Consumption-based equity valuation

Using a CCAPM-based risk-adjustment model, we perform yearly valuations of a large sample of stocks listed on NYSE, AMEX, and NASDAQ over a 30-year period. The model differs from standard valuation models in the sense that it adjusts forecasted residual income for risk in the numerator rather than through a risk-adjusted cost of equity in the denominator. The risk adjustments are derived based on assumptions about the time-series properties of residual income returns and aggregate consumption rather than on historical stock returns. We compare the performance of the model with several implementations of standard valuation models, both in terms of median absolute valuation errors (MAVE) and in terms of excess returns on simple investment strategies based on the differences between model and market prices. The CCAPM-based valuation model yields a significantly lower MAVE than the best performing standard valuation model. Both types of models can identify investment strategies with subsequent excess returns. The CCAPM-based valuation model yields time-series of realized hedge returns with more and higher positive returns and fewer and less negative returns compared with the time-series of realized hedge returns based on the best performing standard valuation model for holding periods from 1 to 5 years. In a statistical test of 1-year-ahead excess return predictability based on the models’ implied pricing errors, the CCAPM-based valuation model is selected as the better model. Using the standard series of aggregate consumption and the nominal price index, a reasonable level of relative risk aversion, and calibrated growth rates in the continuing value at each valuation date, the CCAPM-based valuation model produces small risk adjustments to forecasted residual income and low continuing values. Compared with standard valuation models, it relies less on estimated parameters and speculative elements when aggregating residual earnings forecasts into a valuation.     

Are the Best Small Companies the Best Investments?

Previous research finds that large companies previously judged to be excellent growth companies have subsequently been poor investments. We examine small companies selected by Business Week on the basis of multiple criteria used in annual articles featuring highly rated growth companies. We study the investment performance over the three years before eleven annual Business Week publications and the three years after publication. We find positive excess returns in the pre‐publication period, but negative excess returns in the post‐publication period. This reversal in investment performance appears to be due to a mean‐reversion tendency in operating performance, in which the earnings and the past rates of return on capital of such companies subsequently decrease significantly.     

Time-varying risk premia and the cost of capital: An alternative implication of the Q theory of investment

Evidence suggests that expected excess stock market returns vary over time, and that this variation is much larger than that of expected real interest rates. It follows that a large fraction of the movement in the cost of capital in standard investment models must be attributable to movements in equity risk-premia. In this paper we emphasize that such movements in equity risk premia should have implications not merely for investment today, but also for future investment over long horizons. In this case, predictive variables for excess stock returns over long-horizons are also likely to forecast long-horizon fluctuations in the growth of marginal Q, and therefore investment. We test this implication directly by performing long-horizon forecasting regressions of aggregate investment growth using a variety of predictive variables shown elsewhere to have forecasting power for excess stock market returns.     

Benefits from social trading? Empirical evidence for certificates on wikifolios

Social trading describes the idea that signal providers make their investment decisions available to other investors who follow them. The performance of social trading has hardly been in the focus of research so far. We analyze the performance of 1084 wikifolio certificates used in social trading and issued in 2012 and 2013. We apply factor models to analyze these certificates' returns and alphas relative to benchmark indexes. We find that, on average, wikifolios do not outperform the market. However, wikifolios with geographical focus provide better performance than those without. Furthermore, the best performing wikifolios earn significant short-term excess returns.     

Fortune's Best 100 Companies to Work for in America: Do They Work for Shareholders?

In this paper we examine the market reaction to the announcement by Fortune of the 'Best 100 Companies to Work for in America.' Employees rate firms based on several criteria including trust in management, pride in work/company and camaraderie. To examine long‐term performance, we calculate raw and risk‐adjusted returns and then compare them to the returns of a matched sample of firms. In addition, we calculate the return on a buy and hold investment in the sample firm less the return on a buy‐and‐hold investment in a matched sample firm (BHARs). We find a statistically significant positive response to the announcement of the '100 best companies to work for' by Fortune . Also, based on all measures of risk‐adjusted return, we find these firms generally outperform the matched sample of companies. The BHAR results, although not exhibiting the level of statistical significance, are consistent with the raw and risk‐adjusted return results.     

The effect of R&D on future returns and earnings forecasts

Prior studies attribute the future excess returns of research and development activity (R&D) firms to either compensation for increased risk or to mispricing. We suggest a third explanation and show that neither the level of R&D investment nor the change in R&D investment explains future returns. Rather, the positive future returns that prior studies attribute to R&D investment are actually due to the component of the R&D firm??s realized return that is unrelated to R&D investment but present in R&D firms. Our results suggest that the excess returns of R&D firms are part of the larger value/growth anomaly. In addition, we show that while future earnings are positively associated with current R&D, errors in earnings expectations by investors and analysts are not related to R&D investment.     

Disclosure tone of the spin-off prospectus and insider trading

This paper documents a negative association between the abnormal tone (optimistic versus pessimistic) of the Management’s Discussion and Analysis in a spin-off prospectus and the insider trading pattern (buy versus sell) in the spun-off subsidiary within three months of the spin-off date. Additional tests show that the negative relation exists only for the transactions by insiders who have also been executives in the parent company before the spin-off. I find that the insider purchases result in substantial long-term excess returns, especially when they are accompanied by abnormally negative tone. Given that insiders are extensive net buyers of stock in new spin-offs, these findings suggest that managers may use more pessimistic tone in the prospectus to disguise the upside potential of the spun-off subsidiary to seize the opportunity to purchase shares at lower cost.     

Loss Recoveries,Realized Excess Returns,and Credit Rationing in the Commercial Mortgage Market

In this paper we exploit loan level data combining foreclosure histories with information about the revenues and expenses associated with the ongoing management and eventual sale of financially distressed loans to estimate the magnitude of realized excess returns on commercial mortgages. Our findings are striking. We find that average realized excess returns on commercial mortgages are the lowest at the best times á la Stiglitz and Weiss (Am. Econ. Rev., 71:393–409, 1981). We also find that excess realized returns on commercial mortgages are low when lenders are swamped with funds (which we measure by the volume of commercial mortgage commitments) and when promised spreads are low.      

Winners and Losers as Financial Service Providers Converge: Evidence from the Financial Modernization Act of 1999

The Financial Modernization Act of 1999 dramatically increased insurers' and investment banks' authority to provide an array of financial services and allowed commercial banks to offer investment banking and insurance services. In this paper we examine the market response to this legislation. We find a strong positive response among insurance companies and investment banks, and no significant response among commercial banks. Larger institutions in all three financial sectors earn higher abnormal returns. Additionally, better performing banks earn higher abnormal returns. Our results suggest that allowing financial convergence can add value through synergies and that large players are needed to exploit the scope economies.     

Drivers of Shareholder Returns in Tech Industries (or How to Make Sense of Amazon's Market Value)

Earnings according to GAAP do a notoriously poor job of explaining the current values of the most successful high‐tech companies, which in recent years have experienced remarkable growth in revenues and market capitalizations. But if GAAP earnings fail to account for the values of such companies, are there other measures that do better? The authors address this question in two main ways. They begin by summarizing the findings of their recent study of both the operating and the stock‐market performance of 169 publicly traded tech companies (with market caps of at least $1 billion). The aim of the study was to identify which of the many indicators of corporate operating performance—including growth in revenues, EBITDA margins, and returns on equity—have had the strongest correlation with shareholder returns over a relatively long period of time. The study's main conclusion is that investors appear to be looking for signs of neither growth nor efficiency in using capital alone, but for an optimal mix or balancing of those goals. And that mix, as the study also suggests, is captured in a cash‐flow‐based variant of “residual income” the authors call “residual cash earnings,” or RCE. In the second part of their article, the authors show how and why RCE does a much better job than reported net income or EPS of explaining the current market value of Amazon.com , one of the best‐performing tech companies in the world. Mainly by treating R&D spending as an investment of capital rather than an expense, RCE reveals the value of a company that is distinguished by both the amount and the productivity of its ongoing investment—both of which have been obscured by GAAP.     

Short term persistence in mutual fund market timing and stock selection abilities

Using daily return data from 448 actively managed mutual funds over a recent 9-year period, we look for persistence, over two consecutive quarters, in the ability of funds to select individual stocks and time the market. That is, we decompose overall fund performance into excess returns resulting from stock selection and timing abilities and we separately test for persistence in each ability. We find persistence in the ability to time the market only among well performing funds and in the ability to select stocks only among the very best and worst performers. The existing literature patterns appear only when funds are ranked by their overall performance, which includes stock selection, market timing and fees. With respect to overall performance, there is persistence among most poorly performing and only the top well performing funds. Furthermore, the profitability of a winner-picking strategy depends on the rebalancing frequency and potentially the size of the investment. Small investors cannot profit, whereas large investors can take advantage of the class-A share fee structure and realize positive abnormal returns by annually rebalancing their portfolios.     

Excess Returns to R&D-Intensive Firms

Recent studies indicate that both current R&D investment levels and current or recent changes in R&D investment are positively associated with subsequent excess (risk-adjusted) stock returns. The tentative explanation offered for these results is that shares of R&D-intensive firms are mispriced because investors fail to see through earnings distortions caused by conservative accounting for R&D costs. However, an alternative explanation is that conventional controls for risk do not completely capture the riskiness of R&D-intensive firms, causing measured excess returns for these firms to be biased upward. This study provides evidence useful for distinguishing between the mispricing and risk explanations for R&D-related excess returns. Overall, our empirical results suggest that the positive association between R&D investment levels and excess returns is more likely to result from failure to control adequately for risk than from mispricing. On the other hand, our results do not rule out the possibility of a second source of excess returns that are due to mispricing and that are associated with changes in the level of R&D investment.     

Pathways to Success in M&A

For many if not most publicly traded companies, acquisition capabilities remain a critical component of sustainable longterm growth and profitability. And even as investors press companies to return excess capital through dividends and stock buybacks, the market continues to assign premium valuations to companies that earn above-average returns through a combination of internal investment and judicious acquisition spending.
This article begins by describing major challenges facing acquirers in the current business and regulatory environment. Then, after showing how M&A can be used to address strategic goals, the authors identify key elements in the M&A strategies of three highly successful companies: General Electric, Danaher, and Illinois Tool Works.     

Guaranteed Investment Contracts: Distributed and Undistributed Excess Return

Annual minimum rate of return guarantees are analyzed together with rules for distribution of positive excess return, i.e. investment returns in excess of the guaranteed minimum return. Together with the level of the annual minimum rate of return guarantee both the customer's and the insurer's fractions of the positive excess return are determined so that the market value of the insurer's capital inflow (determined by the fraction of the positive excess return) equals the market value of the insurer's capital outflow (determined by the minimum rate of return guarantee) at the inception of the contract. The analysis is undertaken both with and without a surplus distribution mechanism. The surplus distribution mechanism works through a bonus account that serves as a buffer in the following sense: in (‘bad’) years when the investment returns are lower than the minimum rate of return guarantee, funds are transferred from the bonus account to the customer's account. In (‘good’) years when the investment returns are above the minimum rate of return guarantee, a part of the positive excess return is credited to the bonus account. In addition to characterizations of fair combinations of the level of the annual minimum rate of return guarantee and the sharing rules of the positive excess return, our analysis indicates that the presence of a surplus distribution mechanism allows the insurer to offer a much wider menu of contracts to the customer than without a surplus distribution mechanism.     

Family friendly firms: does it pay to care?

In this paper we examine the returns to a portfolio of 29 firms that are perceived as family-oriented. The sample is based on firms awarded the best 100 companies for working mothers in Working Mother Magazine’s annual survey. There is much anecdotal evidence supporting the benefits of these programs, but little evidence relating family-oriented policies to shareholder wealth. We find, based on raw returns, that family-friendly firms do not earn statistically significant excess returns relative to a matched sample or to the S & P 500. Based on risk-adjusted returns, the family-friendly portfolio outperforms the market, but underperforms a matched sample portfolio.     

Can financial statement analysis beat consensus analysts’ recommendations?

We examine whether investors can exploit financial statement information to identify companies with a greater likelihood of future earnings increases and whether stocks of those companies generate 1-year abnormal returns that exceed the abnormal returns from following analysts’ consensus recommendations. Our approach summarizes financial statement information into a “predicted earnings increase score,” which captures the likelihood of 1-year-ahead earnings increases. We find that, within our sample of consensus recommendations, stocks with high scores are much more likely to experience future earnings increases than stocks with low scores. A hedge portfolio strategy that utilizes our approach within each consensus recommendation level generates average annual abnormal returns of 10.9 percent over our 12-year sample period, after controlling for previously identified risk factors. These abnormal returns exceed those available from following analysts’ consensus recommendations. Our results show that share prices and consensus recommendations fail to impound financial statement information that helps predict future earnings changes.     

Accounting‐Based Probabilistic Prediction of ROE,the Residual Income Valuation Model and the Assessment of Mispricing in the Swedish Stock Market

Using Swedish stock market data, this study investigates whether an investment strategy based on publicly available accounting information can generate abnormal investment returns. The strategy involves two steps. First, an accounting‐based probabilistic prediction model of changes in the medium‐term book return on owners' equity (ROE) is estimated. Second, market expectations of changes in medium‐term ROE are assessed through observed stock prices and the residual income valuation model. Stock market positions over 36‐month holding periods are taken when the accounting‐based predictions of ROE and the market expectations differ. Over the period 1983–2003, the investment strategy generated values of Jensen's alpha corresponding to an average monthly excess return for a hedge position of up to 0.8% for a sample of manufacturing companies. In the main this hedge return was caused by strong positive returns to the long positions, and additional analyses show that the returns appear to have been affected by a positive market sentiment bias (i.e., positive ROE surprises being associated with stronger price reactions than negative ROE surprises) making out‐of‐sample inferences somewhat dubious. Furthermore, most of the investment returns accrued over holding periods up to around 1995, with no indications of market mispricing over the last third (1995–2003) of the investment period. The empirical results are consistent with market investors having become more sophisticated in their use of publicly available accounting information over time.     

Excess Asset Reversions and Shareholder Wealth

The ownership of pension assets in a defined benefit pension plan is an unresolved issue in corporate finance. The issue is important because it defines the appropriate investment policy for a pension fund. In this paper, we summarize the ownership debate in the form of two mutually exclusive theories. We then focus on a recently popular event in pension finance, excess asset reversions. Our paper demonstrates the valuation effects associated with this event in a stochastic dominance framework. Under certain conditions, a reversion constitutes an expropriation of wealth from the participants and beneficiaries of the plan to the firm. Using data provided by the Pension Benefit Guaranty Corporation and the Center for Research in Security Prices tape, we examine the returns to the shareholders of 58 companies which conducted excess asset reversions between 1980 and 1984. Our results show that large abnormal returns accrued to these shareholders around the time of the reversion. These findings have implications both for the appropriate investment policy of pension funds and for public policy with respect to plan terminations.     

Housing Price Dynamics in Time and Space: Predictability,Liquidity and Investor Returns

It is widely accepted that aggregate housing prices are predictable, but that excess returns to investors are precluded by the transactions costs of buying and selling property. We examine this issue using a unique data set—all private condominium transactions in Singapore during an eleven-year period. We model directly the price discovery process for individual dwellings. Our empirical results clearly reject a random walk in prices, supporting mean reversion in housing prices and diffusion of innovations over space. We find that, when house prices and aggregate returns are computed from models that erroneously assume a random walk and spatial independence, they are strongly autocorrelated. However, when they are calculated from the appropriate model, predictability in prices and in investment returns is completely absent. We show that this is due to the illiquid nature of housing transactions. We also conduct extensive simulations, over different time horizons and with different investment rules, testing whether better information on housing price dynamics leads to superior investment performance.     

Reversal of 3‐day losers and continuation of 3‐day winners on the NASDAQ

Using only the 200 large-cap securities that make up the NYSE 100 and NASDAQ 100, this study investigates 130 randomly selected formation periods from January 2000 through December 2012. During these formation periods, the three worst and three best performing stocks (based on excess return) are flagged. Once flagged, the subsequent 10-day holding period excess returns are calculated. Results indicate that NYSE securities demonstrate significant return reversal, but not return momentum. Conversely, the worst performing NASDAQ securities demonstrate return reversal, whereas the best performing NASDAQ securities demonstrate return momentum. Results are robust to the number of best and worst stocks that are flagged. Results are also robust to other combinations of formation and holding period lengths.