Category: Finance

Who Are the Short-Termists?

Who Are the Short-Termists?

In the second article of our Fall 2018 issue we present an edited version of Wei Jiang’s keynote address at the Financial Management Association’s Annual Conference last October. Wei begins by noting that shareholder turnover in U.S. public companies has increased sharply during the past four decades, rising from a low in the mid-1970s of around 10%—which implies an average holding period of 10 years—to its current level of over 350%, or a holding period of some three or four months.  But this increase in average share turnover in recent decades has also been accompanied by a remarkable growth of long-term investors. 

In a recent study, the author and two colleagues used quarterly holdings information from Form 13F to identify short-term investors—which they defined as having annualized turnover rates over 100%, implying a holding period of less than a year—and long-term investors—those with a turnover rate below 33%, with holding periods longer than three years.  Defined in this way, the presence of long-term institutional investors in the average public company’s shareholder base has more than doubled since the early 2000s.

What’s more, in an attempt to determine whether the market encourages corporate short-termism by putting too high a discount rate on—and so undervaluing—earnings or cash flows that are expected to appear in the distant future, the author points to the findings of two studies by others. In the first of the two, an examination of the pricing of a relatively new derivative known as “dividend strips” shows that the implied discount rate for such “incremental” dividends has actually been higher than the rate applied to the long-term residual value, suggesting that the market undervalues near-term cash flows relative to more distant ones. The second of the two cited studies reports that companies with high levels of R&D spending—in other words investments with distant payoffs—are fairly priced in the sense that their future stock returns are comparable to those earned by other companies in the same risk class.

In response to the claim that shareholder activists force companies to pursue near-term profits at the expense of the corporate future, the author cites her own study (with two colleagues) that examines the stock returns of targeted companies from three years before the announcement of an activist’s taking a position in the stock to three years after. What they find is that the targets significantly underperformed the market and their competitors in the period leading up to the activists’ involvement—and that, after a 5% jump in share prices in response to the announcement, the average performance of the targets was roughly equivalent to their competitors’ during the next three years. And, as if reflecting this 5% net gain, the operating performance of these companies, as measured by ROA, improved significantly during this three-year period.

To be sure, there is some evidence that activists discourage corporate R&D. But, as the author (and her three co-authors) shows in a study published this past year in the Journal of Financial Economics, although corporate spending on R&D does fall (by an average of $15 million per company) in the year following the appearance of activists, R&D as a percentage of total assets remains unchanged, reflecting the tendency of companies to sell assets; and the smaller R&D function becomes more productive, accounting for 15% increases in both new patents and citations during the next three years.

Authored by Wei Jiang

Are U.S. Companies Too Short-Term Oriented? Some Thoughts

Are U.S. Companies Too Short-Term Oriented? Some Thoughts

In the first article of our Fall 2018 issue Steve Kaplan notes that today’s widespread criticism of U.S. companies as shortsighted and ever willing to sacrifice their future for near-term profit is by no means new. As the author of this article shows, such charges of short-termism have a long history that goes back at least 40 years. But as he goes on to point out, if these claims were warranted, then the effects we have been warned about all these years would surely have shown up by now.

But it is difficult to find evidence of such effects. For example, a short-term orientation has not been reflected in any erosion of corporate profitability over time. As the author reports, the ratio of U.S. corporate profits as a percentage of U.S. GDP has not only been on a generally upward trend since the early 1980s, but has never been higher than in the past few years. And corporate spending on R&D has also gone up sharply during this period, from 1.1% of GDP in 1977 to 1.7% in 2016. What’s more, evidence of short-termism has not shown up in either higher amounts of investment, or higher rates of return, by venture capitalists and private equity firms, which are both in a good position to profit from widespread corporate failure to pursue valuable growth opportunities.

Nor do stock market investors appear to encourage corporate short-termism, given their willingness to fund IPOs of companies with no previous earnings, and to assign high price-earnings multiples to companies, like Amazon and Tesla, whose reported earnings have been modest at best. What’s more, the fact that today’s P/E and CAPE ratios are at relatively high levels suggests that the market continues to expect significant rates of growth by U.S. companies.

Some critics, to be sure, have argued that the high level of corporate buybacks and other distributions of cash, when combined with today’s near-record corporate cash holdings, provide clear evidence of a widespread failure of companies to invest in their future. But as the author notes, such distributions in fact represent a fairly small fraction—only around 20%—of after-tax corporate net income after infusions of new debt and equity capital are also taken into account.

Authored by Steve Kaplan

A review of Buffett’s commentary on accounting, governance, and investing practices: does he “walk the talk”?

A review of Buffett’s commentary on accounting, governance, and investing practices: does he “walk the talk”?

In our fifth article Special Issue on Growth and Innovation the co-authors seek to understand Warren Buffett’s investing philosophy, as he is regarded as one of the greatest investors. Unsurprisingly, Buffett has made his opinions on corporate governance, accounting, valuation methodology, and market trends known through the annual reports of Berkshire Hathaway and particularly its Chairman’s Letters.

Buffett’s extraordinary success alone would make him inherently worthy of scholarly research. His long investment horizon, specific suggestions for improving corporate governance, evident reasoning for his opinions on accounting practice, and generally excellent reputation for integrity make him especially useful to study.

These three professors studied both Buffett’s publicly expressed opinions and his investment decisions to see how well Buffett’s opinions matched the investments he has made. Additionally, they studied whether Buffett’s investments tended to be made in companies that already shared Buffett’s preferences or whether Buffett’s investment tended to cause companies to change the way they were managed subsequently so that their behavior became better aligned with Buffett’s public views. The findings of Bowen, Rajgopal, and Venkatachalam are a bit mixed.

As predicted, the companies Berkshire invests in (investees) tend to follow more transparent and timely accounting and disclosure of both good and bad news, tend to have accruals and cash flows in accord, have been more likely to expense stock option costs before being required to do so, are less likely to meet or beat targets, and make conservative assumptions about their pension obligations. On the other hand, Berkshire has invested in companies that are more likely than their peers to flout Buffett’s public advice about using EBITDA and a performance metric, continuing to provide “earnings guidance,” and publishing poorly written and ambiguous annual reports as measured by the “FOG Index.”

CEOs at Berkshire investees are paid less and their pay is more sensitive to company performance than their peer CEOs. That said, Berkshire investee pay plans do not penalize

CEOs for poor performance more so than for their peers, do not filter out the effect of marketwide increases in stock prices on CEOs’ compensation, still rely on stock options rather than “straight” stock, are not sensitive to earnings adjusted for the cost of capital, and are as likely as peer companies to boost CEO pay if that CEO’s pay falls in the lower half of his industry peers in the previous year.

The pattern with members of boards of directors is somewhat similar to the CEOs. While board members of Berkshire investees own more of the investee’s stock than do board members at peer firms, boards are no smaller than average, tend to have fewer outside directors, and greater ethnic and gender diversity than Buffett seems to recommend.
The multivariate regression analysis shows that investees are consistent with Buffett’s stated investment philosophy on six out of seven characteristics that Buffett prefers. Berkshire investees had higher “owner earnings,” lower volatility of owner earnings, more persistent sales, less competition, lower financial leverage, lower pension and other post-retirement liabilities, and fewer stock splits compared with the average firm in the same industry and year. Berkshire investees also tended to pay dividends more often and were more likely to issue equity when their stock price was greater than its intrinsic value per share.

Buffett clearly walks the talk on investment practices. However, the results on accounting, compensation, and disclosure practices are less clear cut. Overall, the authors found much evidence that Berkshire investees were already well aligned with Buffett’s investing principles (e.g., high return on equity) before being bought by Berkshire but not so well aligned already in terms of accounting and disclosure practices.

They found less evidence that these practices changed after Berkshire became a shareholder however. Investee board size and leverage decreased while the frequency of dividend payouts increased, suggesting that Buffett was drawn to certain companies because of the attributes they already had.

Buffett is well known for a hands-off policy in the operating decisions of Berkshire firms. So, despite Buffett’s commentary suggesting that large investors can improve the business practices of their investees, his passive approach appears to extend to accounting and governance choices as well.

Although not mutually exclusive, the evidence therefore is more consistent with the “selection” hypothesis than the “influence” hypothesis. Even if Buffett does exert some influence over management after purchasing shares he seems to be relatively passive in doing so—more so than the tone and breadth of his public statements would suggest. We believe it is important to note that Buffett’s passive behavior towards investee management is inconsistent with the belief that large investors have the potential to improve corporate governance.

Authored by Robert M. Bowen, University of Washington; Shivaram Rajgopal, Columbia Business School; and Mohan Venkatachalam, Duke University

Financing Urban Revitalization: A Pro-Growth Template

Financing Urban Revitalization:A Pro-Growth Template

In our fourth article Special Issue on Growth and Innovation the co-authors recommend American cities adopt a particular property-tax rate cutting strategy. They contrast relatively prosperous San Francisco with impoverished Baltimore. Both cities actually raised property taxes frequently between 1950 and 1975 with roughly the same results—falling population and rising crime. During the same period, many other cities also raised tax rates to make up for lower economic output, thereby encouraging more people and businesses to leave.

The change in San Francisco’s economic fortunes did not arise out of either a successful crime-fighting program (it had worse crime than Baltimore in 1975) or through the rising prosperity of Silicon Valley forty miles to its south (still too small and far away to make a difference). Rather, the inflection point for San Francisco was in 1978 when a statewide referendum (“Proposition 13”) limited property taxes to 1% of assessed value. San Francisco’s revenue declined by 18% the next year, 1979, but by 1982, its revenue was 66% higher than before Prop 13, despite the lower rates.

Prop 13 improved cash flows to owners of real property in San Francisco and protected their property rights. Investors bought, built, and improved the city’s residential and commercial capital stock, attracting new residents and creating new job opportunities.

Politicians are reluctant to try to adopt Prop 13-like measures on their own, however, because the short-term consequences for politicians are painful as several years are required for underlying economic activity to grow enough to offset rate cuts.

The key is to build a financial bridge before crossing the river through four-steps:

1. Announce a property tax rate cap that is immediately binding but which would take effect over several years in the future. Rational investors would immediately begin to invest and expand the city’s tax base.
2. During the transition period, the city should limit its spending to a “maintenance of service” level, while allocating any added revenue to an escrow fund.
3. The city should supplement this reserve with the proceeds of sales of assets on its balance sheet via sale-and-leaseback contracts (SLBs).
4. If revenue falls in the short run, cash would be withdrawn from the escrow fund in order to continue to maintain levels of government services at accustomed levels.

Authored by Steve H. Hanke, The Johns Hopkins University and Stephen J.K. Walters, Loyola University Maryland

Funding Strategies in a Rising Interest Rate and a Flattening Yield Curve Environment

Funding Strategies in a Rising Interest Rate and a Flattening Yield Curve Environment

In our third article Special Issue on Growth and Innovation Niso Abuaf suggests that an optimal corporate funding strategy may be a “barbell” that combines short-term borrowings (to exploit still low short-term rates) with some long-term borrowing to lock in historically low interest rates against the possibility of rising inflation and interest rates. Abuaf shows that a “barbell” funding strategy is on the “efficient frontier” of corporate liability structure, i.e., the curve tracing the lowest cost and lowest standard deviation points. Such strategies consist of a barbell with occasional medium-term borrowings, but with some “rollover” or funding risk attached.

Once the efficient frontier has been delineated, the chief financial officer can use breakeven analysis to choose the optimal maturity mix. The choice between fixed and floating interest rates will depend upon management’s tolerance for earnings fluctuations resulting from moves in short-term rates.

While most of the existing literature predicts that a lot of short-term debt leads to early default, Abuaf sees that an upward sloping yield curve can easily make short-term debt cheaper than longterm although it comes at the cost of higher volatility. It follows that in a flatter yield curve environment, longer maturities may be more attractive. If a company’s revenues are highly correlated with short-term rates, it should keep maturities relatively short, however.

If, as Abuaf thinks most likely, that interest rates increase 100 basis points across the curve, CFOs should lengthen maturities now.

Authored by Niso Abuaf, Pace University and Samuel A. Ramirez and Co.

Management’s Key Responsibility

Management’s Key Responsibility

In our second article Special Issue on Growth and Innovation Bartley Madden, a leading management consultant and author, follows up after Edmund Phelps’ leading article on innovation and mass flourishing with specific recommendations for business managers.

Madden identifies a firm’s knowledge-building proficiency as its most important capability in order to survive and prosper over the long term. Even a firm’s competitive advantage and intangible assets are best understood as the result of its ability to build knowledge.

Along with a firm’s organizational structure, knowledge-building proficiency coordinates and improves work, innovation, and resource allocation.

Madden is very critical of much of the current academic finance research that, while ostensibly focused what creates “excess shareholder returns” (i.e., economic profit or economic value-added), is actually irrelevant to a fundamental understanding of what creates long-term value.

Academic studies are usually just statistical factor analyses. Even when economists study individual firms, they usually do so by modeling them simply as production functions: management is assumed to coordinate factors of production to make and sell products until marginal costs equal marginal revenue and profits are maximized. Such a firm is assumed to have clear boundaries and its management tightly controls the work of employees and the accumulation and allocation of its physical assets.

Instead, Madden proposes a new and more sophisticated concept of the firm to position human capital, in general, and knowledge-building proficiency, in particular, at the center of value creation. In this connection he offers two business exemplars: the American retailer Walmart and the Chinese Haier Group that makes consumer electronics and home appliances.

Authored by Bartley J. Madden

Toward a Theory of Indigenous Innovation

Toward a Theory of Indigenous Innovation

In the first article from our Special Issue on Growth and Innovation 2006 Nobelist Edmund Phelps expands upon the ideas about innovation and creativity he introduced in his 2013 book Mass Flourishing. Phelps argues that while economies have continued to evolve, the concepts in economics have lagged behind.

Western nations that have gone from brilliance to very slow growth have little idea of how to redevelop the old élan of their best decades. With only the standard toolkit, economists may offer relief from some of the symptoms of the illness, but not a cure. Standard economics cannot cure the illness because it cannot know the causes.

In standard economic models, the reward for work is fundamentally the market wage. There is no room for any human agency by which a person might gain rewards other than the going wage. Thus, standard models miss the character of a modern economy.

The treatment of “innovation” is especially lacking. Standard economics uses the word “innovation” to denote a shift in a “technology” parameter. Yet these parametric shifts are exogenous to the economy—not new products or new methods conceived in the economy, thus endogenous to the economy.

Western nations that have gone from brilliance to very slow growth have little idea of how to redevelop the old élan of their best decades. With only the standard toolkit, economists may offer relief from some of the symptoms of the illness, but not a cure. Standard economics cannot cure the illness because it cannot know the causes.

The critically missing element in standard economics is indigenous innovation. This refers to new ideas not just to adaptations.

A great many businesspeople take the view that a company “innovates” when it detects and acts on a new opportunity—one that fills a need. But the concept of an indigenous innovation—a new idea that brings new practice—is miles away from the concept of detecting and acting on an opportunity that brings new practice.

Indigenous innovation, where it occurs, is driven by people’s creativity. Innovators use their imagination to conceive of new products or methods and their ingenuity and savvy to implement the new product or method, that is, to make it and market it.
New ideas are not the same thing as science. Science does not tell us whether there will be a market for any of the new possibilities; business knowledge is indispensable here. Even in Western countries, myriad business discoveries may have led to as many new products and methods as from scientific discoveries between the 1820s and 1960s.

Phelps believes the “spirit” of dynamism derived from modern ethical values including individualism, vitalism, and self-expression. They also include what Phelps calls “visionaryism” or the desire to create entirely new things.
Modern societies developed as the result of these modern values. And where these values reached a critical mass, modern economies sprouted up which brought mass innovating and thus rapid economic growth. The dynamism also enriched work. Ordinary people had engaging employment and most of them prospered and many flourished.

Phelps sees several causes for the loss of dynamism, particularly regulation and what he calls “social protection.” He is not referring to social security but to efforts to inhibit change. Not only does social protection stymie potential agents of change on the outside (e.g., by blocking potential startups) but CEOs who might have been innovators are reduced to being lobbyists and rent seekers. He thinks the private sector may also suffer from “decadence” including corruption, weak governance, and short-termism.

Phelps refers collectively to the old values opposing modern values as “corporatist values.” Now pervasive in all the nations of the West, corporatism is behind the self-serving vested interests, clientelism, and cronyism.

Two propositions follow from this assessment:
1. Nations that lack the dynamism for mass indigenous innovation will not achieve the prosperity of which modern economies are capable. “Reform” will be fruitless without the right culture. It will be necessary to bring back into schools and the home the literature of adventure and exploration.

2. The once-dynamic nations of the West cannot regain the stunning indigenous innovation of the 19th and 20th centuries without first doing battle with corporatist values. Western nations will have to reassert the modern values.

Authored by Edmund Phelps, Columbia University

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

In the last article from the (JACF Spring/Summer issue) Richard Ebil Ottoo discusses how much of a firm’s market value derives from expected future growth value rather than from the value of current operations or assets in place. Pharmaceutical companies are good examples of firms where much market value comes from expectations about drugs still in the development “pipeline.”

Using a new osteoporosis drug being developed by Gilead Sciences, Inc., the author combines discounted cash flow methods values and real option models to value it. Alone, discounted cash flow (DCF) calculations are vulnerable to the assumptions of growth, cost of capital, and cash flows. But by integrating the real options approach with the DCF technique, one can value a new product in the highly regulated, risky and research-intensive Biopharmaceutical industry.

This article shows how to value a Biopharmaceutical product, tracked from discovery to market launch in a step-by-step manner. Improving over early real option models, this framework explicitly captures competition, speed of innovation, risk, financing need, the size of the market potential in valuing corporate innovation using a firm-specific measure of risk and the industry-wide value of growth operating cash flows.

This framework shows how the risk of corporate innovation, which is not fully captured by the standard valuation models, is priced into the value of a firm’s growth opportunity. The DCF approach permits top-down estimation of the size of the industry-wide growth opportunity that competing firms must race to capture, while the contingency-claims technique allows bottom-up incorporation of the firm’s successful R&D investment and the timing of introduction of the new product to market. It also specifically prices the risk of innovation by modeling its two components: the consumer validation of technology and the expert validation of technology. Overall, it estimates the value contribution per share of a new product for the firm.

Authored by Richard Ebil Ottoo, Global Association of Risk Professionals (GARP)

An Empirical Study of Insurance Performance Measure

An Empirical Study of Insurance Performance Measure

In the ninth article from the (JACF Spring/Summer issue) this author applies Insurance Performance Measure (IPM) to a set of Indian insurance companies over the period 2005-2016. This is the first article published that applies the IPM model on real industry data and studies its implications.

The IPM was introduced in a Winter 2002 JACF article by Joseph Calandro, Jr., then at General Star management, a subsidiary of Berkshire Hathaway and by Scott Lane, then an accounting professor at the University of New Haven. Those authors explained why financial reporting for insurance companies was so challenging and presented the IPM metric as a better way to assess industry and company performance. Evaluating P&C companies is difficult because the unique format of insurance company financials does not lend itself to traditional financial accounting analysis and because the industry’s preeminent performance measure, the Underwriting Ratio, captures underwriting and claims activity but says nothing about investment and risk distribution (reinsurance).

By contrast, the IPM represents the interrelation of underwriting, investment and reinsurance along with a hurdle rate and is quite consistent with Warren Buffett’s expressed desire for a balanced overview of industry performance. IPM uses financial data without modification thereby simplifying and fastening computation. Operationally, it could help in negotiations for reinsurance renewals and identify “Maximum Profitable capacity”—the threshold limit for overall profitability.

Authored by Sai Ranjani Bharathkumar, XLRI Jamshedpur, India

Processes and Accuracy of Cash Flow Forecasting: A Case Study of a Multinational Corporation

Processes and Accuracy of Cash Flow Forecasting: A Case Study of a Multinational Corporation

The eighth article from the (JACF Spring/Summer issue) discusses how, despite its pivotal importance in enterprise management, cash flow forecasting gets little attention from academics perhaps because few of them have access to internal processes and data. In this article, however, the authors explain how cash flow forecasting is organized at Bayer, a large multinational company headquartered in Germany, and which factors influence the accuracy of its forecasts. The research focuses on cash flow forecasts based on the direct method, prepared three times a yearat Bayer, involving about 62,000 individual forecasting items each time. These forecasts form the basis of the company’s liquidity and financial risk management, in particular, its foreign exchange risk hedging.

The authors explain how local managers in Bayer’s entities across the world derive the forecasts, i.e., what information they use as input, how they validate it, and how they deal with potential bias caused by managerial incentive systems. They also analyze whether forecasting processes are affected by characteristics such as business area, size, region, or specific local conditions, and ultimately whether forecasting practices and entity characteristics affect forecast accuracy.

The findings show that cash flow forecasting procedures vary substantially across Bayer. While the central finance department gives general guidance on the required cash flow forecasting output and provides direction on the input to be used, there are no detailed instructions on how forecasts are to be prepared. Instead, local managers are free to determine their own forecasting practices. They use different forecasting inputs and validate forecasting inputs and output with different intensities, and they also differ in how they treat possible biases in input data. These findings document the limits of standardization and central control in large multinational corporations resulting from local managers’ need for flexibility to cope with the heterogeneity and dynamism of their environments. At the same time, however, local differentiation increases complexity and may increase errors.

Quantitative analysis of forecasting errors shows that forecasts of receipts from customers (cash inflows) are more accurate than forecasts of payments to suppliers (cash outflows). Moreover, forecasting practices affect forecast accuracy. Outflow forecasts are more accurate if managers intensively validate forecasting input; inflow forecasts, if they eliminate input biases that may result from internal target setting or from other managerial incentives, and if they carefully validate their forecasting output.

The study provides several insights.

1. Cash flow forecasting in a large multinational corporation is a complex system of interlaced processes, taking place in many organizational sub- units and located in different environments with different backgrounds.

2. Forecasting processes depend on entity characteristics. Managers at smaller, less complex entities tend to communicate closely with local counterparts and to verify forecasting output, while managers at entities whose liquidity is managed by the central finance department often use only rough assumptions about payment terms of cash inflows and outflows.

3. Quantitative analysis supports the contention that invoices issued to customers can be forecasted more accurately than invoices received from suppliers.

4. Forecasting practices affect forecast accuracy. Forecasts of invoices from suppliers are more accurate if managers intensively validate the forecasting input and prepare their own calculations rather than simply accept at face value input data provided by other departments.

Authored by Martin Glaum, WHU – Otto Beisheim School of Management, Peter Schmidt, Justus-Liebig Universität Giessen, and Kati Schnürer, Bayer AG & Justus-Liebig-Universität Giessen