How Corporate Credit Ratings Induce Short-Termism

Credit rating agencies were under particular scrutiny in the recent financial crisis, as critics argue they gave too high ratings to securities that turned out to be toxic. One potential culprit is the "issuer-pays" model, where it is the company being rated that pays for credit ratings, which may encourage rating agencies to be overly-generous to win business.

But, a recent paper by my new LBS colleague Taylor Begley points to an important additional cost of corporate credit ratings - and one that arises even if ratings are perfectly accurate. Companies may engage in short-term behavior to achieve a particular credit rating. This problem arises because credit ratings are discrete categories (e.g. AAA, AA+, BB) rather than a continuous number (e.g. 93.2, 87.8). Thus, a company has a strong incentive to just get into the AAA- category than be at the top of the AA+ category.

In turn, a major driver of credit ratings is a company's financial ratios. For example, for firms with an excellent business risk profile, a Debt/EBITDA ratio of 1.5-2.0 typically leads to a rating of AA; a ratio of 2.0-3.0 typically leads to a rating of A. For firms with a fair business risk profile, a Debt/EBITDA ratio of 1.5-2.0 typically leads to a rating of BBB-; a ratio of 2.0-3.0 typically leads to a rating of BB+ (which is below investment-grade, i.e. has "junk" status). (Source: Standard & Poor's Business Risk / Financial Risk Matrix).

These discrete thresholds thus give companies incentives to be lie just below a threshold. They can achieve this by short-term behavior such as cutting research and development (R&D). This increases EBITDA, thus reducing the Debt/EBITDA ratio and potentially meeting the threshold. Importantly, the incentives to engage in short-termism depend on where the firm is compared to the next lowest threshold. A firm with a Debt/EBITDA ratio of 2.1 has strong incentives to engage in short-termism, because it has a high chance of being able to lower it to below 2.0, but a firm with a Debt/EBITDA ratio of 2.5 has much weaker incentives. Taylor indeed finds that firms close to a threshold are significantly more likely to cut not only R&D, but also selling, general, and administrative (SG&A) expenses, which contains expenditure in advertising, information technology, employee training, and other forms of organizational capital.

Other papers have previously found evidence of short-termism to meet other types of thresholds - for example, companies may cut R&D to ensure their earnings fall just above analyst earnings expectations. But a particularly novel finding of this paper is that Taylor is able to document negative long-run effects of such short-termism. Companies close to ratings thresholds subsequently suffer declines in the number of patents that they produce, and also the number of citations to their patents (a measure of the quality of innovation). They also experience declines in profitability and valuation ratios.

The cost of credit ratings that critics typically focus upon is that inaccurate ratings lead to redistributional consequences. If the ratings of a security are too high, the buyer pays too much for them. Thus, the seller wins and the buyer loses. While these redistributional concerns are clearly very important, they don't directly affect the overall size of the pie (sellers get a larger slice, buyers a smaller slice). In contrast, Taylor shows that credit ratings have efficiency (rather than just redistributional) consequences - they affect the overall size of the pie. If companies cut investment to meet ratings thresholds, they erode their future value, making everyone worse off in the long-run. This is a particular concern for the 21st century firm, whose value is especially driven by intangible assets (such as brand strength, innovative capabilities, and corporate culture) which requires several years to build and bear fruit.

The paper certainly does not argue that credit ratings should be scrapped; these costs must be weighed against their numerous benefits. Many financial targets (e.g. analyst earnings expectations) also have the potential to lead to short-termism. Rather, the paper highlights a potential cost to credit ratings that boards may be able to mitigate. One potential remedy that discussed in a previous post is to increase the vesting period of executives' stock and options, to tie them to the long-run performance of the firm. 

Reforming CEO Pay - The Dangers of Short-Term Incentives

(This post originally appeared on LinkedIn)

Executive pay is a high-profile topic about which almost everyone has an opinion. Many shareholders, workers, and politicians believe that the entire system is broken and requires a substantial overhaul. But, despite being well-intentioned, their suggested reforms may not be targeting the elements of pay that are most critical for shareholder value and society.

Level 1 Thinking: The Level of Pay

Much of the debate is on what I call a Level 1 issue - the level of pay. For example, in September 2013, the SEC mandated disclosure of the ratio of the CEO’s pay to the median employee’s pay. The European Commission is contemplating going further and requiring a binding vote on this ratio. Separately, proposals to increase taxes – most prominently made by Thomas Piketty – are a response to seemingly excessive pay levels.

While high taxes or ratio caps would indeed address income inequality (an important topic, but beyond the focus of this article), it's very unclear that they would do much to improve shareholder (or stakeholder) value. The levels of CEO pay, while very high compared to median employee pay – and thus a politically-charged issue – are actually very small compared to total firm value. For example, median CEO pay in a large US firm is $10 million – only 0.05% of a $20 billion firm. That’s not to say that it’s not important – a firm can't be blasé about $10 million – but that other dimensions may be more important.

Level 2 Thinking: The Sensitivity of Pay

Instead, what matters for firm value isn't the level of pay, but the incentives that it provides to CEOs: as Jensen and Murphy (1990) famously argued, “it’s not how much you pay, but how”. Level 2 thinking studies the sensitivity of pay to performance. Specifically, it looks at how much of a manager’s total pay is comprised of stock and options (which are sensitive to firm value) rather than cash salary (which is less so). As the thinking goes, greater stock and options align the CEO more with shareholders and thus provide superior incentives. Indeed, Jensen and Murphy bemoaned the low equity incentives at the time as evidence that CEOs were “paid like bureaucrats”.

However, while seemingly intuitive, the idea that better-incented CEOs perform better is unclear. Out of all the banks, Lehman Brothers had arguably the compensation scheme closest to what Level 2 thinkers argued is the ideal – very high employee stock ownership. Using a larger sample, Fahlenbrach and Stulz (2011) “find some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better.” Indeed, the European Commission has recently capped banker bonuses at two times salary, seemingly reducing bankers’ incentives to perform well – but also reducing their punishment if things go badly.

Level 3 Thinking: The Structure of Pay

The concern with high equity incentives is that they encourage CEOs to pump up the short-term stock price at the expense of long-run value – for example, writing sub-prime loans and then cashing out their equity before the loans become delinquent. But, the root cause of this problem isn't the amount of stock and options that the CEO has, but their vesting horizon – whether they vest in the short-term or long-term, and thus whether they align the CEO with short-term or long-term shareholder value. Level 3 thinking thus focuses on the structure of pay.

There's anecdotal evidence that horizons mattered in the financial crisis. Angelo Mozilo, the former Countrywide CEO, made $129 million from stock sales in the twelve months prior to the start of the crisis; a Wall Street Journal article entitled “Before the Bust, These CEOs Took Money Off the Table” documented similar practices among other bank CEOs. But, we can't form policy based on a handful of anecdotes - it's important to undertake a systematic study.

In this paper, Vivian Fang (Minnesota), Katharina Lewellen (Dartmouth) and I study how a CEO behaves in years in which he has a significant amount of shares and options vesting. CEOs typically sell their equity upon vesting to diversify, and so vesting equity makes them particularly concerned about the short-term stock price.

We find that, in years in which the CEO has significant equity vesting, he cuts investment in many forms - R&D, advertising, and capital expenditure. Moreover, in these years, he's more likely to exactly meet or just beat analyst earnings’ forecasts – if the forecast is $1.27 per share, he reports earnings of $1.27 or $1.28. Indeed, the magnitude of the investment cuts is just enough to allow the CEO to meet the target. Thus, vesting equity induces the CEO to act myopically – to cut investment to meet short-term targets. These results are robust to controlling for the CEO’s other equity incentives, such as his unvested equity and voluntary holdings of already-vested equity.

In this paper, Luis Goncalves-Pinto (National University of Singapore), Yanbo Wang (INSEAD), Moqi Xu (LSE) and I show that, in months in which the CEO has vesting equity, he releases more news. This is an easy way to pump up the short-term stock price, as news attracts attention to the stock. This attention also increases trading volume, which allows the CEO to cash out his equity in a more liquid market. Indeed, we find that these news releases lead to significant increases in the stock price and trading volume in a 16-day window, but the effect dies down over 31 days, consistent with a temporary attention boost. The median CEO cashes out all of his vesting equity within 7 days, so within the window of inflation.

The increase in news releases only relates to discretionary news (such as conferences, client and product announcements, and special dividends), which are within the CEO’s control, and not non-discretionary news (such as scheduled earnings announcements). Moreover, the CEO reduces discretionary news releases in both the month before and the month after the vesting month, suggesting a strategic reallocation of news into the vesting month and away from adjacent months. In addition to releasing more news items in the vesting month, the CEO releases more positive news – media articles immediately following these news releases contain significantly more positive words than normal.

Why Do We Care?

Both consequences of vesting equity are important. Investment is critical to the long-run health of a company. Indeed, in the 21st century, most firms compete on product quality rather than cost efficiency, for which intangible assets – such as brand strength and innovative capabilities – are particularly important. Building such intangibles requires sustained investment, particularly in R&D and advertising. Moving to news, many stakeholders, such as employees, suppliers, customers, and investors, base their decision on whether to initiate, continue, or terminate their relationship with a firm on news, or on stock prices that are affected by news. In addition to these efficiency consequences, news also has distributional consequences by affecting the price at which shareholders trade. Indeed, Regulation FD aims to “level the playing field” between investors by prohibiting selective disclosure of information. Public news releases to all shareholders achieve this goal – but the CEO may delay news until months in which he has vesting equity.

What Can Be Done?

One solution is to lengthen vesting periods. While increasing vesting horizons from (say) 3 to 5 years may not be as politically alluring to voters as a rant about the level of pay, it will likely have a much greater effect on shareholder value and society. For example, such a change will now incentivize the CEO to engage in a long-term investment with a 4-year horizon.

Can clawbacks achieve the same thing, e.g. pay out a bonus upon good short-term performance and then claw it back if long-term performance lags? Despite being widely heralded and attracting much fanfare, the legality of clawbacks is very unclear: I know of no cases in which a clawback has been successfully implemented. The CEO may have spent the money, or transferred it to a spouse or a relative. Trying to claw back a bonus that you have prematurely paid (based on short-term performance) is like shutting the barn door after the horse has bolted. The best solution is not to pay out the bonus in the first place, but wait until 5 years.

Is the lengthening of a vesting horizon simply kicking the can down the road? All equity has to vest at some point, and doesn’t this mean that the CEO will now act myopically in 5 years’ time rather than 3 years’ time? I have some sympathy with this concern – indeed, one of the other implications of our papers is that boards of directors, and other stakeholders, should scrutinize CEOs in months (or years) in which they have significant equity vesting. Since most of the current focus is on Levels 1 and 2 of the CEO’s contract, most stakeholders don’t pay attention to vesting horizons. But, the main benefit will be on the CEO’s behavior today – such a lengthening will now encourage him to take that 4 year project.

In short, paying CEOs according to the long-term will ensure they have the long-term interests of the firm at heart.

Time Management Tips to Boost Your Productivity

(A shorter version of this article was originally published in CityAM. A talk on time management and personal leadership is here.)

At work, often the last thing you can do is work.  Emails flood in, colleagues make urgent requests, and fires need to be fought.  But, a few pointers can help us get the most out of each day.

Focus on the Important, not the Urgent

Traditional time management involves writing a “To Do” list and doing the Urgent tasks first.  It’s extremely addictive to tick Urgent things off your list – but you may end the day having done 9 Urgent tasks, but not the 10^th, most important one.  Stephen Covey, in his excellent book “The Seven Habits of Highly Effective People”, instead advocates tackling the Important tasks first.  Urgent tasks are those that you have to do, externally imposed by others, and often low-hanging fruit – so it’s tempting to start with them.  Important tasks are those that you want to do, internally generated by you, such as developing a new idea.  No-one’s nagging you to do them, and they take significant time.  So if we don’t prioritize them, they’ll get swept aside by the Urgent. 

Covey also emphasised that people act differently when keeping score: you’ll run faster if wearing a stopwatch.  The same is true for work.  Have a stopwatch on your desk, and start it when working on an Important task.  Stop it when you’re distracted to surf the internet, or respond to an Urgent email.  Set yourself a target of how much real work you aim to get done that day. It will change your behaviour.

Control Your Email

Urgent email burns a hole in your inbox and demands to be attended to.  How can you focus on the Important, but still meet your deadlines?  Create a sub-folder called “Today”, and another called “This Week”.  When urgent emails come in, file them in the appropriate subfolder.  When they’re out of sight, they’re out of mind, freeing you to do the Important tasks.  Then, in the late afternoon, after the Important duties have been accomplished and when your mind is less sharp, you can turn your attention to these folders.

What if the Important tasks involve writing email?  Select “Work Offline” so that you’re not distracted by incoming email when doing so.  Change your settings so that you don’t have the “new email” little envelope in the bottom right, which demands to be clicked on.  Remove the “new email” chime for the same reason.

Emails to mailing list (e.g. advertising special offers) are neither Urgent nor Important.  Such emails will have “Unsubscribe” at the bottom.  Create a new sub-folder called “Mailing Lists”, and use a filter rule (in Outlook, go to File – Manage Rules and Alerts) to automatically move messages with the word “Unsubscribe” into this sub-folder.  You can read them at the end of the day.

Outsource and Automate

Many emails you send will contain stock phrases, e.g. directions to your office.  In an Outlook email, go to Insert – Quick Parts, and save these phrases, so that you can paste them into an email at a flash. 

For incoming email that you can give a standard response to, but don’t trust an auto-responder, create a sub-folder that your secretary has access to.  File these emails into the sub-folder, and inform your secretary of the stock responses to such emails. 

For non-work-related admin, use a virtual assistant (e.g. AskSunday or GetFriday).  For example, a virtual assistant could download all talks from a website, or delete duplicate photos from your computer. 

Use Natural Stimuli

On the hour, every hour, do a short physical activity – a set of press-ups if you have your own office, a brief walk if not.  This accomplishes two goals.  First, the actual activity is energizing.  Second, you’ll try to complete the task in hand before the next enforced break.  I dislike doing press-ups, so if it’s 10:50am, I think “I only have 10 minutes before an unpleasant activity” and make the best use of them. 

As an alternative to coffee, Jamie Oliver recommends a fresh chilli.  One or two seeds will give you a pick-me up.  Sounds maverick? Maybe so, but a lot of punch can come from something very little.  That’s the art of time management.

The Effect of the 2014 World Cup on Stock Markets So Far

(Update 15 July)

The 2014 World Cup is now over. After Argentina's loss in the final, its market was up 0.2%, underperforming the world index which rose by 0.6%. Germany's index rose 1.2% - the biggest gainer among the major European indices.

Excluding the anomalous Brazil defeat (which is explained below), out of the 39 losses by a country with an active stock market, 26 (= two thirds) were followed by the national market underperforming the world market. A loss was followed by underperformance by 0.2% on average; a loss by the "big seven" soccer nations (England, France, Germany, Italy, Spain, Argentina, Brazil) was followed by underperformance by 0.4% on average.

Thanks to everyone who followed this post as the World Cup unfolded. A series of three interviews that I did on CNN on the effect of the 2014 World Cup on stock markets is here.

(Update 11 July)

So far this World Cup, most defeats have been met by national stock market declines. Indeed, Holland's market fell by 1.7% on Thursday after being eliminated by Argentina on Wednesday, while the world market fell only 0.7%. But, after Brazil's 7-1 humiliation by Germany on Tuesday, the stock market rose 1.8% on Thursday (the market was closed on Wednesday), while the world market fell 0.4% over Wednesday and Thursday. Surely this disproves the theory?!

Actually, the Brazil situation has an interesting twist. Here, the market rose because the defeat was so bad that investors think it significantly increases the chances that socialist President Dilma Rousseff will be ousted in October's elections and be replaced by Aecio Neves, the leader of the more pro-business PSDB party. The economy has been mired in stagflation under Rousseff's presidency. Her popularity may be particularly tied to the soccer team because she chose to spend billions on stadiums for the World Cup instead of keeping her pre-election promises to spend on schools, hospitals, and general infrastructure.

Is this just clutching at straws to make an excuse for a major contradictory data point? In fact, this hypothesis was predicted even before the start of the World Cup. UBS analysts argued that a Brazilian exit would boost the stock market by hindering Rousseff's re-election bid, and Brazil's Ibovespa stock index had risen 19% from a low on March 14 due to speculation that the economy's poor performance would lead to her being ousted. Overall, out of the 38 losses by a country with an active stock market, 25 have been followed by the national stock market doing worse than the world market.

Moreover, the stock market increase upon seemingly bad news is consistent with a more general phenomenon studied in one of my other papers, with Itay Goldstein (Wharton) and Wei Jiang (Columbia). Typically, we think that a high stock price suggests that the CEO is doing well. But in fact, a high stock price may suggest that the CEO is doing badly - so badly that investors think that the firm will be the target of a hostile takeover, and so bid up the price. Thus, there's an interesting two-way relationship between prices and real decisions. A low price may trigger a corrective action (e.g. hostile takeover of a CEO, replacement of a President) - but the expectation of the corrective action drives the price up.

Indeed, Commerzbank was a takeover target around the financial crisis due to its poor performance. It was believed to have adopted a rather unusual takeover defense - it spread rumors that it was a takeover target, to increase its stock price, preventing a takeover from ultimately occurring! Thus, stock prices may be self-defeating - prices prevent the very actions that they anticipate.

As Shakespeare's Hamlet said, "thinking makes it so". But in financial markets, "thinking may make it not so".

(Update 9 July)

At the time of writing, Germany is the only major European stock market that's up - all other European stock markets are down due to negative economic news. Luckily for Brazil, their stock market is closed for a public holiday to mark a constitutional revolt in 1932.

(Updated 8 July)

In an earlier post I summarized my paper (with Diego Garcia and Oyvind Norli) which shows that international football defeats lead to declines in the national stock market index. Controlling for other drivers of stock returns, a World Cup defeat leads to a next-day fall of 0.4%, and a defeat in the elimination stages leads to a next-day fall of 0.5%. We also found that the effect was stronger in England, France, Germany, Spain, Italy, Argentina, and Brazil. A brief, humorous, 5-minute talk about the paper is here. 

How has this theory played out in the 2014 World Cup so far? Typically you find that stock market effects get weaker after a paper is published, because investors are aware of the effect and trade against it. However, we have indeed seen stock market declines after defeats in this World Cup. Across all countries with a stock market index, a defeat has led to the index falling by 0.2% faster than the MSCI World index. Moreover, defeats by the "big seven" countries (notably England, Spain, and Italy) have led to declines of 0.5%. Out of the 36 defeats by countries with an active stock market, 24 have been followed by market declines faster than the MSCI World.

Let's look at some of the most negative stock market responses:

Spain 1-5 Netherlands. The Spanish market fell by 1% the next day, while the world market went up by 0.1%. This was a crushing and surprising defeat by the reigning world champions. 

England 0-1 Italy. The English market fell by 0.4%, while the world market was flat.

Japan 1-2 Ivory Coast. The Japanese market fell by 1%, while the world market was flat. Japan went into the tournament with high expectations since the general consensus was that they had an easy group.

Italy 0-1 Costa Rica. The Italian market fell by 1.5%, while the world market was flat. This was perhaps the biggest shock of the World Cup so far, and severely jeopardized Italy’s chances of qualifying.

Switzerland 2-5 France. The Swiss market fell by 0.7%, while the world market was flat. While this loss wasn't too unexpected, the magnitude of the defeat was severe - Switzerland were down 0-5 until late in the game. 

Italy 0-1 Uruguay. The Italian market fell by 0.5%, while the world market was flat. Italy were eliminated from the World Cup.

Japan 1-4 Colombia. The Japanese market fell by 0.7%, while the world market was flat. Japan were eliminated from the World Cup. A win would have seen them through against an already-qualified Colombia team that rested several players.

Korea 0-1 Belgium. The Korean market fell by 0.3%, while the world market was up 0.2%. Korea were eliminated from the World Cup by a Belgian side that rested several players and was down to ten men for half of the match.

Nigeria 0-2 France. The Nigerian market rose 0.3%, while the world market rose 0.7%. Nigeria were eliminated from the World Cup. 

France 0-1 Germany. The French market fell by 1.4%, while the world market fell 0.5%. Clash of two leading nations in the quarter-finals, both of which harbored hopes of winning the competition.

However, not every result has been consistent with the theory. Some losses have been accompanied by stock market increases, perhaps because these losses actually boosted national mood:

Croatia 1-3 Brazil. The Croatian market rose 0.4%, while the world market rose by 0.3%. This result did not worsen Croatian national mood, as they were believed to have played well and lost to unlucky refereeing decisions. 

Bosnia 1-2 Argentina. The Bosnian market rose 0.5%, while the world market was flat. This was Bosnia's first appearance in a World Cup and the consensus was they played very well.

Australia 2-3 Netherlands. The Australian market rose 1.5%, while the world market rose 0.9%. Australia's performance was widely praised by the press afterwards, in contrast to the significant negative coverage of the team before the tournament. 

Greece 1-1 Costa Rica (3-5 on penalties). The Greek market rose 0.4%, while the world market rose 0.1%. This was the first time Greece advanced through the group stages and so the nation was happy with the team's performance in the overall World Cup. 

However, there were a couple of losses that did lead to a decline in national mood, yet still were accompanied by stock market increases. Clearly, football results aren't the only factor that drives stock returns, because there may be some major economic news. For example, when Spain lost 2-0 to Chile, the market went up by 0.7% the next day (while the world market rose 0.5%), due to news of a new king. 

In addition, there have been losses that were accompanied by stock price declines and thus consistent with the theory, but likely these declines were caused by other factors. For example, when Nigeria lost 3-2 to Argentina, the market fell 0.6% the next day. However, Nigeria had already qualified so the loss wasn't particularly painful; the market decline was likely due to the terror attack in the capital on the same day.

While there might be particular occasions where economic news overshadows the mood impact of a football result, these idiosyncratic events will even out in a large sample. Thus, the initial paper studied 1,100 football matches (plus 1,500 matches in rugby, cricket, basketball, and ice hockey) to find the average effect of football defeats on the stock market. A football loss won't lead to a stock market decline in every single case, but it does on average, and this has been borne out by the 2014 World Cup so far. 

(Thanks to LBS PhD student David Schoenherr for his help in gathering the data for this World Cup.)

World Cup fever: Why an England loss will wipe billions off the stock market

(This article was originally published in CityAM. A brief, humorous, five-minute talk on the paper is here.)

THE WORLD Cup, which starts today, will spark a huge range of human emotions, from the excitement of victory to the despair of defeat. The effect of football results on national mood is so strong that it can spill over into the stock market and cause swings of billions of pounds. Why?

While the World Cup pits arch-rivals against each other, raring to settle scores of decades past (did Geoff Hurst’s shot cross the line in 1966? Frank Lampard’s in 2010?), there are also long-standing feuds in the halls of academia. The equivalent of England-Germany is the debate over what drives financial markets. The “efficient markets” camp argues that the price of a share incorporates every single piece of relevant information: management quality, product mix, growth options, and so on. Prices end up at the theoretically “correct” fundamental value, as if calculated by an infinitely powerful computer.

The “behavioural finance” team points out that traders aren’t computers, but humans. They’re prone to mistakes and psychological biases. Thus, share prices are affected not only by fundamentals, but also by emotions. Internet shares were wildly expensive in the late 1990s, not because these companies’ prospects were stellar, but because investors had become irrationally exuberant.

Refereeing the “efficient” versus “behavioural” match is extremely difficult. One way to settle the tie would be to compare actual prices against the theoretical “correct” value based on fundamentals. But we don’t know what the “correct” value is. It could be that, based on information at the time, internet shares were fairly valued in the late 1990s, and the subsequent crash only occurred because bad news unexpectedly came out afterwards.

But there is another tactic we can use – study whether prices are affected by emotions. Previous papers looked at whether weather affects the stock market. However, weather isn’t correlated across a country. If it’s sunny in Bristol but cloudy in Manchester, it’s not clear what will happen to the overall stock market. Moreover, the effect of weather is unlikely to be strong enough to drive your trading behaviour, particularly since traders work in insulated offices.

That’s why I chose to look at sports. Sports have huge effects on people’s emotions, these are far stronger than the effects of weather, and they can’t simply be neutralised by the office environment. When England lost to Argentina in the 1998 World Cup, heart attacks increased over the next few days. Suicides rise in Canada when the Montreal ice hockey team loses in the Stanley Cup, and murders go up when the local American Football team loses in the playoffs. International sports, like the World Cup, affect the whole nation in the same way, and lead to a large effect on national mood that is correlated across a country.

Together with co-authors Diego Garcia and Oyvind Norli, I investigated the link between 1,100 international football matches and stock returns in 39 countries in our paper Sports Sentiment and Stock Returns. The results were striking. Being eliminated from the World Cup leads to the national market falling by 0.5 per cent on the next day – controlling for everything else that might drive stock returns. Applied to the UK stock market, this translates into £10bn wiped off the market in a single day, just because England loses another penalty shootout.

The effect is stronger in the World Cup than the European Championship, which makes sense because the World Cup is the bigger stage and conjures up even more emotion. It’s stronger in the elimination stages than the group stages, because if you lose you’re instantly out. It’s also stronger in football-crazy countries like England, France, Germany, Spain, Italy, Argentina and Brazil. We also studied 1,500 other international sports matches and found a similar effect in one-day cricket, rugby, and basketball. We ruled out the explanation that the market declines are due to the economic effects of losses (e.g. reduced sales of replica merchandise, or reduced worker productivity).

Depressingly, we found no effect of a win in any sport. One reason could be that sports fans are notoriously over-optimistic about their team’s prospects. If fans go into each game expecting they’ll win, there’s little effect if they do win, but they become depressed if they lose. Another is the asymmetry of the competition: winning an elimination game merely sends you into the next round, but losing leads to instant exit. 

Let’s hope the Three Lions not only give us some cheer on the pitch, but also help to maintain the value of our portfolios.

Underperformance of Companies Holding Meetings in Remote Locations

If a company has bad news that it wishes to hide, where will it hold its shareholder meeting? As far away as possible! That’s the hypothesis of an ingenious paper entitled “Evasive Shareholder Meetings”, by Yuanzhi Li (Temple) and David Yermack (NYU Stern) that I saw at the Rotterdam Workshop on Executive Compensation and Corporate Governance yesterday.

Companies are forced to hold shareholder meetings once a year. But, such meetings can be notoriously inconvenient for management. For example, at McDonald’s 2013 shareholder meeting, a 9-year old girl was famously planted to tell CEO Don Thompson "it would be nice if you stopped trying to trick kids into wanting to eat your food all the time". Thompson's spontaneous response, "we don't sell junk food", went viral and was ridiculed by the media. 

Thus, if the company expects trouble brewing, it can choose to hold its meeting at an inconvenient location, to deter shareholders or the press from attending.  This in turn implies a trading strategy for astute investors – short companies with remote meetings.

70% of shareholder meetings are non-evasive, occurring within 5 miles of the headquarters.  But at the other extreme, Li and Yermack found 34 meetings that took place overseas. General Cable is headquartered in Kentucky but has held its annual meetings in Spain, Costa Rica, and Germany; a mining company held a meeting at one of its mines. Even for domestic meetings, the company can choose to hold it hundreds of miles from a major airport. For example, TRW Automotive held its 2007 meeting in McAllen, Texas, at the Southern tip of the continental United States near the Mexican border - 1,400 miles from the company's headquarters outside Detroit, and 300 miles from the nearest major airport (Houston). 

Particularly suspicious are companies that hold the meeting at the same location every year, but make a one-time deviation. For example, 9 out 10 years, the regional bank KeyCorp held its annual meeting close to its Cleveland headquarters, but in one hear it held it at an art museum in Portland, Maine. The authors found that firms that hold these exceptional meetings - that involve one-time deviations -  underperform their peers by 11.7% over the next six months.  Similarly, companies that hold their meetings at remote locations (defined as 50 miles from their headquarters and 50 miles from a Tier 1 airport) underperform by 6.8%.  Moreover, the future underperformance goes up with both distance measures. 

Most shareholder meetings take place in May. Thus, the subsequent 6-month period typically includes the firm’s Quarter 2 and Quarter 3 earnings announcements.  Over the whole sample, the average return to an earnings announcement is +0.41%, because firms typically meet or beat their earnings target.  However, firms that hold exceptional meetings (a one-time deviation from the standard location) suffer returns of -2.24% at future earnings announcements, suggesting that they miss their targets.

The idea of evasive management is related to this earlier post on a paper showing that companies who avoid questions from pessimistic analysts (during earnings calls) subsequently underperform.  Both papers are very clever ways to identify shifty managers with something to hide, and use this to form a profitable trading strategy.

Profiting from momentum strategies - Part 2

The previous post concerned momentum - a strategy of buying past winners and selling past losers. It discussed how this strategy does well on average, but on rare occasions (recent market downturns and high market volatility) does very poorly.

Another reason why momentum may perform poorly is because other investors are chasing the same strategy. One of the "behavioral" explanations for momentum is underreaction, and goes as follows. Suppose a company experiences good news, which increases its true value by 10%. However, the stock price may only rise by 6%, because (a) only some investors notice the news, due to limited attention - they follow hundreds of stocks, and cannot notice what happens to every single stock on a particular day, and/or (b) investors do notice the news, but have stubborn prior beliefs - an investor may have a long-standing belief that the stock is of low-quality, and may cling to this belief even after receiving the news. 

Regardless of the explanation, momentum works. You should buy a company that has risen by 6% over the past six months, because its true value has increased by 10%, and so it may gain the final 4% over the next six months.

However, what if all investors think like that? Then, they may pile into a stock that has risen by 6%. This extra buying pressure causes it to rise another 5% - so that the total increase is now 11% and so it has overshot. How does a would-be momentum investor ensure that he hasn't bought a stock that has overshot?

Christopher Polk and Dong Lou of the London School of Economics study this question in an interesting paper entitled "Comomentum". The idea is as follows. If investors are trying to exploit momentum (causing stocks to overshoot), they would have piled into many past winners, and equivalent sold many past losers. Then, the stock returns of past winners will covary with each other (i.e. move up together), and similarly the stock returns of past losers will covary with each other. They introduce a new measure, comomentum, which is the abnormal correlations among past winners and past losers - the stocks the momentum trader will trade on. When comomentum is high, this suggests that lots of investors are piling into momentum trades, and so the trades are less profitable. 

Indeed, they find that their comomentum measure significantly predicts the future profitability of momentum. The effects are economically large. When comomentum is in the top 20% of its range, the momentum strategy earns 10.4% lower returns in its first year than when it is in the bottom 20% of its range.  Simply put, when comomentum is high, other investors are pursuing the momentum strategy. This strategy is now crowded, so you should get out.