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” 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
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
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
Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy
In our third article of the Winter 30.1 issue we look at whether logically, the practice of corporate finance and corporate strategy should be closely coordinated, but in reality there remains a massive gap between the two. This can lead strategically oriented firms to de-emphasize or even discard NPV. Neither financial theory nor competitive strategy has been very open to the economic value of investment opportunity capture. Strategy must recognize that financial flexibility provides powerful advantages and financial theory must evaluate entire strategic programs rather than discrete, stand-alone projects.
Necessarily, the financial discussion of cost of capital and capital structure has to change. The authors offer two specific concepts to bridge the Gap between Finance and Strategy:
1) Reserve Financial Capacity is the annual sum of Free Cash Flow, Financing Flexibility and Cash Reserves over the period envisioned for strategy execution. Individual projects must belong to strategic programs in the sense that they either: 1) keep the base business running; 2) preserve an existing competitive position; or 3) form part of a program to enhance advantage or fashion a strategic breakout.
2) Strategically Sustainable Cost of Capital is the true, blended cost of capital required to complete an entire capital program.
These concepts provide financial rigor to firms with well-defined strategies and allow managements to wield Financial Flexibility as a strategic weapon, creating options on unique buying opportunities, such as at the bottom of industry cycles. The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.
Authored by Stephen V. Arbogast, Kenan-Flagler Business School, University of North Carolina at Chapel Hill and Dr. Praveen Kumar, C.T. Bauer College of Business, University of Houston.
The second article of our Winter 30.1 issue of the Journal of Applied Finance deals with whether directors may wonder if their fiduciary duties have changed. The authors synthesize the latest decisions of the Delaware courts on the standards of conduct for directors and the standards by which their conduct is reviewed. While directors should expect uncertainty in corporate life, neither the fiduciary duties of directors nor the protections afforded them have changed. Disinterested and independent directors, acting in good faith to make decisions they deem in the best interests of the corporation, continue to have broad protections under the business judgment rule. This legal framework enables and encourages active directors to make hard choices when they need to do so.
The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.
Written by Ira M. Millstein, Ellen J. Odoner, and Aabha Sharma, of Weil, Gotshal & Manges.
See Wiley’s online library to access the full text of this article.
Eclipse of the Public Corporation or Eclipse of the Public Markets?
In our Winter 30.1 issue of the Journal of Applied Finance our first article looks back at Michael Jensen’s 1989 article “The Eclipse of the Public Corporation.” The authors find some of his predictions have been borne out but other important ones, not. Jensen concluded that the publicly held corporation was in decline and had outlived its usefulness in many sectors. He argued that agency costs made public corporations an inefficient form of organization and that new private organizational forms promoted by private equity firms would likely replace the public firm.
The number of public firms in the U.S. has declined significantly but there are still many hugely profitable and successful public companies. U.S. public markets are still well-suited for firms with mostly tangible assets. So, what we are really witnessing is an eclipse not of public corporations, but of the public markets as the place where young firms with mostly intangible capital seek their funding.
This is especially true when the usefulness of the intangible assets has yet to be proven. Sometimes the market is extremely optimistic about some intangible assets, but otherwise firms with unproven intangible assets may be better off funding themselves privately. This evolution has a downside: investors limited to public markets are cut off from investing in high intangible-asset firms. Additionally, as fewer firms remain publicly listed, fewer firms will be transparent to society.
By authors Craig Doidge, University of Toronto, Kathleen M. Kahle, University of Arizona, G. Andrew Karolyi, Cornell University, and René M. Stulz of Ohio State University.
See Wiley’s Online Library to access the full text of this article.
The Trendsetter: Where a California Pension Plan Sees Opportunity Now
Chris Ailman was a SASB panelist in our Spring 2017 issue of The Journal of Applied Corporate Finance. He gives his investment outlook and elaborates on what ESG means to him in an article in Barron’s entitled The Trendsetter: Christopher Ailman of CalSTRS.
See Wiley’s Online Library to access the full text of our SASB roundtable.
Sustainability and Shareholder Value
The JACF, with the support of the High Meadows Foundation, has just published the fourth (read the complete issue here) in what has become an annual series of issues devoted to the corporate “sustainability” question: how can companies address environmental and social problems while still earning high enough rates of return to attract the capital necessary to sustain themselves?
Our first sustainability issue featured corporate initiatives and investments designed to protect the environment while preserving—or, in some cases, even increasing—value for shareholders. The main focus of the second in our series was large influential investors and the growing role of “ESG” (environmental, social, and governance) criteria in their decision-making. That issue emphasized that public companies could find long-term “partners” among a small but distinguished group of “value-based” investors who have made ESG analysis a critical part of their stock valuation process.
Our third sustainability issue explained how companies could find such investors and persuade them to buy their shares. Most of the suggestions involved “integrated reporting,” a relatively new form of investor communication but one recently adopted by as widely admired a company as GE. Integrated reporting differs from the “sustainability reports” that provide exhaustive accounts of all corporate environmental and social activities. Integrated reporting instead aims to provide, within and as part of a company’s traditional financial statements, detailed accounts of only their “material” environmental and social risks—the ones that are capable of having significant effects on profitability and value.
And that brings us to the focus of this, our fourth, sustainability issue: the critical importance of identifying material corporate ESG exposures and of communicating to the capital markets both the plans to manage such exposures and their expected effects on corporate strategy and value. In our lead article, Harvard Business School’s George Serafeim and Chris Pinney, President of the High Meadows Institute, dispel a number of “myths” about ESG investing. The most prevalent, and misleading, of these myths is that ESG investors must settle for below-market returns. In reality, investors who have incorporated “material” ESG risks and opportunities into their decision-making have earned returns that are if anything higher than those earned by conventional portfolios, while exhibiting lower risk. Also in this issue, Jean Rogers, CEO of the Sustainability Accounting Standards Board, (SASB) and co-author (and former FASB head) Bob Herz discuss the practical import of SASB’s success in identifying and providing standards for corporate reporting on material ESG exposures in 79 different industries. But that success does not keep Bob Eccles and Tim Youmans of Harvard Business School from arguing that determinations of materiality are important “exercises of judgment” that should not be left to the SASB or to corporate managements. They should instead be viewed as the responsibility of corporate boards, which are urged to issue a one-page Statement of Significant Audiences and Materiality each year that explains their determinations of which exposures are material, and what the companies plan to do about them.
When we come to do our fifth sustainability issue a year from now, it will be interesting to see how many corporate boards have chosen to take this step. But even if the answer is none, the corporate share of mind for the concept of “materiality” should have increased significantly.
– Don Chew
Tactics of Activist Investors
This morning’s Wall Street Journal features an article (“Don’t Make Me Do This: Rise of the Reluctant Activist”, February 19, 2016) on how many investors are adopting, even if reluctantly, the tactic of activist investors. Referring to a technology-oriented hedge fund manager:
Investor Jeffrey Osher sat on his holdings in prepaid-debit-card issuer Green Dot Corp. for three years before he lost his patience.
In December, after a string of disappointing earnings reports that left the company’s shares down sharply, the hedge-fund manager met with the board and asked directors to fire founder and Chief Executive Steven Streit, according to people familiar with the meeting. When the board refused, Mr. Osher’s Harvest Capital Strategies LLC did something it had never done before: It publicly threatened to run a campaign to oust the company’s directors.
Those moves put Mr. Osher into a newly emerging class of shareholders: Typically passive investors who are adopting, sometimes reluctantly, the tactics of activists (emphasis added).
This phenomenon was discussed at length in the Roundtable on Activist Investing published in the JACF’s Summer 2015 issue. Participants including professors from Harvard Law and Business Schools, senior decision-makers from leading hedge funds, and corporate managers with experience dealing with activist investors.
To read more and to download the issue Click here.