Category: Finance

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

Global Trade – Hostage to the Volatile US Dollar

Global Trade – Hostage to the Volatile US Dollar

Brian Kantor says that (JACF Winter issue) every financial manager ought to have a multi-decade historical perspective on foreign exchange rates to appreciate how quickly and dramatically rates can change. Managers should understand how domestic politics influences central bank policies and, ultimately, foreign exchange rates, even if unintentionally. Longer-term historical perspectives are a necessary part of a solid decision-making foundation.

He provides a summary foreign exchange history from the perspective of the South African Rand (ZAR) and the US dollar (USD). What is most remarkable about such exchange rates, perhaps, is not just the variation around established trends but the tendency of apparently well-established trends to reverse completely. Kantor explains that, since 1970, the global economy has had to cope with flexible exchange rates that do not necessarily trend to Purchasing Power Parity “equilibrium.” This is a highly unsatisfactory feature of the global financial and trading system.

The chance of a reintroduction of genuinely fixed exchange rates seems very small, however. Business decision-makers will have to cope as best they can with unpredictable real exchange rates.

Authored by Brian Kantor, Investec

How to Evaluate Risk Management Units in Financial Institutions?

How to Evaluate Risk Management Units in Financial Institutions?

Continuing in our series of articles from the JACF Winter issue our authors discuss the existing Enterprise Risk Management framework and current government regulations, “banks are required to establish risk management units (RMUs) to review and evaluate their risks, monitor them, and to advise top management.” Currently an integral part of the risk governance and management process, RMUs in financial institutions have become increasingly important since the 2007-2008 financial crisis.

This article details the authors’ creation of an index to evaluate the performance of risk management units in financial institutions, and then examines some of their findings. The index transforms twelve parameters into a simple and convenient index that isolates the RMU’s activities from the rest of the organizational risk management process, its risk preferences and the activities of the rest of the units. The index’s parameters are divided into three dimensions of the RMU’s performance: professionalism, organizational status and relationship with top management and the board.

The authors found a positive relationship between their RMUI and some important risk governance characteristics: CROs who are among the five highest paid executives at the bank, banks with at least one independent director serving on the board’s risk committee having banking and finance experience and boards with greater efficacy.

Authored by Michael Gelman, Ben-Gurion University of the Negev, Doron Greenberg, Ariel University, and Mosi Rosenboim, Ben-Gurion University of the Negev

Biomarker of Quality? Venture-Backed Biotech IPOs and Insider Participation

Biomarker of Quality? Venture-Backed Biotech IPOs and Insider Participation

Corporate financial managers of biotech firms need long-term financing to reach key milestones, and that requires a long-term capital structure.

In Hans Jeppsson’s article on venture capitalists and IPOs from our JACF Winter issue the author discusses how corporate financial managers of biotech firms must balance a mix of investors with different objectives and different investment horizons that includes traditional venture capitalists and also hedge funds and mutual funds. This study helps practitioners understand the complex role of exit decisions, as venture capitalists seek better exit strategies and performance. IPOs are financing but not “exit” moves.

In addition to certifying firm value, insider purchasing of shares in the IPO offering has two major consequences. First, venture capitalists reallocate large sums of capital from early-stage to late-stage deals that are expected to have lower risk (but also lower expected return) and shorter time to exit. Second, the speed at which VCs exit after the IPO depends on the firm ownership structure after the IPO and the stock liquidity. Going public with a significant participation by venture capitalists will probably increase the post-IPO ownership and decrease the free float of the stock, implying a delay of the exit and the realization of the capital gains from the investments.

Although this study has focused exclusively on the biotechnology industry, insider participation is not unique to it. Biotech’s venture brethren in the software and technology industries also have insider participation in IPOs. During 2003-2015, approximately 41 venture-backed firms outside of the biotechnology sector had insider participation.

Authored by Hans Jeppsson, University of Gothenburg

An Improved Method for Valuing Mature Companies and Estimating Terminal Value

An Improved Method for Valuing Mature Companies and Estimating Terminal Value

The theory underlying discounted cash flow (DCF) models is uncontroversial in academia. Nevertheless, in practice, DCF models are applied inconsistently with very different valuation results.

In David Holland’s article on discounted cash flow models from our JACF Winter issue the author writes that the theory underlying discounted cash flow (DCF) models is uncontroversial in academia, the economic intuition behind them is straightforward, and the mathematics reassuringly simple. Nevertheless, in practice, they are applied inconsistently with very different valuation results. Because of the assumed infinite life (“going concern”) of a business enterprise, DCF models implicitly assume the ability to forecast future cash flows forever. This forces analysts to make assumptions about the terminal period using simplistic metrics such as P/E or EV/EBITDA to estimate terminal values or to embed a perpetual stream of excess profitability and value creation in the terminal period.

The author offers an uncomplicated alternative to these unrealistic assumptions. The first step is to introduce an adjustable fade rate called f. A fade rate of 100% brings about immediate convergence, and a fade rate of 0% specifies no fade and perpetual excess profitability. The notion that excess profits get competed away over time can be modeled by assuming that the spread of (ROIC – r) fades to zero and that economic profit dissipates.

Intrinsic value is very sensitive to the fade rate assumption and this helps explain the risk premium for quality stocks. The risk of owning quality stocks is that they lose their economic moat and competitive advantage. An adjustable fade rate provides an excellent means to value the effect of profitability attenuation in a DCF model.

Authored by David Holland, University of Cape Town Graduate School of Business

Fundamental Investors Reduce the Distraction on Management from Random Market “Noise”

Fundamental Investors Reduce the Distraction on Management from Random Market “Noise”: Evidence from France

Some temporary market enthusiasm may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility

In another of our articles from the JACF Winter issue. the authors find that financial markets have real effects on corporate decisions but that, unfortunately, some temporary market enthusiasm, unrelated to firm intrinsic value, may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility. In particular, they are prone to making bad decisions after stock market overreactions to “surprise” earnings announcements.

This study shows a positive effect of greater long-term ownership on French listed firms. Fundamental investor ownership reduces the degree of market mispricing which serves long-run shareholder value maximization. A fundamental investor is one that, on average, hold his shares for at least two years, is in the top quartile of a firm ownership, and has an active allocation strategy. They are about 8% of all investors. Compared to non-fundamental investors, fundamental investors hold their positions on average three times longer and have positions 1.5 times larger. Fundamental investors are more present in firms which have more liquid stocks, which pay dividends, and which are relatively poorer performers and have relatively lower market-to-book than their industry peers.

Authored by Alexandre Garel, Auckland University of Technology, and Jean-Florent Rérolle, Morrow Somali

Clawbacks, Holdbacks, and CEO Contracting

Clawbacks” are much discussed in the context of senior executive compensation

“Clawbacks” are much discussed in the context of senior executive compensation, yet the discussion has largely ignored the presence of holdbacks that are already in place in many firms. Holdbacks are deferred compensation that is potentially foregone in the event that the CEO leaves the firm without good reason or they are dismissed for wrong-doing. They are explicit or written features of a CEOs employment contract, as Stuart Gillan writes in the sixth article of the Winter 30.1 issue.

Holdbacks are already in use at 70% of S&P 500 firms and average $18.4 million each. Firms with higher CEO replacement costs, greater information asymmetry, a recent bad experience (fraud, lawsuit, or restatement), or in more certain environments are more likely to have a holdback. In contrast, clawback adoptions are mainly driven by firms’ bad experiences and external pressure from shareholders. Holdbacks and incentive-based compensation are substitutes, as termination incentives can reduce the need for incentive compensation. As managers reasonably demand a premium for accepting risky compensation, a measure of abnormal compensation is positively associated with holdbacks, but there is no significant association between clawbacks and holdbacks.

These findings suggest that the holdbacks many firms already have in place could help an “ex-post settling up” in the event of financial misconduct, or even simply misstated financials. As companies have more control over the amounts held back ex-ante, holdbacks are potentially more efficient.

Authored by Stuart Gillan, University of Georgia, and Nga Nguyen, Marquette University

Internal Governance Does Matter to Equity Returns but Much More So During “Flights to Quality”

Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns

In our fifth article of the Winter 30.1 issue our authors discuss how good internal governance helps firms perform better.

Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns

Although few doubt that good internal governance helps firms perform better, the statistical evidence is actually mixed because the positive effects of good corporate governance matters much more so at some times than others. The statistical link is strongest during “flights to quality,” when market sentiment turns bearish and pessimistic but weakens for long periods of time during bull markets and low market volatility. Using more than ten years’ evidence from Australian firms, the authors show that internal governance is related to both firm value and performance and that firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns. When risk aversion is high, demand for well-governed firms increases and investors discount the value of firms with potential agency conflicts. This time-varying relationship between internal governance and returns may explain both the limited explanatory power of governance on firm value and the mixed empirical evidence reported in previous studies.

Firms with strong internal governance do earn significantly higher stock returns compared with firms with weak governance; but that also means that the value of governance is not fully incorporated into prices, thereby explaining the limited explanatory power of governance on firm value.

Authored by Peter Brooke, Platypus Asset Management, Paul Docherty, Monash University,
Jim Psaros, The University of Newcastle and Michael Seamer, The University of Newcastle

Say on Pay: Is It Needed? Does It Work?

The fourth article in our Winter 30.1 issue deals with “Say on Pay” rules, those corporate practices giving shareholders the right to vote on executive compensation. The assumption behind “Say on Pay” is that managers may be overpaid because directors fail to provide adequate oversight. Stephen O’Byrne questions this underlying assumption.

O’Byrne provides substantial evidence that directors do a poor job overseeing executive pay and that directors have weak incentives to pursue shareholder interests in executive pay.

“Say on Pay voting is sensitive to differences in pay for performance, but so forgiving that extraordinary pay premiums are required to elicit a majority ‘no’ vote.”

The common corporate practice of providing competitive target compensation regardless of past performance leads to low alignment of pay and performance. Unfortunately, directors have little incentive to protect shareholder interests “because they are paid labor providers, just like management, not stewards of substantial personal capital.”

Authored by Stephen O’Byrne, Shareholder Value Advisors