Customers finance companies by paying companies more than the total costs of producing the product. Total costs include the direct materials and direct labor used to produce the product as well as the factory, management staff, etc. Companies producing more relevant and desirable products are able to extract more profit from their customers.
Profits are an important source of financing for companies. Customers paying firms profits do not require compensation in return. Customers do not require subsequent interest payments or ownership interests. Companies can use the profits to expand organically, without having to raise outside capital that comes with demands.
Why is outside capital more costly? Outside capital finances the company so that the company can extract profits from customers in the future. The ability of the company to produce a relevant product and extract future profits is uncertain and risky. Outside capital requires compensation for bearing risks.
Insights into financial behavior
Tuesday, March 17, 2015
How ripped off are passive stock market investors?
A famous activist investor, Mark Rachesky, said in an interview, "We are extremely hands-on, and I've always been a believer that if you are not in control then somebody else is and they aren't looking out for you." (February 11, 2014)
This quote reveals an important lesson for passive investors - no one is looking out for your interests. So why would a passive investor have performed so well over the past century in the U.S. stock market? Why weren't passive investors more ripped off?
Whoever controls a company, whether a large investor or executives, the controller (not owner) is interested in maximizing the controller's value. The controller of the firm can earn by increasing the stock price, but the controller can also earn by extracting private benefits from a company at the expense of the shareholders.
Mark Rachesky is a firm believer that one can gain substantial influence over a company without paying the control premium of an out-right leveraged buy-out or acquisition. For Rachesky, owning 20% of the equity or more already affords him many of the benefits of control. In some sense, Rachesky is leveraging because he control the firm without having to own 100% of the shares.
Large investors like Mark Rachesky are then able to extract private benefits from the company. Assume that a controller of the firm takes out $1 million. If the market is aware of this but did not suspect it, the stock price falls so that the market capitalization of the company falls by $1 million. However, the controller of the firm owns less than 100% of the equity, so the penalty of taking out the $1 million is only a loss on shares proportional to holdings. If own 20% of the stock, then loses $200,000.
Controlling investors can extract many types of benefits. For example, a controlling investor can delay investments or delay providing "activist" advice until the investor has accumulated his or her full stock position. This way the controller does not pay for the value the controller plans to add. The market may have some expectation of the value a controller may add, but this expectation is uncertain and will not be fully priced in to the stock.
Controlling investors can also access board seats and management more easily. This access provides tremendous amounts of valuable information. Often investors focus on sectors where their network sources opportunities. Access to important information is a large private benefit for these controlling investors.
While the equity premium is a puzzle in finance? A related puzzle is why does an equity premium exist when all firms are controlled by someone who also wants private benefits? Perhaps, the equity premium represents the minimum "bribe" to the shareholders to get them to accept the arrangement.
This quote reveals an important lesson for passive investors - no one is looking out for your interests. So why would a passive investor have performed so well over the past century in the U.S. stock market? Why weren't passive investors more ripped off?
Whoever controls a company, whether a large investor or executives, the controller (not owner) is interested in maximizing the controller's value. The controller of the firm can earn by increasing the stock price, but the controller can also earn by extracting private benefits from a company at the expense of the shareholders.
Mark Rachesky is a firm believer that one can gain substantial influence over a company without paying the control premium of an out-right leveraged buy-out or acquisition. For Rachesky, owning 20% of the equity or more already affords him many of the benefits of control. In some sense, Rachesky is leveraging because he control the firm without having to own 100% of the shares.
Large investors like Mark Rachesky are then able to extract private benefits from the company. Assume that a controller of the firm takes out $1 million. If the market is aware of this but did not suspect it, the stock price falls so that the market capitalization of the company falls by $1 million. However, the controller of the firm owns less than 100% of the equity, so the penalty of taking out the $1 million is only a loss on shares proportional to holdings. If own 20% of the stock, then loses $200,000.
Controlling investors can extract many types of benefits. For example, a controlling investor can delay investments or delay providing "activist" advice until the investor has accumulated his or her full stock position. This way the controller does not pay for the value the controller plans to add. The market may have some expectation of the value a controller may add, but this expectation is uncertain and will not be fully priced in to the stock.
Controlling investors can also access board seats and management more easily. This access provides tremendous amounts of valuable information. Often investors focus on sectors where their network sources opportunities. Access to important information is a large private benefit for these controlling investors.
While the equity premium is a puzzle in finance? A related puzzle is why does an equity premium exist when all firms are controlled by someone who also wants private benefits? Perhaps, the equity premium represents the minimum "bribe" to the shareholders to get them to accept the arrangement.
Sunday, March 8, 2015
Who's at fault for the Greek sovereign crisis?
The current negotiation game in Europe is to pin losses on Greek defaults on the tax payers of another country. The difficulty of determining who should lose is determining who is at fault. I cannot put my thumb squarely on who is at fault.
Is Greece at fault for borrowing heavily? Or was Greece logically exploiting access to much cheaper financing by being a member in the EU? Regardless, Greece has lost credibility in the international financial markets. Unless Greece can adhere to austerity requirements and pay down the debt slowly, Greece will have a permanent black mark in Greece's credit history.
Are the banks and countries financing Greece at fault? These financiers (often German) made the choice of parting with their funds. The financiers may have expected the EU to never default on debt or Germany to bailout any peripheral country in trouble. However, just because the financiers had incorrect expectations does not mean they should not bear the consequences of their risks. Germany stands to benefit from Greece only slowly improving since uncertainty about Greece keeps the euro from appreciating against other countries. A weaker euro makes German exports look more attractive. Germany has an incentive to keep Greece on the verge of bankruptcy for as long as possible unless the cost of bailing out Greece becomes too large.
Are the taxpayers of any country off the hook? Well, the taxpayers are most likely going to bear any losses. Banks cannot bear losses because imposing losses on banks weakens the financial system important for production and growth. Tax payers are responsible for electing their governments, and tax payers also benefit in the short term from faster economic growth and more employment. The tax payers may be the most naive when it comes to making choices regarding the financial system, but naïveté is no excuse against suffering consequences.
Is the structure of the EU at fault? The EU is a monetary union but not a fiscal union. Member countries all have incentives to act in their interests at the expense of other countries. The prolonged discussions about resolving the EU crisis reflect this lack of fiscal integration since no EU institution controls the fiscal choices of a country. The fiscal requirements in the Stability and Growth Pact that were supposed to constrain fiscal choices of member countries were relaxed when Germany and France did not want to pay penalties in 2005. Germany and France were running excessive deficits under the definition of the pact for years. Once Germany and France waived the penalties on themselves, Greece and other countries saw an opportunity to ignore the fiscal requirements in the pact.
Is Greece at fault for borrowing heavily? Or was Greece logically exploiting access to much cheaper financing by being a member in the EU? Regardless, Greece has lost credibility in the international financial markets. Unless Greece can adhere to austerity requirements and pay down the debt slowly, Greece will have a permanent black mark in Greece's credit history.
Are the banks and countries financing Greece at fault? These financiers (often German) made the choice of parting with their funds. The financiers may have expected the EU to never default on debt or Germany to bailout any peripheral country in trouble. However, just because the financiers had incorrect expectations does not mean they should not bear the consequences of their risks. Germany stands to benefit from Greece only slowly improving since uncertainty about Greece keeps the euro from appreciating against other countries. A weaker euro makes German exports look more attractive. Germany has an incentive to keep Greece on the verge of bankruptcy for as long as possible unless the cost of bailing out Greece becomes too large.
Are the taxpayers of any country off the hook? Well, the taxpayers are most likely going to bear any losses. Banks cannot bear losses because imposing losses on banks weakens the financial system important for production and growth. Tax payers are responsible for electing their governments, and tax payers also benefit in the short term from faster economic growth and more employment. The tax payers may be the most naive when it comes to making choices regarding the financial system, but naïveté is no excuse against suffering consequences.
Is the structure of the EU at fault? The EU is a monetary union but not a fiscal union. Member countries all have incentives to act in their interests at the expense of other countries. The prolonged discussions about resolving the EU crisis reflect this lack of fiscal integration since no EU institution controls the fiscal choices of a country. The fiscal requirements in the Stability and Growth Pact that were supposed to constrain fiscal choices of member countries were relaxed when Germany and France did not want to pay penalties in 2005. Germany and France were running excessive deficits under the definition of the pact for years. Once Germany and France waived the penalties on themselves, Greece and other countries saw an opportunity to ignore the fiscal requirements in the pact.
Wednesday, March 4, 2015
When do sunk costs matter for choices? An explanation of the sunk cost fallacy
A sunk cost is an unrecoverable past cost. Business school professors like to advise MBAs to ignore sunk costs when making strategic decisions. The lesson boils down to don't throw money at a bad investment when better investments are available. People have a tendency to get attached to projects or investments they have spent a lot of time with and a lot of money on. People hope to recover from bad decisions by dedicating more resources to the problems. The advice suggests that people should wipe their hands of bad decisions and strategize their investments on the margin. The logic is that one cannot go back and change the sunk expenses, so one should forget about them and choose the highest NPV (net present value) project available for new investments.
The sunk cost fallacy arises because the common definition of sunk cost is sometimes not fully appreciated. A sunk cost is not only a cost that is unrecoverable and possibly performed very poorly. A sunk cost requires that the value of the original investment can in no way be altered by current choices.
To help appreciate this nuance, consider the following example. If one half-builds a shopping mall, one has made plenty of unrecoverable investments. If one stops at any moment, then the value of the already made investments is very low, making the investments look bad. Perhaps one put in $100 million but the mall in the current condition is only worth $50 million.
Now lets think of what to do with the next million dollars. A marginal decision would examine only the return on the million dollars invested in different projects. Imagine that an investment other than the mall offers an astounding 100% return for sure - so that the one million becomes two million in a year. Assume that the investment in the mall yields 0% on the new one million. If the definition of a sunk cost is not fully appreciated, then one might be tempted to take the other project and make a 100% return.
However, this strategy ignores the possibility that the million dollar investment makes a terrible mall investment into a mediocre mall investment. The capital gain on the much larger sum invested in the mall could significantly outweigh the one million dollar gain on the other project. In order for the one million dollar new investment to beat the outside option of a 100% return, all the one million dollars has to achieve with the original mall investment is to raise the value from $51 (including new investment) to $52. In fact, the mall investment may rise from $51 to $75. Even though the investment in the mall is still negative since one put in $100 million, one is better off throwing money at the bad idea because doing so affects the value of the original investment.
So the key element of sunk cost reasoning is that the value of a previous investment or sunk cost cannot be affected by new, marginal investments.
The sunk cost fallacy arises because the common definition of sunk cost is sometimes not fully appreciated. A sunk cost is not only a cost that is unrecoverable and possibly performed very poorly. A sunk cost requires that the value of the original investment can in no way be altered by current choices.
To help appreciate this nuance, consider the following example. If one half-builds a shopping mall, one has made plenty of unrecoverable investments. If one stops at any moment, then the value of the already made investments is very low, making the investments look bad. Perhaps one put in $100 million but the mall in the current condition is only worth $50 million.
Now lets think of what to do with the next million dollars. A marginal decision would examine only the return on the million dollars invested in different projects. Imagine that an investment other than the mall offers an astounding 100% return for sure - so that the one million becomes two million in a year. Assume that the investment in the mall yields 0% on the new one million. If the definition of a sunk cost is not fully appreciated, then one might be tempted to take the other project and make a 100% return.
However, this strategy ignores the possibility that the million dollar investment makes a terrible mall investment into a mediocre mall investment. The capital gain on the much larger sum invested in the mall could significantly outweigh the one million dollar gain on the other project. In order for the one million dollar new investment to beat the outside option of a 100% return, all the one million dollars has to achieve with the original mall investment is to raise the value from $51 (including new investment) to $52. In fact, the mall investment may rise from $51 to $75. Even though the investment in the mall is still negative since one put in $100 million, one is better off throwing money at the bad idea because doing so affects the value of the original investment.
So the key element of sunk cost reasoning is that the value of a previous investment or sunk cost cannot be affected by new, marginal investments.
Tuesday, March 3, 2015
Why can't stocks with prices below $1 keep reverse splitting to avoid delisting?
Let's start with defining what a reverse stock split is? A reverse-split is a corporate action in which a company reduces the total number of its outstanding shares. A reverse stock split involves the company dividing its current shares by a number such as 5 or 10. A reverse stock split is the opposite of a conventional stock split, which increases the number of shares outstanding.
Companies have to meet minimum requirements to stay listed on exchanges. The minimum requirements vary by exchange. Let's discuss the minimum requirements for the Nasdaq Capital Markets Companies before answering the question. Each company listed on the Nasdaq has to meet the minimum requirements of at least one of the columns.
Companies have to meet minimum requirements to stay listed on exchanges. The minimum requirements vary by exchange. Let's discuss the minimum requirements for the Nasdaq Capital Markets Companies before answering the question. Each company listed on the Nasdaq has to meet the minimum requirements of at least one of the columns.
A direct limitation on the ability to do repeated reverse stock splits is the requirement to have at least 500,000 publicly held shares. Note that the 500,000 publicly held shares is not the same thing as shares outstanding. Publicly held shares equals total shares outstanding less insider holdings. Insider holdings include shares held by the company's officers, directors, employee stock ownership plan and shareholders with 10% or greater beneficial ownership of the company's shares. Often, companies with smaller market caps have concentrated ownership by insiders or significant shareholders, which more severely constrains the ability to do reverse-splits.
Why do exchanges set these minimum requirements? One possibility is to improve profitability of the exchange. While small stocks pay exchange fees, the exchange also earns revenue by levying taxes on trades. The margins are very low, so a lot of transactions need to be occur to produce real value. This story makes sense if their is a fixed cost to having a stock trade on the exchange and the contribution to the fixed costs is not adequate. Profitability has been an issue for exchanges, which is one reason exchanges have been merging with or acquiring other exchanges. These combinations have synergies by cutting duplicate IT costs for example.
Another possible reason for the minimum requirements is to keep investors out of stocks that are going to perform very poorly. The exchanges have some incentive to weed out poor performers so that investors look at companies trading on the exchange as more reputable. Reputation may lead to lower costs of capital for the firm because of greater trust by investors.
Let's see if reverse stock splits are associated with poorer subsequent performance. In theory nothing about the fundamental value of the business has changed given a stock split or a reverse stock split. However, a variety of papers have documented abnormal returns post splits. Hemang Desai and Prem C. Jain (1997) finds that 1-3 year performance of common stock following stock splits is 7.05% and 11.87% respectively. The 1-3 year performance following reverse splits has abnormal returns of -11% to -34% respectively.
The longer term abnormal returns are a puzzle and suggest that investors under react to information about the business revealed in the corporate action to reverse split the stock. Thus removing under performing companies protects investors.
However, why doesn't the information enter the stock price immediately? Why haven't investors learned about this pattern from historical data and erased the pattern with diversified portfolios shorting reverse split companies and going long forward split companies?
A few theories have materialized to try and explain the information content in a stock split. The first theory relates to managers’ private information about firm fundamentals which the market infers from a stock split announcement, while the second theory relates to increased liquidity that stocks achieve via a split. A more recent catering theory argues that managers split their stock to cater to investors who value lower priced stocks relatively more during certain times. However, none of these theories explain why the pattern in returns has not been exploited immediately.
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