Minimum Rate of Return Guarantees: The Danish Case

We analyze minimum rate of return guarantees for life-insurance (investment) contracts and pension plans with a smooth surplus distribution mechanism. We specifically model the smoothing mechanism used by most Danish life-insurance companies and pension funds. The annual distribution of bonus will be based on this smoothing mechanism after taking the minimum rate of return guarantee into account. In addition, based on the contribution method the customer will receive a final (non-negative) undistributed surplus when the contract matures. We consider two different methods that the company can use to collect payment for issuing these minimum rate of return guarantee contracts: the direct method where the company gets a fixed (percentage) fee of the customer's savings each year, e.g. 0.5% in Denmark, and the indirect method where the company gets a share of the distributed surplus. In both cases we analyze how to set the terms of the contract in order to have a fair contract between an individual customer and the company. Having analyzed the one-customer case, we turn to analyzing the case with two customers. We consider the consequences of pooling the undistributed surplus over two inhomogeneous customers. This implies setting up different mechanisms for distributing final bonus (undistributed surplus) between the customers.     

Reinsurance decisions in life insurance: An empirical test of the risk–return criterion

Recent studies have analyzed optimal reinsurance contracts within the framework of profit maximization and/or risk minimization. This type of framework, however, does not consider reinsurance as a tool for capital management and financing. In the present paper, we consider different proportional reinsurance contracts used in life insurance (viz., quota-share, surplus, and combinations of quota-share and surplus) while taking into account the insurer's capital constraints. The objective is to determine how different reinsurance transactions affect the risk/reward profile of the insurer and whether factors, such as claims severity, premiums, and insurer's risk appetite, influence the choice of a proportional reinsurance coverage. We compare each reinsurance structure based on actual insurance company data, using the risk–return criterion. This criterion determines the type of reinsurance that enables insurer to retain the largest underwriting profits and/or minimize the risk of the retained claims while keeping the insurer's risk appetite constant, assuming a given capital constraint. The results of this study confirm that the choice of reinsurance arrangement depends on many factors, including risk retention levels, premiums, and the variance of the sum insured values (and therefore claims). As such, under heterogeneous insurance portfolio single type of reinsurance arrangement cannot maximize insurer's returns and/or minimize the risk, therefore a combination of different reinsurance coverages should be employed. Hence, future research on optimal risk management choices should consider heterogeneous portfolios while determining the effects of different financial and risk management tools on companies' risk–return profiles.     

Why EVA Bonus Plans Failed—and How to Revive Them

Most companies rely heavily on earnings to measure their financial performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings growth may come at the expense of future earnings through, say, shortsighted cutbacks in corporate investment, including R&D or advertising. But growth in earnings per share can also be achieved by “overinvesting”—that is, committing ever more capital to projects with expected rates of return that, although well below the cost of capital, exceed the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance, and often fails to motivate corporate managers who believe that meeting consensus earnings is more important than investing to maintain future earnings. EVA often doesn't work well because increases in current EVA often come with reduced expectations of future EVA improvement—and reductions in current EVA are often accompanied by increases in future growth values. Since EVA bonus plans reward current EVA increases without taking account of changes in expected future growth values, they have the potential to encourage margin improvement that comes at the expense of business growth and discourage positive‐NPV investments that, because of longer‐run payoffs, reduce current EVA. In this article, the author demonstrates the possibility of overcoming such short‐termism by developing an operating model of changes in future growth value that can be used to calibrate “dynamic” EVA improvement targets that more closely align EVA bonus plan payouts with investors’ excess returns. With the use of “dynamic” targets, margin improvements that come at the expense of business growth can be discouraged by raising EVA performance targets, while growth investments can be encouraged by the use of lower EVA targets.     

The Impact of Capital Expenditures on Property Performance in Commercial Real Estate

Using a sample of 47,260 annual and 12,276 unique property observations during 2000–2011 we analyze the relationship between capital expenditures and performance by employing 2SLS models, in which capital expenditures are modeled as a function of property characteristics (age, square footage, occupancy rate, leverage, leasing commissions, lagged returns and property type), market conditions (interest rates, credit spread and standard deviation of cap rates) and property fixed effects. Our results reveal that while capital expenditures are mostly idiosyncratic and related to unique property characteristics, they are a significant determinant of property returns. We find persistently strong positive relationship between capital expenditures and excess NPI returns when controlling for the endogeneity of capital expenditures for industrial, office and retail properties. A further analysis reveals that this relationship is driven by the positive impact of building improvements and building expansions, while returns in all property types do not fully adjust to account for tenant improvements.     

Investment Timing for Dynamic Business Expansion

We investigate the timing of business expansion. With an indefinite sequence of growth opportunities that have constant returns to scale, current investment neither displaces nor impairs future returns. In a dynamic setting with expansion restricted to a fraction of firm size, the endogenously determined cost of capital uniformly exceeds the value maximizing return threshold for expansion. Taking this into account, a manager accelerates investment to facilitate larger and more valuable future investments when earnings stochastically improve. This result is the opposite of deferral that the investment literature recommends due to irreversibility. This means that the managerial application of the cost of capital as an expansion hurdle rate is improperly conservative.     

Monetary randomness and investment

This paper develops a neoclassical model in which the behavior of the money supply affects investment by affecting the real distribution of asset returns. Investment depends on wealthholders' demand for capital. A stochastic money growth rule influences portfolio choice by affecting the distribution of the inflation rate. The variance of inflation matters to wealthholders because of the existence of assets with returns that are not indexed to changes in the price level: money and bonds which are contracted in nominal terms. In a rational expectations environment, asset demands will thus be sensitive to the distribution of the money growth rate. Our principle conclusion is that an increase in the variance of the money growth rate lowers investment, which complements Tobin's (1965) result that an increase in the mean stimulates capital accumulation. The paper also represents a step toward incorporating an asset market into a macroeconomic model in a manner which takes account of Lucas' (1976) criticism of econometric policy evaluation. All variables in the model, including asset return distributions, are functions of technology, preferences and the money supply rule. Further, expectations are rational.     

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.     

Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment

This paper derives a real options model that accounts for the value premium. If real investment is largely irreversible, the book value of assets of a distressed firm is high relative to its market value because it has idle physical capital. The firm's excess installed capital capacity enables it to fully benefit from positive aggregate shocks without undertaking costly investment. Thus, returns to equity holders of a high book‐to‐market firm are sensitive to aggregate conditions and its systematic risk is high. Simulations indicate that the model goes a long way toward accounting for the observed value premium.     

Why Capital Efficiency Measures Are Rarely Used in Incentive Plans, and How to Change That

Despite the wide acceptance of DCF valuation and its corollary that value is created only by earning more than the cost of capital, very few companies use performance measures that focus on corporate efficiency in using capital—measures such as return on capital (ROC) or economic value added (EVA)—as the main basis for their top management incentive programs. In this article, the authors begin by documenting the surprisingly limited use of such measures in management incentive plans. Next they analyze three often cited problems—difficulty in retaining managers, discouragement of growth investment, and complexity—that could account for the limited use of such measures. Third and last, they suggest a number of adjustments to standard capital efficiency measures that are designed to address these problems and, in so doing, to give corporate directors more confidence in using measures like EVA to reward and hold managers accountable for value-adding performance.
In illustrating the problems encountered when using such performance measures, the article uses case studies of three long-time "EVA companies"—Briggs & Stratton, Herman Miller, and Manitowoc—to highlight the difficulty of using a "bonus bank" (or "clawback") system to hold managers fully accountable for earning a minimum return on capital. After presenting empirical data that shows "delayed productivity" of invested capital, the authors suggest that conventional capital efficiency measures can discourage value-increasing growth.
The article concludes by recommending that although measures like EVA used in combination with negative bonus banks provide the right incentives, EVA capital charges should be phased in gradually to reflect the delayed productivity of capital. At the same time, corporate boards should consider providing bonus bank "relief" when market and industry factors have excessively large negative effects on the performance measures and bonus awards.     

Implied cost of capital investment strategies: evidence from international stock markets

Investors can generate excess returns by implementing trading strategies based on publicly available equity analyst forecasts. This paper captures the information provided by analysts by the implied cost of capital (ICC), the internal rate of return that equates a firm’s share price to the present value of analysts’ earnings forecasts. We find that U.S. stocks with a high ICC outperform low ICC stocks on average by 6.0 % per year. This spread is significant when controlling the investment returns for their risk exposure as proxied by standard pricing models. Further analysis across the world’s largest equity markets validates these results.     

Creating Customer Value in Participating Life Insurance

The value of a life insurance contract may differ depending on whether it is looked at from the customer's point of view or that of the insurance company. We assume that the insurer is able to replicate the life insurance contract's cash flows via assets traded on the capital market and can hence apply risk‐neutral valuation techniques. The policyholder, on the other hand, will take risk preferences and diversification opportunities into account when placing a value on that same contract. Customer value is represented by policyholder willingness to pay and depends on the contract parameters, that is, the guaranteed interest rate and the annual and terminal surplus participation rate. The aim of this article is to analyze and compare these two perspectives. In particular, we identify contract parameter combinations that—while keeping the contract value fixed for the insurer—maximize customer value. In addition, we derive explicit expressions for a selection of specific cases. Our results suggest that a customer segmentation in this sense, that is, based on the different ways customers evaluate life insurance contracts and embedded investment guarantees while ensuring fair values, is worthwhile for insurance companies as doing so can result in substantial increases in policyholder willingness to pay.     

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.     

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.     

On estimating the expected return on the market: An exploratory investigation

The expected market return is a number frequently required for the solution of many investment and corporate finance problems, but by comparison with other financial variables, there has been little research on estimating this expected return. Current practice for estimating the expected market return adds the historical average realized excess market returns to the current observed interest rate. While this model explicitly reflects the dependence of the market return on the interest rate, it fails to account for the effect of changes in the level of market risk. Three models of equilibrium expected market returns which reflect this dependence are analyzed in this paper. Estimation procedures which incorporate the prior restriction that equilibrium expected excess returns on the market must be positive are derived and applied to return data for the period 1926–1978. The principal conclusions from this exploratory investigation are: (1) in estimating models of the expected market return, the non-negativity restriction of the expected excess return should be explicity included as part of the specification: (2) estimators which use realized returns should be adjusted for heteroscedasticity.     

An Unconventional Conglomerateur: Henry Singleton and Teledyne

Capital allocation involves decisions about raising and returning capital, and about acquiring and selling companies—all of which can have major effects on shareholder value. Rather than judging CEOs by growth in revenues or earnings, the author argues that they should be judged by increases in the per share value of the companies they manage and also in comparison with the returns generated by peer firms and the broader market. Successful CEOs have been able to overcome the “institutional imperative”—the tendency of managers to focus on the sheer size of their enterprises and to avoid doing things that might be seen as unconventional. In this chapter from his recent book, The Outsiders, which provides accounts of eight remarkably successful and long‐tenured CEOs, the author describes the successful management by Henry Singleton of the conglomerate Teledyne from 1963 to 1990, a period during which the company's shareholders enjoyed annualized returns of over 20%. During the 1960s, the company produced high returns mainly by making large acquisitions funded by new equity issues. During the 1970s and '80s, by contrast, Teledyne used massive share repurchases to return excess capital to shareholders. Thus, Singleton adjusted his capital allocation strategy in response to changes in product and financial markets—and to changes in the perceived difference between market and intrinsic values. When investors provided capital with relatively low required rates of return, as in the 1960s, Singleton was an aggressive buyer investor in a wide range of businesses. But when interest rates were high and equity valuations were low, as in the 1970s and early 1980s, Singleton used share repurchases to create value by reducing investment and limiting growth. The company's shareholders were well rewarded in both environments.     

THE NEGLECTED AND SMALL FIRM EFFECTS

This paper addresses the empirical question of whether the differential attention which companies receive affects the capital asset pricing process. The degree of attention was measured by research concentration rankings based on the number of analysts regularly following the firm's securities. The results suggest: (i) that there is a “neglected firm effect” in terms of superior performance for less researched companies and (ii) that the neglected firm effect persists over and above the small firm effect; namely, the excess returns are not fully attributable to size. The ex-post capital asset pricing model is unable to account for the differences in return across security research ranking. Several possible explanations for the results are considered but not tested.     

Asset liquidity and stock returns

We document the significant predictive power of firms' asset liquidity in the cross section of subsequent stock returns. The annual return spread between portfolios featuring the highest and lowest levels of asset liquidity is significantly positive. Our proposed measure of asset liquidity outperforms those measures developed by Gopalan et al. (2012) in predicting returns. The asset liquidity anomaly also provides significantly positive alphas when controlling for the asset pricing factors in the Fama and French (1993) three-factor model and the Carhart (1997) four-factor model. Asset liquidity exhibits strong return forecasting power even after controlling for acknowledged cross-sectional determinants of return. The positive relation between asset liquidity and future returns tends to be stronger for firms with greater asset productivity, higher quality cash flow and lower capital investment.     

Stock Repurchases and Excess Returns: An Empirical Examination

The excess returns associated with repurchase announcements are viewed largely as a reaction to management's statement that the firm's shares are underpriced; management's signal provides new information that enhances the firm's market value. Although earlier studies have found the excess return to be closely related to the premium set by managment, other factors play a part in determining both the market reaction and the premium level set by management. Among these factors ar relative market capitalization, holdings by institutions, immediate alternative uses for cash, level of insider control, recent stock price performance, relative size of the tender offer, and the resultant change in the firm's capital structure.     

Analysis of a threshold dividend strategy for a MAP risk model

We consider a class of Markovian risk models in which the insurer collects premiums at rate c₁(c₂) whenever the surplus level is below (above) a constant threshold level b. We derive the Laplace-Stieltjes transform (LST) of the distribution of the time to ruin as well as the LST (with respect to time) of the joint distribution of the time to ruin, the surplus prior to ruin, and the deficit at ruin. By interpreting that the insurer pays dividends continuously at rate c₁?c₂ whenever the surplus level is above b, we also derive the expected discounted value of total dividend payments made prior to ruin. Our results are obtained by making use of an existing connection which links an insurer's surplus process to an embedded fluid flow process.     

Putty-clay technology and stock market volatility

Firms' first-order conditions imply that stock returns equal investment returns from the production technology. Much applied work uses the adjustment cost technology, which implies that the realized return is high when the investment-capital ratio is high. This paper derives, for an arbitrary stochastic discount factor, the investment return implied by the putty-clay technology. The combination of capital heterogeneity and irreversibility creates a novel channel for return volatility. The investment return is high when the ratio of investment to gross job creation is low. Empirically, the putty-clay feature helps account for U.S. stock market data.