Aggregate Earnings and Asset Prices

A principal-components analysis demonstrates that common earnings factors explain a substantial portion of firm-level earnings variation, implying earnings shocks have substantial systematic components and are not almost fully diversifiable as prior literature has concluded. Furthermore, the principal components of earnings and returns are highly correlated, implying aggregate earnings risks and return risks are related. In contrast to previous studies, the correlation we report between the systematic components of earnings and returns is stable over time. We also show that the earnings factors are priced, in the sense that the sensitivities of securities' returns to the earnings factors explain a significant portion of the cross-sectional variation in returns, even controlling for return risk. This suggests earnings performance is an underlying source of priced risk. Our evidence that the information sets of returns and earnings are jointly determined implies cash flow risk and return risk are not fully separable, and raises the possibility that it is the common variation of earnings and returns that is priced.     

Attracting Long‐Term Shareholders

Corporate CEOs often say they don't hear enough from shareholders about strategic issues related to long‐term value creation. At the same time, they claim to hear with predictable regularity from short‐term investors about their success (or failure) in hitting consensus earnings targets. But as the authors of this article begin by noting, there is mounting evidence that companies get the shareholders they deserve—that companies that provide quarterly earnings guidance and otherwise focus investor attention on near‐term earnings targets tend to attract more transient investors. The authors go on to argue that companies with a compelling long‐term vision can expect to benefit not only from more farsighted managerial decision‐making, but also from building a base of longer‐term investors who share management's view of success, and how it can and ought to be achieved. Such a shift in strategic focus and disclosure toward longer‐run performance creates a virtuous cycle—one in which companies that gain the interest and backing of investors with longer horizons end up reinforcing management's confidence to undertake value‐adding investments in their company's future. Even if most companies can't pick their shareholders, they can develop an investor engagement strategy designed to attract long‐term investors. In this article, the chairman and president of FCLTGlobal outline the underlying strategy behind long‐term investor relations and the four key components of such an approach.     

The Economic Significance of Long‐Term Plans

The authors summarize the findings of their event study of the capital market reactions to an inaugural set of 17 CEO presentations of their ‘long‐term plans’ to institutional investors. The findings show that, although sell‐side analysts appear unresponsive to such plans, both trading volumes and stock prices exhibit significant abnormal reactions to the presentations, providing suggestive evidence that the communication of such plans conveys ‘value‐relevant’ information to investors with longer time horizons. Although based on an admittedly small sample, these findings shed light on the promise of long‐term plans and have been corroborated by analysis of the market response to the presentations of 10 more companies since the study was conducted. The authors also provide the outlines of a ‘content framework’ designed to help companies put together effective corporate plans and other long‐term disclosures. The framework is organized around nine main ‘themes,’ including policies governing capital allocation, corporate governance, and human capital development, as well as the statement of corporate purpose. After applying this framework to the 17 CEO presentations, the authors find that the more specific and forward‐looking the information disclosed in these long‐term plans, the more positive the capital market reaction.     

The Determinants of Long‐Term Corporate Debt Issuances

A significant proportion of the debt issued by investment‐grade firms has maturities greater than 20 years. In this paper we provide evidence that gap‐filling behavior is an important determinant of these very long‐term issues. Using data on individual corporate debt issues between 1987 and 2009, we find that gap‐filling behavior is more prominent in the very long end of the maturity spectrum where the required risk capital makes arbitrage costly. In addition, changes in the supply of long‐term government bonds affect not just the choice of maturity but also the overall level of corporate borrowing.     

Institutional Trade Persistence and Long‐Term Equity Returns

Recent studies show that single‐quarter institutional herding positively predicts short‐term returns. Motivated by the theoretical herding literature, which emphasizes endogenous persistence in decisions over time, we estimate the effect of multiquarter institutional buying and selling on stock returns. Using both regression and portfolio tests, we find that persistent institutional trading negatively predicts long‐term returns: persistently sold stocks outperform persistently bought stocks at long horizons. The negative association between returns and institutional trade persistence is not subsumed by past returns or other stock characteristics, is concentrated among smaller stocks, and is stronger for stocks with higher institutional ownership.     

Labor‐Market Institutions and Long‐Term Effects of Youth Unemployment

Graduating from a school during a time of adverse economic conditions has a persistent, harmful effect on workers’ subsequent employment opportunities. An analysis of panel data from OECD countries during the 1960–2010 periods reveals that a worker who experiences a 1 percentage point higher unemployment rate while the worker is 16–24 years old has a 0.14 percentage point higher unemployment rate at ages 25–29 years and 0.03 percentage points higher at ages 30–34 years. The persistence of this negative effect is stronger in countries with stricter employment protection legislation. A composite index for labor‐market rigidity is constructed and the index is shown to have positive correlation with the persistence. Moderating macroeconomic fluctuations is more important in countries that have more persistent labor‐market entry effects on subsequent outcomes.     

Long‐Term Return Reversals: Overreaction or Taxes?

Long‐term reversals in U.S. stock returns are better explained as the rational reactions of investors to locked‐in capital gains than an irrational overreaction to news. Predictors of returns based on the overreaction hypothesis have no power, while those that measure locked‐in capital gains do, completely subsuming past returns measures that are traditionally used to predict long‐term returns. In data from Hong Kong, where investment income is not taxed, reversals are nonexistent, and returns are not forecastable either by traditional measures or by measures based on the capital gains lock‐in hypothesis that successfully predict U.S. returns.     

CEO Overconfidence and Long‐Term Performance Following R&D Increases

We examine the relation between Chief Executive Officer (CEO) overconfidence and significant increases in research and development (R&D) expenditures. Although prior studies reveal a significantly positive market reaction to increases in R&D expenditures in both the long and short run, we find that long‐run stock performance is positive only for firms whose CEOs are not overconfident. Our findings, which may be attributable to overinvestment and the overestimation of future cash flows, imply that R&D resulting from overconfident behavior does not provide any value to firms.     

Greenspan's Conundrum and the Fed's Ability to Affect Long‐Term Yields

In February 2005 Federal Reserve Chairman Alan Greenspan noticed that the 10‐year Treasury yields failed to increase despite a 150‐basis‐point increase in the federal funds rate and called it a “conundrum.” This paper investigates the historical relationship between the 10‐year Treasury yield and the federal funds rate and finds that the relationship changed dramatically in the late 1980s, well in advance of Greenspan's observation. The paper evaluates three competing hypotheses for the change. The evidence from a variety of sources supports the conclusion that the most plausible explanation is that the change occurred because the FOMC began using the federal funds rate as a policy instrument.     

The Time‐Varying Volatility of Earnings and Aggregate Consumption Growth

Time‐varying specifications for the conditional variance of earnings of U.S. households are estimated with micro data over the period 1968–92. The cross‐sectional mean of the estimated time‐varying uncertainty of individual households has a significant impact on aggregate consumption growth. As such, aggregate precautionary savings may be more important than what is suggested by the results of estimating standard regression equations for aggregate consumption growth that incorporate only lagged income growth and the real interest rate. The estimation of a buffer stock consumption model with time‐varying earnings uncertainty suggests that the precautionary savings motive is cyclical and has become less important in the 1980s.     

Does the Failure of the Expectations Hypothesis Matter for Long‐Term Investors?

We solve the portfolio problem of a long‐run investor when the term structure is Gaussian and when the investor has access to nominal bonds and stock. We apply our method to a three‐factor model that captures the failure of the expectations hypothesis. We extend this model to account for time‐varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio of a long‐run investor looks very different from the portfolio of a mean‐variance optimizer. In particular, time‐varying term premia generate large hedging demands for long‐term bonds.     

Long‐Term post‐merger announcement performance. A case study of Australian listed real estate

This study examines the long‐term postmerger performance of Australian Real Estate Investment Trusts (A‐REITs). The A‐REIT sector is used as a case study being less vulnerable to agency issues due to its regulatory structure (Eichholtz and Kok, 2008; Ratcliffe et al., 2009). Research on conventional firms has shown, on average, shareholders are worse off in the long run (Alexandridis et al., 2012). In contrast, we find that shareholders experience significantly positive abnormal returns, after accounting for the financial crisis. This outcome suggests that when managers are restricted with the use of retained earnings and the type of investment, they may be less susceptible to hubris and/or agency issues.     

Who Will Pay for Long‐Term Care in the UK? Projections Linking Macro‐ and Micro‐Simulation Models

The long‐term care funding system continues to attract much debate in the UK. We produce projections of state and private long‐term care expenditure and analyse the distributional impact of state‐financed care, through innovative linking of macro‐ and micro‐simulation models. Variant assumptions about life expectancy, dependency and care costs are examined and the impact of universal state‐financed (‘free’) personal care, based on need but not ability to pay, is investigated. We find that future long‐term care expenditure is subject to considerable uncertainty and is particularly sensitive to assumed future trends in real input costs. On a central set of assumptions, free personal care would, by 2051, increase public spending on long‐term care from 1.1 per cent of GDP to 1.3 per cent, or more if it generated an increase in demand. Among the care‐home population aged 85 or over, the immediate beneficiaries of free personal care would be those with relatively high incomes.     

The Response of Equity Prices to Movements in Long‐Term Interest Rates Associated with Monetary Policy Statements: Before and After the Zero Lower Bound

Monetary policy actions since 2008 have influenced long‐term interest rates through forward guidance and quantitative easing. I propose a strategy to identify the comovement between interest rate and equity price movements induced by monetary policy when an observable representing policy changes is not available. A decline in long‐term interest rates induced by monetary policy statements has a larger positive effect on equity prices prior to 2009 than in the subsequent period. This change appears to reflect the impact of the zero lower bound on short‐term interest rates.     

A Glimpse Behind a Closed Door: The Long‐Term Investment Value of Buy‐Side Research and Its Effect on Fund Trades and Performance

We examine proprietary research produced by buy‐side analysts working for a large fund management company. We find that the buy‐side research has investment value for a one‐year horizon, and the analysts producing this research exhibit differential ability that tends to persist over time. The buy‐side research strongly influences trades made by the company's funds, especially when it coveys information that is independent of the fund managers' own information, when it is produced by buy‐side analysts with good track records, and when the underlying stocks have little sell‐side coverage. The influence of sell‐side research is concentrated primarily in stocks not followed by buy‐side analysts and in funds with low overall buy‐side coverage. The company's funds that rely more heavily on buy‐side research generate superior performance.     

A CEO's Playbook for Creating Long‐Term Value: Ten Essential Resource Allocation Practices

A former CEO of a large and successful public company teams up with a former chief investment strategist and a well‐known academic to suggest ten practices for public companies intent on creating long‐run value:

1. Establish long‐term value creation as the company's governing objective.
2. Ensure that annual plans are consistent with the company's long‐term strategic plan.
3. Understand the expectations embedded in today's stock price.
4. Conduct a “premortem”—and so gain a solid understanding of what can go wrong—before making any large capital allocation decisions.
5. Incorporate the “outside view” in the strategic planning process.
6. Reallocate capital to its highest‐valued use, selling corporate assets that are worth more to or in the hands of others.
7. Prioritize strategies rather than individual projects.
8. Avoid public commitments, such as earnings guidance, that can compromise a company's capital allocation flexibility.
9. Apply best private equity practices to public companies.
10. CEOs should work closely with their boards of directors to set clear expectations for creating long‐term value.

These practices, as the authors note in closing, “are meant to provide a starting point for public companies in carrying out their mission of creating long‐run value—and in a way that earns the respect, if not the admiration and support, of all its important stakeholders.”     

Earnings Management During Antidumping Investigations in Europe: Sample‐Wide and Cross‐Sectional Evidence

This paper examines earnings management by EU firms that initiate an antidumping investigation. We first document economically and statistically significant income‐decreasing earnings management around the initiation of an antidumping investigation. We show that earnings management increases when accounting data directly affect the magnitude of the tariffs imposed in the trade investigation. We also find that earnings management decreases as the number of petitioning firms increases or as the distance between petitioning firms increases, suggesting free‐rider and coordination problems. We find that earnings management increases when the petition is directed at a country that imports more goods from the petitioning firm's home country, suggesting that retaliation threats affect incentives. We document that raising equity or debt financing moderates income‐decreasing earnings management, consistent with the idea that sample firms trade off capital market and regulatory considerations. Our results indicate that contemporary research methods can detect accruals‐based earnings management in settings in which the incentives for earnings management can be clearly identified.     

A Fireside Chat with Raj Gupta: What It Takes to Create Long‐Term Value

The chairman of two public companies (and former chair and CEO of Rohm and Haas) draws on his experience as a director of five private and 15 public companies in discussing the challenges and opportunities facing today's corporate boards. Perhaps the most formidable challenge is the pace of technological change, which is making business models ‘in all industries and countries’ obsolete and forcing companies to adapt much more quickly than in the past. Along with the risk of obsolescence is the increase in ‘reputational risk’ associated with an ‘information age’ in which companies are forced to monitor the nearly continuous flow of fact, hearsay, and outright fabrication. The author recommends that public company boards adopt a new ‘partnership’ model. Besides ensuring an ‘ethical tone at the top,’ corporate directors should aim to become partners with the senior management team by playing more active roles in strategic planning, risk management, and the design of performance evaluation and incentive pay systems. In the most striking departure from current practice, the author urges directors to seize the opportunity created by the ‘reconcentration’ of ownership of U.S. public companies by actively engaging large institutional investors in a strategic dialogue about the companies' strengths and vulnerabilities. In so doing, proactive directors can help their management teams preempt shareholder activists and create long‐run value by creating a more effective two‐way channel of communication, one with the potential to give management more confidence when undertaking large strategic investments with longer‐run payoffs.     

The Effects of Analyst‐Country Institutions on Biased Research: Evidence from Target Prices

Prior research demonstrates that a strong institutional infrastructure in a country moderates self‐serving behavior of market participants. Cross‐country economic activities have increased significantly, presenting a research opportunity to examine the relative influence of local versus foreign institutional infrastructure on individual market participants. We utilize variation in analyst‐country location relative to covered firm location to examine institutional determinants of optimism in analyst research. Focusing on target prices, where persistent optimism is well documented, we find that analysts domiciled in countries with stronger institutional infrastructures exhibit significantly attenuated target price optimism and more value‐relevant target prices. Our results demonstrate the importance of domestic country‐level institutional factors in moderating self‐serving behavior of market participants engaged in cross‐country activities.     

Does Meeting Earnings Expectations Matter? Evidence from Analyst Forecast Revisions and Share Prices

This paper investigates whether the market rewards firms meeting current period earnings expectations, and whether any such reward reflects the implications of meeting expectations in the current period for future earnings or reflects a distinct market premium. We document that abnormal annual returns are significantly greater for firms meeting expectations, controlling for the information in the current year's earnings. We then test whether firms meeting expectations experience higher returns simply because their expected future earnings are also higher. We find firms meeting expectations have significantly higher earnings forecasts and realized earnings than firms that do not. We find that controlling for these higher future earnings, firms meeting expectations in one or two years do not receive a greater valuation than their fundamentals would suggest. We find, however, that the market assigns a higher value to firms that meet expectations consistently, controlling for an estimate of the firm's fundamental value.