FIN 355 Behavioral Finance

Transcription

1 FIN 355 Behavioral Finance Class 5. Behavioral Corporate Finance Dmitry A Shapiro University of Mannheim Spring 2017 Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

2 Introduction Most of what follows is covered in Baker, Ruback and Wurglar "Behavioral Corporate Finance. An Updated Survey" (2012) Two separate strands of research: Irrational Investors: Market timing and catering approach; Irrational Managers: Managerial biases approach; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

3 Market Timing For arbitrageurs it can be difficult to take advantage of mispricing because of limits to arbitrage. What about firms managers? Assume rational managers and irrational investors: Suppose the manager knows that P FV Should the manager do anything? If irrational investors cause mispricing, rational managers should: issue equity when the firm is overpriced; repurchase equity when the firm is underpriced; This is the market timing view of security issuance; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

4 Market Timing: Who gains? Suppose current price of E (per share) is $100, but FV = $50: N shares outstanding. What can CFO do? Issue n shares at $100 and keep proceeds in cash. Long-run price per share is now (50N + 100n)/(N + n) > 50. Ongoing shareholders gain in the long run: the price was supposed to go down to $50 and it goes down not as far; New shareholders lose. Do manager time the security issues? Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

5 Security Issuance: Empirical Evidence Do managers time their securities issues? In a 1998 survey, 67% of CFOs said that the extent to which our stock is under- or over-valued is an important consideration in issuing equity (Grahan and Harvey, 2001) The equity share is a good predictor of future stock market returns (Baker, Wurgler (JF, 2000)) where equity share = equity issues debt issues + equity issues Returns after issuance are low and high after repurchase; the M/B ratio is a good cross-sectional predictor of equity issuance; Managers when they issue equity also sell them from their portfolio (Jenter (JF, 2005)). Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

6 Capital Structure. Empirical Evidence of Market Timing Capital structure is the cumulative result of past financing decisions; If market timing plays a role in financing then it should also shed light on capital structure; Baker and Wurgler (2002, JF) show that a firm s average historical M/B ratio predicts its capital structure today. Average is taken over those years in which the firm makes a financing decisions, either debt or equity; Assume that firms A and B now have same M/B ratio but before that A s market-to-book ratio is higher; Then A will have higher equity share and so probably it was overvalued. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

7 Market Timing. More Empirical Evidence Net equity issuance has predictive power on the returns of portfolios defined on firm characteristics(greenwood and Hanson (JF, 2011)): Firms issue (repurchase) prior to periods when other stocks with similar characteristics perform poorly (well); The difference in characteristics (issuer-repurchaser spread) is the strongest for book-to-market and size; Characteristics of stock issuers can be used to forecast important common factors in stock returns, even after excluding issuing and repurchasing firms; All these results fit nicely with market timing explanation. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

8 Interpretation It s not like managers somehow can predict the market. Mispricing is correlated across firms, because investor sentiment affects many stocks at the same time. If all firms are overvalued at the same time they will tend to issue equity at the same time, even though each firm responds to its own misvaluation. As a result aggregate equity issuance can predict firms returns with a given characteristics even if a given firm would not issue/purchase securities. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

9 Repurchases When p < FV rational managers can benefit ongoing shareholders by repurchasing equities. Repurchaser performance Over 3-5 years following repurchase, returns are abnormally high (Ikenberry et al. 1995, Figure 1); Investors seem to recognize repurchases as good news, just not to full extent. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

10 Catering Evidence suggests rational managerial try to exploit mispricing for long-term benefits; Managers also have incentives to maximize short-term share price; Catering: managerial actions to boost current share price by appealing to investor sentiment; It is more likely when: it doesn t interfere with long-run investment policy (i.e. reduce FV); managers can profit from short-run overvaluation; managers have short horizons. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

11 Catering. Name changes Adding.com (Cooper, Dimitrov and Rau, 2001): Anecdotes regarding Internet frenzy (CDR, p. 2374); Examine 95.com name changes in 1998, 1999 (Table, II); Find large value increase (around 74%) even for firms without a real, fundamental business connection to Internet Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

12 Catering. Name changes Deleting.com (Rau et al. 2005): After Internet bubble burst (March, 2000) firmst started to change their names back (Table II, Figure 1); Again, large value increase: +20%; A few double-dippers changed twice! Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

13 Catering. Dividends Like firm names, dividend policy should be irrelevant to firm value in perfect and efficient markets (Modigliani and Miller); Furthermore, dividends are tax disadvantaged since tax rate on dividends is higher than on capital gain. Rational explanations: Asymmetric information; Agency costs; Is catering also an explanation? Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

14 Catering. Dividends Baker and Wurgler (JF, 2004) argues that changes in dividend policy reflect changing investor sentiment about dividend-paying vs. non-paying firms If there are two categories (styles) of firms: those who pay dividends and those who not; Managers try to see what investors are excited about; They find that firms are more likely to initiate a dividend when: The dividend premium is high, where dividend premium is M/B of dividend payers - M/B of non-payers; The average market reaction to dividend initiations is higher: If price of the firm that started paying dividends goes up then next quarter many other firms will do the same; They also find that future stock returns of dividend payers are lower than those of non-payers; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

15 Investment Policy Critical question is: does market inefficiency distort actual investment? If yes then Behavioral Finance does matter! If the manager is rational and cares about true firm value then it shouldn t (Stein, JB 1996): When firm is overpriced, should issue equity but should NOT increase actual investment; It may be that investors want the manager to invest but the manager should just ignore that because investors are crazy; On the other hand, when firm is underpriced, manager should repurchase shares but should NOT cut back actual investment; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

16 Rational Explanations However in a more complex world, sentiment could, in principle, affect investment Firm might have only few internal funds and might depend on equity for marginal investment. Thus when stock is underpriced it might have to cut back actual investments; Prediction: Investment of equity-dependent firms should vary more with price fluctuations than does investment of other firms. Investors might pressure the manager to do the investments they find attractive (i.e. managers cannot just ignore what investors want) Even if the manager is rational he might care about things other than true firm value, e.g. empire building For example managers like to manage big firms; Then they might use investor exuberance as a cover for wasteful expansion; Manager might put weight on investors opinions, i.e. might mistake irrational exuberance for well-founded exuberance. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

17 Investment Policy Studies in early 90s find little effect of sentiment on investment, i.e. it is statistically significant but economically small; More recent studies come to a different conclusion; Baker, Stein and Wurgler (2003, QJE) find that investment of equity-dependent firms is more sensitive to stock price fluctuations than investment of other firms; Equity-dependent firm is identified by: low cash balances; low cash flow; high leverage Polk, Sapienza The Stock Market and Corporate Investment: A Test of Catering Theory (RFS, 2009) find that overvalued firms indeed invest more, controlling for actual investment opportunities; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

18 Irrational Managers First need to ask: Is it likely that an irrational person would become a senior manager in the first place? Many really overconfident people who are taking a lot of risk; Some of them can get lucky and get on the top. Isn t it possible to undo the effects of managerial irrationality using standard tools for dealing with agency problems? executive stock options; high leverage; takeover markets board of directors The first two might work for empire builders but not for overconfident managers who believe that they are correct; Takeover markets might work but costly. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

19 Mergers and Acquisitions. Basic Facts Huge Scale: during last two decades, $3.4trln and 12, 000 mergers; Joint effect of acquirers and targets may be positive; Acquiring shareholders lose $220bln (because of overpaid targets); Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

20 Mergers and Acquisitions. Managerial Optimism How would you rate your ability to pick which investment projects will be profitable for your firm? FEI-Duke CFO Outlook Survey - 4th quarter, 2003, 235 CFO questioned; 20% ranked themselves 4 of 7; 25% ranked themselves 5 of 7; 43.4% ranked themselves 6 of 7; 9.4% ranked themselves 7 of 7; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

21 Mergers and Acquisitions. WWWBS? What would Warren Buffet say? Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of the target company. We ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses-even after their corporate backyards are knee-deep in unresponsive toads. Berkshire Hathaway Inc. Annual Report, 1981 Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

22 Mergers and Acquisitions. Managerial Optimism Hirshleifer, Low and Teoh (JF, 2012): Use options- and press-based proxies for CEO overconfidence; Firms with overconfident CEOs have greater volatility, invest more in innovation, obtain more patents, achieve greater innovative success for given R&D expenditures; However, these fundings only applicable for innovative industries; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

23 Mergers and Acquisitions Shleifer, Vishny (JFE, 2003) argue that mis-valuation may be a driver of many mergers; show that when firms are mis-valued there are two kinds of mergers: undervalued firms get bought, either with cash or equity overvalued firms get bought by even more overvalued firms, for equity Think of AOL (ridiculously overvalued) who bought Time Warner (which was not so bad); The idea is that managers are terrified that their assets will collapse; Need to buy harder asset which is less overvalued; It is harder to find undervalued firm and make a deal; Second type is more interesting; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

24 Empirical Evidence Dong, Hirshleifer, Richardson, Teoh (JF, 2006) find supportive evidence Bidders generally have higher M/B ratio than targets Implication of both kind of merges higher bidder valuations are more likely to lead to equity-financed mergers; Which makes sense since the equity is overpriced; higher target valuations are also more likely to lead to equity-financed mergers; Overvaluation can reduce fundamental value by deterring value-creating takeovers, i.e. by worsening corporate governance (Edmans et al., JF 2012); Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

25 Empirical Evidence. Arikan and Stulz (JF, 2016): Acquisition rate follows a U-shape over firm s life cycle; Cash, not equity, is the preferred payment mode for young and mature firms; Mis-valuation is significantly related to the acquisition of the middle-aged firms only; However, market reacts negatively on acquisition news by old firms Fu, Lin and Officer (JFE, 2013): Overvalued acquirers significantly overpay for their targets; CEO compensation appears to be the primary motive behind acquisitions of overvalued acquirers; Concentrated among acquirers with the largest governance problems; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

26 Optimism-based models If the manager over-optimistic about his ability to create value then he will always consider his firm equity to be undervalued he will follow a pecking-order policy for financing projects (first cash then debt and then equity). This is because if the equity is undervalued the manager will not want to issue them; The firm will exhibit a high correlation of investment and cash flow; The manager will engage in too many mergers. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

27 Optimism-Based Models Optimism-Based Models may help explain: Why there are so many mergers, even though there is little evidence that they create value on average; In 3 years after acquisition, the acquiring firm tends to underperform. Why at the firm level investment is highly correlated with cash flow; This finding is surprising because if a firm has good investment opportunities it should borrow money and so it does not matter if there is cash available. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

28 Optimism-Based Models Malmendier and Tate (JFE, 2008 Who Makes Acquisitions? ) provide new evidence for the optimism-based mergers: They identify over-optimistic managers as those who hold on to their executive stock options longer than recommended by standard models of option exercise. They find that these managers do more mergers particularly within subset of firms with plenty of internal funds; These managers do more diversifying mergers Thought to be more value destructive Market reacts more negatively to merger announcements from such managers As if market knows that these managers are crazy. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

29 Optimism-Based Models They also find that Same results hold with a measure of optimism based on news reports: How often is the manger described as confident or optimistic? How often is he described as cautious or steady? Argue that a story based on private information of managers does not fit facts Managers would indeed be better off if they exercised their stock options earlier. Using the same option-based measure of optimism show that firms of overoptimistic managers exhibit a higher investment/cash flow correlation. Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

30 Other personal features of CEOs Popular trend is studying CEOs personal characteristics: Malmendier, Tate and Yan (JF, 2011) Overconfidence and Early-life Experience: The Effect of Managerial Traits on Corporate Financial Policies. CEOs that use bigger mortgages for their own home purchases also use more leverage in their firms (Cronqvist, Makhija and Yonker (WP,2011)). Firms run by CEOs who experienced distress have less debt, save more cash and invest less in other firms. Effects are stronger when they are more recent or more salient (Dittmar, Duchin (JF, 2015)). Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31

31 Other personal features of CEOs Kelly Shue (RFS, 2013): Assignment of MBA students to sections at Harvard Business School affects managerial decision-making; Firm outcomes are significantly more similar among graduates from the same sections; Peer effects are twice as strong in the year following alumni reunions Graham, Harvey and Puri (JFE, 2013): Use questionnaire to measure CEOs attitudes regarding risk-aversion, loss-aversion and time preferences; CEOs are more optimistic and risk-tolerant than the lay population; Dmitry A Shapiro (UNCC) Behavioral Corporate Finance Spring / 31