managers that are on the upward slope of the ESG intensity curve and are fully committed to advancing up it.

Authored by Michael Cappucci, Harvard Management Company

‘The Big Four’ Review: Titans of the Books

‘The Big Four’ Review: Titans of the Books

Wall Street Journal, Book Review, September 24, 2018

The mightiest accounting firms now scorn their traditional core business of auditing and have taken to “consulting” like ducks to water. Jane Gleeson-White reviews “The Big Four” by Ian D. Gow and Stuart Kells.

By Jane Gleeson-White
Sept. 23, 2018 1:32 p.m. ET

Deloitte, EY, KPMG and PwC are among the best-known brands in the world. These “Big Four” accountancy firms are international organizations which together generate revenues of more than $130 billion annually and employ almost 1 million staff. Despite their modish names with hip abbreviations and the stylish typography of their logos, each firm can trace its origins to 19th-century Britain. Take PricewaterhouseCoopers: Samuel Price started practicing in 1848, and William Cooper in 1854. William Deloitte began in 1845. The earliest ancestor organizations of Ernst & Young and KPMG were also founded in England.

In “The Big Four,” Ian Gow and Stuart Kells, with a characteristically light touch, observe that the 19th century was the accounting profession’s “ ‘wild west’ era, even more so than the 1980s.” Samuel “Sammy” Price was a “rule-breaking, lumbago-suffering oddball.” From a family of potters, he could work his hands in more than one respect: As a “fan of prize fights, streetfights and indeed any kind of fight, he was not averse to joining in himself.” Edwin Waterhouse was a member of the Religious Society of Friends—that is, a Quaker. His Quakerism shaped his view of himself as “a ‘Christian gentleman’ responsible for delivering an important social service.” His son Nicholas, however, threw “very un-Quaker-like” parties in his Chelsea home that featured “drugs as well as sex.”

The boom in British railways fueled the need for financial rigor, and as the law increasingly required accounting for the conduct of commerce, the small firms flourished and merged to meet the demand for auditing, annual reporting, and liquidation. In the century and a half since, their descendant firms have expanded globally and survived fraud, lawsuits and scandals. Yet unusually in these times of transparency, the inner workings of the accounting giants remain shrouded from view.

“The Big Four” is not so much the history of these institutions as a brief tour of accounting’s past, from its origins in Renaissance Italy to the current era of mega-firm dominance. The authors are well-placed to examine this history. Mr. Gow has worked for Morgan Stanley and other multinationals, has taught at Harvard Business School and is now a professor at the University of Melbourne. Mr. Kells has been a director of KPMG, as well as an assistant auditor-general of the state of Victoria in Australia.

Their pacy prelude opens with the 1880 founding of the world’s first national accounting association, the Institute of Chartered Accountants in England and Wales, and then canvasses the origins of modern accounting via three formative books acquired by the organization for its library. One is Luca Pacioli’s 1494 “Summa de Arithmetica,” which includes the first printed treatise on double-entry bookkeeping. The other two, published in 16th-century Antwerp and London, reflect double entry’s movement west across Europe.

The authors argue that the institute’s collection of such books is a monument to the principle “that sound bookkeeping is the foundation of success in statecraft and in commerce.” The Big Four reached the pinnacle of their profession by trading on a widespread belief in this idea; the authors then explore how well-founded the public’s faith in these institutions is today.

The book is divided into four parts whose titles convey its argument: “Infancy’” “Maturity,” “The Difficulties of Adulthood” and “The Twilight Years.” The first two sections take us from the Medici Bank through the rise of the Big Four. But the authors hit their stride in part three, which covers the postwar years, when the firms made auditing the books of major corporations into the basis of their brands. Recently, the authors note, auditing has become undervalued and scorned within the four fiefdoms. Instead, they have taken to “consulting” like ducks to water.

Messrs. Gow and Kells believe the Big Four are endangering their futures by neglecting their one-time core business. They point out that the corporate collapses and scandals of the early 21st century—most spectacularly Enron, which brought down its adviser and auditor Arthur Andersen—led to a regulatory response “focused largely on the role of the auditor.” In the United States, the Sarbanes-Oxley Act of 2002 didn’t prevent “a string of similar-sized calamities” during the 2008 financial crisis.

As the authors observe, each of the Big Four was linked to “some of the most spectacular failures. Deloitte had audited Bear Stearns and Fannie Mae. KPMG had audited Citigroup. PwC had audited American International Group and Goldman Sachs. EY had audited Lehman Brothers.” These examples challenge the mistaken view of outsiders that audited accounts are trustworthy.

In part four, “The Twilight Years,” the authors assess the threats to the supremacy of these giants from “smaller players with low overheads and high agility.” But they also take us back to a story begun earlier in the book, that of the unraveling of the Medici Bank, which is offered as a sort of precursor to the Big Four. What the two stories share, the authors suggest, is the dilution of an original purpose: “Focus had been at the heart of the Medicis’ success,” they write. “Gradually, though, they had forgotten their core business.” The book’s analysis of the causes of the Medici Bank’s collapse—defaults by profligate borrowers, increased appetite for risk, failure to oversee the bank’s distant franchises and a departure from the organization’s core business—offers a salutary lesson for the Big Four today.

While there is still a larger, more detailed history of these firms to be written, Messrs. Gow and Kells have made an invaluable contribution, writing in an amused tone that nevertheless acknowledges the firms’ immense power and the seriousness of their neglect of traditional responsibilities. “The Big Four” will appeal to all those interested in the future of the profession—and of capitalism itself.

Ms. Gleeson-White is the author of “Double Entry: How the Merchants of Venice Created Modern Finance.”

Rethinking the Purpose of the Corporation

Rethinking the Purpose of the Corporation

Our second article from the (JACF Spring/Summer issue), written by Edward Waitzer, reviews how over the last forty years, corporate governance and corporate law have focused on minimizing “agency costs” by aligning the interests of shareholders and managers through a series of techniques, including regulatory standards, independent directors, take-overs and activist shareholders.

These means, combined with implicit acceptance of the “Efficient Market Hypothesis” (EMH) reinforced belief that share prices reflected objective corporate performance and that maximizing shareholder wealth was the purpose of the corporation.

This author, however, argues that proper corporate governance requires more than just faith in efficient equity markets and strong managerial incentives. Despite the desire for simplicity, there is no one “right” governance model. Governance is highly contextual and, ironically, the existing corporate law and regulation have tended to frustrate dynamic adaption and have led to governance systems that underperform.

The author offers Systems Theory as a better way to think about corporate purpose and governance. Systems are more than the sum of their parts, they are comprised of subsystems which in turn are comprised of other subsystems on so on, and the overall health of the system depends on the continued health of each of its essential subsystems, as well as of the larger system.

Systems theory counsels against focusing on any single metric (and in favor of the need for new ones – the relevance of metrics inevitably run down over time). Metrics such as profits, employee turnover, and customer satisfaction are not ends in themselves. Rather, they are a source of information about whether the corporation is relevant, resilient and sustainable. The systems challenge is to bring about a paradigm shift that restores connectivity between investors, employees, management, other corporate stakeholders and governments. This will require thinking differently about how the constituent elements interact and produce results.

Authored by Edward J. Waitzer, Stikeman Elliott LLP

Investors as Stewards of the Commons?

Investors as Stewards of the Commons?

In our first article from the (JACF Spring/Summer issue) George Serafeim makes the case that business generally, not just government, should assume responsibility for social and environmental problems. The Sustainable Development Goals (SDGs) formally recognize the role of the private sector in addressing some of the world’s most pressing environmental and social challenges. What started as a corporate social responsibility movement now a focuses on integrating positive social impact into the core mission of the organization.

Encouragingly, studies document that improving firm performance on business-relevant ESG issues has a positive association with future financial performance. Investors can enable better societal outcomes by exercising ‘voice’ and voting rights in corporate governance.

He acknowledges that competitive businesses face a “commons” or “free-rider” problem where a defector avoids the full cost of his actions. Overcoming this problem requires legally sanctioned collaboration between business enterprises and large institutional shareholders, particularly pension funds. He also acknowledges that the corporate level free-rider problem has a counterpart that at the investor level. Investor engagement with companies involves resources, money and time. It is no simple matter to justify increased costs in the context of asset managers that compete on the basis of low management fees, such as index funds.

Collaboration between companies can mitigate some of these free riding problems. Large institutional investors with long time horizons and significant common ownership across different companies may have the best opportunities for collaboration. But, smaller activist funds and retail investors also have an important role in pushing large institutional investors to engage. While it is unlikely that investors will be able to solve all of the pressing societal problems, progress can be made.

Authored by George Serafeim, Harvard Business School

What Really Drives “Short-Termism”?


What Really Drives “Short-Termism”?

Earlier this month, the CEO of Pepsi Co. suggested to President Trump that eliminating quarterly reporting (and shifting to biannual reporting) would reduce the pressure on managers to focus on the short-term. As impulsive as Elon Musk, the president bought this view hook, line, and sinker and tweeted his proposed shift to the world (and a probably startled SEC).

But what will be the actual impact? Those who have a law and economics orientation will predictably respond that widening reporting frames will present investors with greater uncertainty and risk, with the result that stock prices should decline (and the cost of capital should increase). Some corporate managers will point to offsetting cost savings from reduced reporting, but cost savings are trivial in comparison with even a small stock price decline. Nonetheless, the argument that moves more managers is that, under six-month reporting, they can focus more on the long-run. Yet, this argument may be precisely backwards; that is, the shift to six-month reporting is more likely to exacerbate than alleviate this problem.

The empirical research in this area (while limited) tends to show that financial managers will indeed sacrifice long-term shareholder value in order to meet a quarterly earnings forecast. In a well-known study, three respected financial economists surveyed 401 senior financial executives and posed a hypothetical problem to these executives: If they saw they were likely to fall short of a quarterly earnings target, would they cancel or delay an investment or project with a positive net present value (“NPV”)?(1) The majority conceded that they would. In addition, more than three-quarters of the surveyed executives agreed that they would sacrifice shareholder value (by deferring NPV investments) to smooth earnings—apparently because they believe that missing the earnings target (or experiencing earnings volatility) will cause a stock price drop.

So, there is a problem (which my neoclassical friends in the law and economics field tend to ignore). But does a shift to less frequent reporting help or hinder? If we shift to six-month reporting, financial managers may face even greater pressure to meet their earnings target (or the consensus forecast). After all, impatient investors will have waited longer and faced greater uncertainty. The failure to “meet your forecast” would cast even a greater cloud on management’s reputation and competence.

Consider the problem this way: If it were possible to report earnings on a monthly basis (or—and this is sheer fantasy—a weekly basis), missing the monthly or weekly target would not mean that much. A short fall in one week could be offset by a compensating gain in the next week. But a failure to meet a six-month forecast could not be corrected until the annual audited results were posted some eight or nine months later (when the issuer filed its Form 10-K). Thus, self-interested managers will be even more incentivized to sacrifice NPV projects to meet the earnings target.

Ironically, logic thus suggests that the narrower the reporting frame, the less that the long-run will be subordinated to the short-run. To be sure, nothing here is certain. The UK moved from six-month reporting to quarterly reporting in 2003, and then moved back to six-month reporting in 2013. No one has detected any measurable change in capital investments on either of these shifts. Still, cultures and pressures may be different on opposite sides of the Atlantic, and there is both much greater use of incentive compensation in the United States and much greater pressure from activist hedge funds focused on the short-run. These factors may incline managers in the U.S. to focus more on the short-run to please the market.

Some other impacts do seem more certain. Under a six-month reporting cycle, information asymmetries will increase, and this will make insider trading even more profitable (and probably even more predictable). Stock volatility seems also likely to increase in the face of greater uncertainty.

So what should be done? Probably the simplest and best answer would be for financial managers to give less guidance about future earnings. Once a financial manager makes a forecast, he has effectively pledged his reputation and needs to protect it by manipulating earnings. Hence, less in the way of earnings forecasts implies less pressure on managers. The SEC and the stock exchange could discourage forecasting in a variety of incremental ways, but, of course, they cannot prohibit forecasts.

Can the SEC simply shift from quarterly to six-month reporting? This is a legal question that may cause the SEC to assert its powers under Section 36 of the Securities Exchange Act of 1934. Section 36 (“General Exemptive Authority”) authorizes the SEC to “exempt any person, security, or transaction, or any class or classes of persons, securities or transactions, from any provision or provisions of this title or of any rule or regulation thereunder…” But exercise of this authority requires the SEC to find “that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.” To date, the SEC has used this provision only sparingly. Suppose then that such an exemption is granted by the SEC, based on cost savings justifications and the claim that it will protect investors from short-termism. Suppose next that a large group of institutional investors (including the Council of Institutional Investors) sues, claiming that the SEC’s exemption is very inconsistent with the “protection of investors.” How much deference should the SEC get?(2) Indeed, does this exemption even qualify for Chevron deference? This is a short column that will not attempt to resolve the current status of Chevron deference, but my bet would be that a conservative Supreme Court would back a conservative SEC.

But maybe I am just a pessimist.

John C. Coffee, Jr., is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

(1) See John R. Graham, Campbell R. Harvey and Shivaram Rajgopal, The Economic Implications of Corporate Financial Reporting, (available at (2005). This study later appeared in the Journal of Accounting and Economics in 2005).

(2) If one wishes to read more on this topic, see Daniel T. Deacon, Administrative Forbearance, 125 Yale L.J. 1548 (2016); Lesley Chen, The SEC’s Forgotten Power of Exemption: How the SEC Can Receive Deference in Favor of Internal Whistleblowers Even When the Text is Clear, 67 Emery L. J. 1043 (2018).

Ending quarterly reports will not stop corporate short-termism

Requiring less information would favour better-connected professional investors

Progressive critics and chief executives decry what they see as a myopic market’s pressure to cut back on investment and increase dividends and share repurchases

Larry Summers has written a remarkable piece in the September 3, 2018 issue of the Financial Times, which can be found here by subscription.

President Donald Trump has asked the US Securities and Exchange Commission to investigate moving public companies to a six-month rather than three-month reporting cycle to combat an excessive corporate focus on the short term.

Progressive critics and chief executives alike decry what they see as a myopic market’s pressure to cut back on investment and increase dividends and share repurchases. In her 2016 presidential campaign, Hillary Clinton proposed raising capital gains taxes for investments held for less than six years to combat short-termism.

Few ideas command such widespread support as the notion that companies should be induced to concentrate more on the long term. Unfortunately, while there are important ways in which corporate governance can be improved, the idea that a myopic market forces companies to forgo highly attractive investment opportunities is unsupported either by logic or evidence.

It is no surprise that the idea is attractive to many. Just as my students often suggest that the grading system forces them to study a particular syllabus rather than pursue their intellectual passions, managers prefer to avoid frequent accountability for results. The former chief executive of GM, Rick Wagoner, who presided over tens of billions of dollars of unsuccessful investment during the 2000s, was a leading voice against market-generated pressures for short-termism.

There is also an apparent worker interest in resisting payouts: employees at existing companies naturally prefer them to retain cash and grow, while the potential new groups that could be financed out of cash payouts do not yet have workers.

But popularity is not the same thing as validity. A variety of facts about market behaviour belie the systemic short-termism thesis. First, there are large numbers of companies, of which Amazon is only the most prominent example, that trade at huge multiples to current profits because of credible long-term plans.

There are now hundreds of unicorns — private start ups valued at more than $1bn — almost all of whom have little or no profits. This suggests that investors are happy to buy into credible, long-run corporate visions.

Second, many studies have now confirmed that companies where cash flows are highest relative to stock prices earn the highest returns. If, as the short-termism thesis suggests, these companies were over-valued, one would expect them to earn abnormally low returns rather than unusually high ones.

Third, private equity firms and venture capitalists expect companies they own to report on a monthly basis. Capable chief executives set a similar standard for divisions within their company. Otherwise they fear that problems will fester without being addressed. If companies with a sole owner in possession of a professional staff are expected to report frequently, why should not the same be true for public companies?

Fourth, companies differ greatly in their management quality. It is natural that those with better management and more opportunities will reinvest more of their profits and earn higher returns over time. To infer — as many advocates of the short-termism, including a 2017 McKinsey study, do — that this proves all companies should invest more, is to commit the obvious fallacy of confusing correlation with causation.

Reducing the frequency of corporate profit reporting would make big surprises and drastic market moves more likely. It would also allow managers to wait longer before they revealed large problems. Think of how much longer it would have taken for the issues at GE to become clear if the company reported only every six months.

Less frequent reporting would favour professional investors who are in constant touch with management over those whose information would be even more limited than it is today. In an age of big data and transparency, moving towards less would be a very odd step.

What, then, should be done? The rules limiting activists’ ability to distort corporate behaviour should be updated. More transparency on share accumulation would protect ordinary shareholders. At the same time, new restrictions should be imposed to prevent corporate activists from voting as shareholders in companies where they have divergent economic interests from other stockholders — because, for example, they used the options markets to hedge their risk.

Wise corporate leaders should give a sense of their long-term vision on at least an annual basis. Investors who insist on such information are only being reasonable.

The writer is the Charles W. Eliot university professor at Harvard and a former US Treasury secretary.

Corporate Finance and Sustainability

The Case of the Electric Utility Industry

In our last article from the (JACF Winter issue) we discuss how although the electric utility industry is in transition, it still needs to move faster for the country to meet its emissions goals. The industry has historically moved cautiously, but policies and regulatory approaches must avoid unintentionally reinforcing the status quo. Incentive-oriented policies and redesigned regulations must balance environmental sustainability with economic sustainability. The authors draw on well-established corporate finance principles to guide more effective policies. Shareholder-focused utility executives must make investments conditioned by three elements: (1) the return on equity the utility can expect to make on each project; (2) the investors’ required return on equity capital for each project; and (3) the size of the investment.

The well-established economic value added (EVA) model can assist policy analysis: V=(r-k)I; where V is the shareholder value created, r is the return on equity, k is the return investors require if they are to invest in the stock, and I is the scale of the project. Any new incremental V translates into higher stock prices.

All three elements of their model (i.e., risk, return, and scale) require attention by regulators and policymakers to create value for shareholders. The authors show how the right state policies could create powerful incentives for shareholder focused utility executives to support such transitions.

Authored by Steven Kihm, Seventhwave; Peter Cappers, Lawrence Berkeley National Laboratory; Andrew Satchwell, Lawrence Berkeley National Laboratory; and Elisabeth Graffy, Arizona State University