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.

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.

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.

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.

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.

Why and when do corporate executives transfer shares to charities or family foundations?

Executives donating appreciated shares of stock to charities or charitable family foundations are able to obtain a personal income tax deduction for the market value of the shares. This tax deduction benefit is greater when the shares have appreciated more. Donating appreciated shares to a charitable organization also nullifies the capital gains tax that would be due if the shares were sold.

Are there restrictions on when executives can make gifts? Gifts of stock are generally not constrained by U.S. insider trading laws. Company officers can then donate shares of stock to charities during periods when selling the shares would be prohibited.

When do executives make these donations? Are they strategic in timing? A preliminary study from NYU suggests that Chairmen and CEOs of public companies often make these gifts prior to sharp declines in their companies' stock prices. Foundations hold the donated stock for long periods rather than diversifying, permitting CEOs to continue voting the shares.

How is difference-in-differences estimation useful for economics and finance?

Difference-in-differences (diff-in-diff) is commonly used in scientific and social science experiments to estimate a treatment effect. A treatment group is shocked or treated and the difference in an outcome variable for the treated group is compared with the difference in the same outcome variable for the control group.

In economic studies using observational data, the researcher does not have a clone of a person so that he can shock one and compare the treated person to his un-treated twin. Often times one region - like a state - is shocked while another state is not shocked. A key assumption researchers make when using diff-in-diff estimation with states is that the trend in the outcome variable for the treated state would have been the same as that of the un-treated state had the treated state not be treated. In other words, we do not see the counterfactual world in which the treated state was not treated. We use the untreated state as a proxy for the counterfactual world behavior but the proxy is an assumption.

The diff-in-diff test allows states to differ so long as the differences can be controlled for. States can have a time-invariant state fixed effect. For example, states can have different fixed legal codes that cause constant differences in the outcome variable. The diff-in-diff test also allows the overall environment to change over time - a year effect that is common across states. For example, a bad stock market may influence the outcome variable in all states equally. Controlling for time fixed effects soaks up all of these period-to-period changes common to all states.

The reason the diff-in-diff allows for time-invariant state fixed effects and time fixed effects is because the diff-in-diff ends up subtracting out these fixed effects. The difference from one period to the next of the treatment group knocks out the time-invariant state fixed effect. The difference leaves behind a difference in time fixed effects - i.e. the time fixed effect in period 1 less the time fixed effect in period 0. The next step - the diff-in-diff - then knocks out the common difference in time fixed effects. The remaining quantity is the treatment effect.

One can estimate a diff-in-diff treatment effect using regression. Regress the outcome variable on a constant, dummy for treatment group, dummy for time period and an interaction of the dummy for treatment group and dummy for time period.

A check on the previous diff-in-diff regression is available with panel data. Regress the outcome variable on a state specific intercept a state specific time trend variable, a time fixed effect across states and the treatment dummy, which is 1 if a state is treated in that time period. One can also add other state-specific time trends as regressors too. This approach allows treatment and control states to follow different trends. It is nice if the estimated effect of interest in the previous diff-in-diff regression is unchanged by inclusion of these trends.

Why do regulators ban short sales during crises?

Regulators regularly ban short selling during crises with the intention of stabilizing markets. The SEC halted short selling in the stocks of financial firms in U.S. markets between September 19, 2008 and October 8, 2008. Does banning short selling achieve this objective of stabilization? Short sellers generally receive bad press because they are betting on "declines" rather than "growth." Perhaps, the policy is more to reduce the ability of the informed and typically well-to-do from benefiting from the downturn. Imagine newspapers titled, "Wall Street's boom during Main Street's bust!"

The consequences of temporarily banning short selling are serious. First, short selling is important for market efficiency. Assume that investors with better information were not long the security in the first place. These investors know that the security is worth less and are willing to go short. The ban keeps the possibly better informed investors out of the market. Only the less informed owners of the stock are able to price the stock, but there information is less accurate. Less accurate prices mean policy makers and others have less accurate information about the health of the company or financial system at a time when accurate information is particularly important.

Second, short sellers cannot kill the company. Even if short sellers could force the price down to $0, the company will not fail unless the company cannot make required debt payments i.e. go bankrupt. The press often claims that short sellers can shake investor confidence. Short sellers do shake investor confidence by pricing into the market more negative information than the original investors probably had. For short sellers to really be able to cause unwarranted - erroneous - fear in the market requires an absence of other informed investors (including in the pull of short sellers) from taking the long position and keeping the stock price at an efficient level. Efficiency means the available information to traders is priced into the market.

Third, banning short sellers cuts liquidity. If short selling is integral to efficient prices, then why would investors want to buy stocks that are likely overvalued? Banning short selling defeats both those wanting to sell short and those wanting to go long. Less liquidity hurts existing shareholders who may want or have to reduce positions and sell into less liquid markets, resulting in a larger negative price impact.

Also, bans on selling certain companies short does not eliminate the ability to sell those companies short on other markets - like CDS or options markets.