Sunday, March 24, 2013

Does the Market Fail to Reward Long-run Managers?

        In the Wall Street Journal’s Intelligent Investor column, Jason Zweig reported on March 23 that the short-term focus of the stock market, measured by increasingly active trading and dramatic market reaction to apparently short-term information, was having an impact on executive decision making.  More specifically the article noted that,
This past week, Oracle's ORCL -0.99% stock lost 10% in a day after the company fell short of quarterly earnings expectations by one penny per share, and shares in FedEx  FDX +2.05% dropped by 9% in two days after a sharp decline in quarterly profits.  Investors with such itchy trigger fingers make corporate managers gun-shy—and that, in turn, might hurt profits in the long run. A survey of more than 400 senior corporate executives in 2003 found that 59% wouldn't invest in a project that would generate significantly higher long-term profits if it reduced earnings in the short run.
   Such an interpretation is unfair to the market.  Neither the price drops in response to earnings nor the active trading implies that the market is not attempting to assess the long-run value of a company.  In fact, the case of Facebook and many other technology companies is dramatic evidence of how far out the market looks.  Otherwise, how could Facebook have a market capitalization of more than $62 billion on the basis of its current, relatively anemic earnings?  It takes a little analysis to explain how a long-term oriented market could respond so strongly to apparently short-term information, but the key idea is the difference between projections, plans, and objective evidence.

    Presumably every major American company has a long-term strategic plan.  What’s more, management presumably has concluded that its current plan is the best one for creating value.  Otherwise why would that be the plan?  It should come as no surprise, therefore, that if managers are asked whether they have a plan for maximizing shareholder value, they will always answer, “yes.”  But since everyone will always say yes, the market cannot rely on what is said to evaluate a company’s long-term prospects and plan – it needs objective evidence.  The most important objective evidence to which investors have access is actual financial performance.  Unfortunately, that information arrives only in short-term quarterly installments.  There is no way for investors to observe the “long term” except via short-term increments.  What is critical to recognize is that the reaction to those short-term announcements reflects the market’s effort to use the objective evidence to reassess the company’s long-term outlook.  Oracle and FedEx dropped not only because they missed current earnings expectations, but because of what those misses implied about the earning power of the companies going forward.  A more dramatic example is Apple.  Apple dropped from $705 to $420 on the basis of apparently minor short-term news, not because the market is short-term oriented, but because that news led to reassessment of Apple’s long-run competitive position.  You might argue that the market overreacted to news regarding Apple, that the long-term implications of the news were not that significant, but that is a different argument the thesis of which is that the market does not properly assess the long-term implications of short-term news, not that it fails to consider those long-run implications.

    The foregoing can be demonstrated more formally by taking advantage of data on the revisions of analysts’ forecasts in response to earnings announcements.  In a comprehensive paper Bill Beaver, Wayne Landsman, Steve Stubben, and I show that when stock prices move sharply in response to earnings announcements, it is not the current earnings surprise that is the primary cause of the stock price movement; it is the revision of expectations for future earnings up to five years into the future.  This research makes it clear that the market is using short-term objective information to update its assessment of the company’s long-run outlook.

   In light of the foregoing, rejecting projects that offer long-term profits because of short-term negative impact on earnings is completed misguided.  Companies that adopt such a viewpoint have a long-term problem – namely managers who fail to understand how the capital market operates and penalize their shareholders and society as a result.

Friday, March 8, 2013

Property Rights and Incentives

            A constant theme in this blog has been that the key to successful economic policy is “getting the incentives right.”  One element of making incentives work is establishing that property rights are secure and well defined.  An obvious, but often overlooked, fact is that the incentive to produce requires property rights to the fruits of one's labor.  Without a legal system which fairly enforces property rights, the incentive to produce is greatly diluted by the incentive to become a “political lobbyist.”

           Recent work by Hernandode Soto demonstrates the importance of the interplay between incentives and property rights in the context of the Arab Spring uprisings.  Mr. de Soto notes that in Egypt, for example, 82% of the businesses and 92% of the land holdings are unrecorded and thus unprotected by the rule of law.  Such failure to secure property rights plays havoc with incentives.  Without objective and fair legal protection, the only way to safeguard the value of a business is by courting government officials, hiding from government officials, or attempting to overthrow government officials.  Unfortunately, none of the above makes for a productive economy or a stable society.

Monday, March 4, 2013

Apple, Buybacks and Einhorn

            A decade ago I published an article in the MIT Sloan Management Review arguing that the information that was most important for a company’s Board to discharge its duties was a carefully prepared analysis of the company’s fundamental value.  That is doubly true today for Apple.  Managers and boards are better able to estimate fundamental value because they know the company’s strategic plan.  In Apple’s case that means knowing what products the company plans to develop in the years ahead.

            In previous post, I calculated that if Apple could basically maintain its current position, even without substantial real growth, the stock should be worth around $600 per share.  If that is close to being true, then Apple management has an obvious thing to do with its cash – buy Apple stock.  No less than Warren Buffett has noted that doing so amounts to buying dollars bills for 80 cents.  (Actually 71 cents if the $600 valuation is correct.)  There is no need for complicated preferred shares such as those suggested by David Einhorn, just buying back the stock is the best thing that Apple can do for its shareholders.  Viewed in this light, the fact that the company has not announced a major buyback might be a warning sign.  If management believed the true value of the shares was $350, then buying them back today would be equivalent to paying $1.21 for dollar bills.  I don’t think Mr. Buffett would approve of that.

Sunday, March 3, 2013

House of Cards

            Netflix is airing an entertaining series about Washington entitled “House of Cards.”  It stars Kevin Spacey who is a sensational actor.  The 13 segment series focuses on the machinations of Washington life.  As the majority party Whip, Mr. Spacey engages in all sorts of nefarious schemes to increase the personal power that he openly covets.  Along the way, there are episodes with drugs, hookers, and infidelity, as well as the usual lying and cheating.  It is hard not to get hooked by the series.  It is very entertaining.

            On the other hand, consider Ben Bernanke.  As a fellow scholar, I have followed Mr. Bernanke’s career and research from the outset.  Mr. Bernanke’s professional life has consisted primarily of decades of studying the complicated details of monetary theory and policy.  When he rose to head of the Federal Reserve, Mr. Bernanke attempted to put his decades of study to work to help guide the central bank and the nation through a perilous time. 

            Now that does not mean I agree with all of Mr. Bernanke’s policies.  Nor do other economists more distinguished than I such as John Taylor and John Cochrane.  But that is not the point here.  The point is that Mr. Bernanke is not entertaining.  No mistresses, no cocaine, no hidden agendas.  What a bore.  There will never be a “House of Cards” about Mr. Bernanke.  The unfortunate fact is that entertainment will always be a biased depiction of reality because it must be entertaining.  The cultural implications of that fact would be interesting to explore.  But for now, thank heavens for boring people like Mr. Bernanke who spend a lifetime studying what they think is best for the country and then attempting to implement what those studies indicate.  Perhaps the most depressing fact about Mr. Spacey’s character is that he spends so much time pursuing power that he has no meaningful idea what to do with the power he achieves.