The investment opportunity set,director ownership,and corporate policies: evidence from an emerging market

This paper provides evidence of the association between a firm's investment opportunity set (IOS), director ownership, and corporate policy choices. Using a sample of growth and non-growth firms in an emerging Asian market, we find that the IOS theory has significant explanatory power in the financing, dividend, executive compensation, and leasing aspects of corporate policies. Growth firms have lower debt-to-equity ratios and dividend yields, pay higher cash compensation and bonus amounts to their top executives, and finance a higher proportion of their asset acquisitions through operating leases. We also find that director ownership moderates and counteracts the association between IOS and corporate policies. Our results are consistent with contracting theory predictions that high director ownership mitigates the need for incentive or bonus compensation plans in growth firms.     

THE INVESTMENT OPPORTUNITY SET AND ITS PROXY VARIABLES

We use a real options approach to evaluate the performance of several proxy variables for a firm's investment opportunity set. The results show that, on a relative scale, the market‐to‐book assets ratio has the highest information content with respect to investment opportunities. Although both the market‐to‐book equity and the earnings–price ratios are related to investment opportunities, they do not contain information that is not already contained in the market‐to‐book assets ratio. Consistent with this finding, a common factor constructed from several proxy variables does not improve the performance of the market‐to‐book assets ratio.     

Glamour among value: P/E ratios and value investor attention

The trailing-four-quarter price–earnings (P/E) ratio is the most popular fundamental value proxy. This article is the first to examine the P/E ratio as the preeminent measure of value investor attention. Trailing-four-quarter P/E ratios predict significantly greater cross-sectional variation in stock returns than lagged P/E ratios or current price-to-book (P/B) ratios. P/E strategy returns are robust to variables that proxy for fundamental risk, variables mechanically related to P/E ratios, relative trading volume, and liquidity. The role of attention is evident in return patterns across long and short portfolios, day of the week, and time since formation. Stocks with low P/E ratios exhibit an increase in total trading volume driven by small trades, an improvement in liquidity, and lower idiosyncratic volatility. These patterns are consistent with the typical trading activity of individual investors, who have the strongest attention constraints.     

Measuring securities litigation risk

Extant research commonly uses indicator variables for industry membership to proxy for securities litigation risk. We provide evidence on the construct validity of this measure by reporting on the predictive ability of alternative models of litigation risk. While the industry measure alone does a relatively poor job of predicting litigation, supplementing this variable with measures of firm characteristics (such as size, growth, and stock volatility) considerably improves predictive ability. Additional variables such as those that proxy for corporate governance quality and managerial opportunism do not add much to predictive ability and so do not meet the cost–benefit test for inclusion.     

Predicting market returns using aggregate implied cost of capital

Theoretically, the implied cost of capital (ICC) is a good proxy for time-varying expected returns. We find that aggregate ICC strongly predicts future excess market returns at horizons ranging from one month to four years. This predictive power persists even in the presence of popular valuation ratios and business cycle variables, both in-sample and out-of-sample, and is robust to alternative implementations. We also find that ICCs of size and book-to-market portfolios predict corresponding portfolio returns.     

The Impact of Uncertainty Shocks under Measurement Error: A Proxy SVAR Approach

A growing literature considers the impact of uncertainty using SVAR models that include proxies for uncertainty shocks as endogenous variables. In this paper, we consider the impact of measurement error in these proxies on the estimated impulse responses. We show via a Monte Carlo experiment that measurement error can result in attenuation bias in impulse responses. In contrast, the proxy SVAR that uses the uncertainty shock proxy as an instrument does not suffer from this bias. Applying this latter method to the Bloom (2009) data set results in impulse responses to uncertainty shocks that are larger in magnitude and more persistent than those obtained from a recursive SVAR.     

Empirical Tests of the Proxy Hypothesis

The proxy hypothesis states that the negative relationship between inflation and stock returns is spurious and really only proxies for the positive relationship between stock returns and real variables. Previous testes of the proxy hypothesis have used actual values instead of forecasted values for the real activity variable. Using only forecasted variables, our results do not support the proxy hypothesis.     

THE USE OF MULTIPLE INSTRUMENTS FOR MEASUREMENT OF EARNINGS FORECAST ERRORS, FIRM SIZE EFFECT AND THE QUALITY OF ANALYSTS'FORECAST ERRORS

This paper develops an instrumental variables framework to form a better proxy for earnings forecast errors. The key aspect of the approach is to extract information from alternative proxies for the same underlying variable, namely a portion of realized earnings signals unexpected by the market. We use signs of various proxies for earnings forecast errors obtained from different time-series forecasting models as multiple instruments. The results show that the instrumental variables approach is effective for reducing measurement errors inherent in various proxies for earnings forecast errors. It produces not only a smaller magnitude but also a narrower dispersion of earnings forecast errors. The paper provides evidence that the instrumental variables approach performs better for small-firm samples than for large-firm samples. Finally, we observe that analysts' forecast errors seasoned with the signs of various time-series forecast errors (as well as the signs of their own forecast errors) outperform those without seasoning. This indicates that analysts' forecast errors can still be improved by employing the instrumental variables technique.     

Proportionate Growth and the Theoretical Foundations of Financial Ratios

The article proposes a theoretical framework for understanding financial ratios, showing that the multiplicative character of the financial variables from which financial ratios are constructed is a necessary condition of valid ratio usage, not just an assumption supported by evidence. Also, by assuming that firm size is a measurable statistical effect, the article offers an informed reappraisal of the limitations of financial ratios, particularly the well–known limitation of proportionality. The article is divided into two parts, one where ratio components are viewed as deterministic vari– ables and the other where they are random. Such an approach allows the characteristics of ratios to be more easily understood before generalizing the relationship between ratio components to encompass randomness. In the second part, when variability introduced by firm size is treated as a random effect, it is shown that if the accounting variables Y and X used to calculate a financial ratio Y/X are exponential Brownian motion, and if continuous growth rates are equal and proportionate to firm size, this may lead to ratios which are asymmetric but which do not necessarily drift.     

A note on modelling economic growth determinants in the Dominican Republic

The article models economic growth determinants in the Dominican Republic. The exercise considers a panel of 25 candidate explanatory variables observed during the last three decades of the twentieth century. The time series are selected on the basis of economic theory and previous findings in the cross-country empirical growth literature. The modelling reveals that the annual growth rate of real gross domestic product per capita is, on average, inversely associated to a proxy for market distortions, and positively related to government expenditure, economic growth in the United States of America, and an index of globalization comprising international trade and migration variables.     

Corporate bankruptcy prediction: a high dimensional analysis

Much bankruptcy research has relied on parametric models, such as multiple discriminant analysis and logit, which can only handle a finite number of predictors (Altman in The Journal of Finance 23 (4), 589–609, 1968; Ohlson in Journal of Accounting Research 18 (1), 109–131, 1980). The gradient boosting model is a statistical learning method that overcomes this limitation. The model accommodates very large numbers of predictors which can be rank ordered, from best to worst, based on their overall predictive power (Friedman in The Annals of Statistics 29 (5), 1189–1232, 2001; Hastie et al. 2009). Using a sample of 1115 US bankruptcy filings and 91 predictor variables, the study finds that non-traditional variables, such as ownership structure/concentration and CEO compensation are among the strongest predictors overall. The next best predictors are unscaled market and accounting variables that proxy for size effects. This is followed by market-price measures and financial ratios. The weakest predictors overall included macro-economic variables, analyst recommendations/forecasts and industry variables.     

An empirical study of interest rate swap usage by nonfinancial corporate business

This study examines the relationship between the probability and extent of a firm's participation in interestrate swap markets and the magnitude of some of its operating and financial ratios. These ratios are selected to proxy incentives to reduce agency costs of leverage and information asymmetry in credit markets. The data on swap usage are obtained from disclosures mandated by SFAS 105. The results suggest that fixed-rate payers, compared to non-swap-users, have more leverage, greater profitability, more growth options, less operating risk, lower ratios of fixed to total assets, and more divergent earnings estimates. On the other hand, floating-rate payers do not seem to have financial and operating characteristics significantly different from non-swap-users, although they do have less divergent earnings estimates.This study is based, in part, on one of the essays in my doctoral dissertation at Indiana University. Further research was supported by a grant from the Western Michigan University Faculty Research and Creative Activities Support Fund. The study has also benefited from comments on an earlier version by participants at the Eastern Finance Association Annual Meetings, 1993.     

Are the Latent Variables in Time-Varying Expected Returns Compensation for Consumption Risk?

Multibeta asset pricing models are examined using proxies for economic state variables in a framework which exploits time-varying expected returns to estimate conditional betas. Examples include multiple consumption-beta models and models where asset returns proxy for the state variables. When the state variables are not specified, the tests indicate two or three time-varying expected risk premiums in the sample of quarterly asset returns. Conditional betas relative to consumption generate less striking evidence against the model than betas relative to asset returns, but both the consumption and the market variables fail to proxy for the state variables.     

A Note on the Financial Variable and Ratio Structure of New Zealand Listed Companies*

This paper reports the results of an investigation into the financial structure of accounting variables and ratios of New Zealand listed firms. Seven major factors were identified and these accounted for more than 82 percent of the information contained in a set of forty-four variables. These factors are labelled profitability, size, activity, solvency, liquidity, growth in size and, growth in profits/profitability. Although the first five factors have also been identified as separate corporate dimensions in studies conducted in the United States and elsewhere, variables representing growth have not been examined before. Our study suggests that the growth variables represent two distinct and significant factors.     

Explaining the accrual anomaly by market expectations of future returns and earnings

This study examines the accrual anomaly under the framework of the Campbell [Campbell, J.Y. (1991). A variance decomposition for stock returns. Economic Journal 101 (405), 157-179.] model. The Campbell (1991) model shows that realized asset returns are a joint function of 1) expected returns, 2) revisions in market expected future returns (i.e., return news), and 3) revisions in market expected future cash flows (i.e., cash flow news). The current study adopts the Easton [Easton, P. (2004). PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review 79 (1), 73-96.] model to estimate proxies for expected returns, return news, and cash flow news. The results show that firms with low accruals have lower expected returns than firms with high accruals, which is contradictory to prior research that argues that firms with low accruals are more risky. However, investors underestimate (overestimate) future earnings growth, a proxy for cash flow growth, for low (high) accrual firms. Further analysis demonstrates that earnings news (proxy for cash flow news) plays a major role in explaining abnormal returns associated with the accrual anomaly.     

Structural properties of the price-to-earnings and price-to-book ratios

We examine the structural properties of a firm’s price-to-earnings (P/E) and price-to-book (P/B) ratios and the relation between these two ratios. A benchmark result is obtained under the hypothesis that firms use replacement cost accounting to value their operating assets, so that the P/B ratio coincides with Tobin’s q. The firm’s P/E ratio can then be expressed as a convex combination of the P/E ratios suggested respectively by the permanent earnings model and the Gordon growth model, with the relative weight to be placed on these two endpoints determined entirely by Tobin’s q. Under current financial reporting rules, the accounting for operating assets is likely to be more conservative than replacement cost accounting. Our findings characterize how the magnitude and behavior of the P/E and P/B ratios are jointly shaped by several key variables, including both past and anticipated future growth, economic profitability, and accounting conservatism     

A Structured Financial Statement Analysis and the Direct Prediction of Stock Prices in Korea

Using a large sample of firms listed on the Korea Stock Exchange, this paper evaluates the usefulness of a structured, programmable financial statement analysis for investment decisions. In doing so, we develop a firm valuation model which links a firm's market value with fundamental variables such as the ability of a firm to generate cash flows, growth potentials, and risk. We predict a firm's intrinsic value directly from an extensive set of financial statement variables which proxy for the theoretical variables implied by the model. We then construct a series of trading strategies with zero net investment (called D-strategies) on the basis of D-values which measure percentage differences between predicted intrinsic values and observed market values. We observe that the market-adjusted and size-adjusted (hedge-portfolio) returns to the most conservative D-strategy turn out to be in the order of 16.92% and 11.44%, respectively,for the 12-month holding period. When our sample is stratified into two sub-samples based on firm size, the D-strategy yields higher excess return for the small-firm sub-sample than for the large-firm sub-sample. The above evidence, taken as a whole, strongly indicates that one can construct a profitable trading strategy by directly predicting intrinsic values through a structured financial statement analysis such as ours.     

中国商业银行宏观绩效与微观绩效相关性研究

本文以商业银行的不良贷款率和对经济增长的贡献度分别作为其微观绩效和宏观绩效的代理变量,建立了宏观绩效与微观绩效相关性的误差修正模型,通过对我国13家商业银行1995-2005年的数据进行分析．揭示两者之间的关系。本文研究结果表明：商业银行对经济增长的贡献度越大,不良贷款率越高,两重绩效之间存在替代关系,均衡误差项存在反向修复机制。最后,本文分析了误差修正模型的政策含义,提出缓解两重绩效冲突的政策措施。     

The Time Series Properties of Financial Ratios: Lev Revisited

This paper re‐evaluates the time series properties of financial ratios. It presents new empirical analysis which explicitly allows for the possibility that financial ratios can be characterized as non‐linear mean‐reverting processes. Financial ratios are widely employed as explanatory variables in accounting and finance research with applications ranging from the determinants of auditors' compensation to explaining firms' investment decisions. An implicit assumption in this empirical work is that the ratios are stationary so that the postulated models can be estimated by classical regression methods. However, recent empirical work on the time series properties of corporate financial ratios has reported that the level of the majority of ratios is described by non‐stationary, I (1), integrated processes and that the ratio differences are parsimoniously described by random walks. We hypothesize that financial ratios may follow a random walk near their target level, but that the more distant a ratio is from target, the more likely the firm is to take remedial action to bring it back towards target. This behavior will result in a significant size distortion of the conventional stationarity tests and lead to frequent non‐rejection of the null hypothesis of non‐stationarity, a finding which undermines the use of these ratios as reliable conditioning variables for the explanation of firms' decisions.     

Off-balance sheet exposures and banking crises in OECD countries

Against the background of the acknowledged importance of off-balance-sheet exposures in the sub prime crisis, we seek to investigate whether this was a new phenomenon or common to earlier crises. Using a logit approach to predicting banking crises in 14 OECD countries we find a significant impact of a proxy for the ratio of banks’ off-balance-sheet activity to total (off and on balance sheet) activity, as well as capital and liquidity ratios, the current account balance and GDP growth. These results are robust to the exclusion of the most crisis prone countries in our model. For early warning purposes we show that real house price growth is a good proxy for off balance sheet activity prior to the sub-prime episode. Variables capturing off-balance sheet activity have been neglected in most early warning models to date. We consider it essential that regulators take into account the results for crisis prediction in regulating banks and their off-balance sheet exposures, and thus controlling their contribution to systemic risk.