Week 10 Flashcards
Perfectly efficient markets would make it
Perfectly efficient markets would make it impossible to identify mispriced stocks using public information such as published financial reports
– Implies that we can’t use public info to ‘buy low and sell high’ because any price reaction to the info happens instantaneously
Perfectly Efficient Market
Unlikely to exist in equilibrium
If perfect efficiency exists at a point in time, there would be no incentive for people conduct such research
– Market would ‘slip away’ from efficiency, creating incentive for research
• More likely that the market is ‘close’ to efficient, as per following slide
People who are able to read, analyse and understand the implications of the new info for the asset’s future returns more swiftly than others may be able to ‘buy low and sell high’
• Why doesn’t everyone do this?
– Barriers to entry: innate ability, financial and opportunity costs of formal education, practical experience etc
– Trading profits may be viewed as a return on an individual’s investment in developing their human capital
Even if the market is very close to being efficient,
there is potential value to fundamental analysis (at least for the people who are the very best at it).
•
fundamental analysis may assist in
assessing whether a security is consistent with risk preferences / intended investment horizon
There is evidence that suggests that markets fail
Several studies, including Bernard and Thomas (1989, 1990) find evidence that suggests that markets fail to fully impound the implication of changes in current quarterly earnings for subsequent quarterly earnings
‘Post Earnings Announcement Drift’
Markets Failure to fully recognise positive autocorrelation with next quarter earnings, negative autocorrelation with 4 th quarter earnings
Does the relative amount of accruals and CFO within firms’ net profit affect the persistence of earnings (i.e. the extent to which the current level of earnings persists into the future)
Limitation
Accruals require more subjective judgement, and there is greater uncertainty as to whether an associated cash flow will EVER occur
Does the relative amount of accruals and CFO within firms’ net profit affect the persistence of earnings (i.e. the extent to which the current level of earnings persists into the future)
current period earnings which are similar in magnitude to current CFO are more likely to persist next year, relative to current earnings which are very different to current CFO
If the amount of accruals implied by a firm’s profits and CFOs does affect earnings persistence, do stock prices efficiently impound this information?
What is assumed
Given that the data underpinning Sloan’s findings are/were public info, and also the existence of anecdotal evidence that analysts consider the relation b/w Profit and CFO when valuing firms, one would expect that the greater persistence of cash flows is reflected in stock prices, and thus cannot be used to ‘beat the market’
Sloan tested the market pricing of accruals and cash flows several ways
This includes
Constructing a ‘hedge portfolio’ which includes a positive investment in firms with very high CFO relative to Net Profit and a equivalent negative investment in firms with v. High Accruals relative to Net Profit
– This zero net investment portfolio should earn a zero return if market is efficient
What did sloan’s study show in terms of market pricing
regardless of the method by which Sloan controlled for ‘normal’ market returns, a strategy of ‘buying’ firms with high CFO relative to Profit, and ‘selling’ those with high ‘Accruals’ relative to Profit earned positive returns
– Most of the return comes from the apparent mis-pricing of high accrual firms (row above ‘hedge’)
DRS(2008) broke down sources of firms profit by using an alternate ROE breakdowns to decompose income into the following ‘components’:
ACCRUALS + (ΔCASH + DISTRIBUTIONS TO EQUITY + DISTRIBUTIONS TO DEBT)
DRS(2008) thus decomposed income into the following ‘components’:
– ACCRUALS + (ΔCASH + DISTRIBUTIONS TO EQUITY + DISTRIBUTIONS TO DEBT)
– Are each of those components equally persistent over time?,
ACCRUALS and ΔCASH have similar persistence, and each much less likely to persist than DIST to EQUITY
DRS(2008) Findings
• 1) ACCRUALS and ΔCASH have similar persistence, and each much less likely to persist than DIST to EQUITY
Explain
where annual earnings and distributions to equity and debt are very similar, those earnings are more likely to persist than occurs when firms earnings differ greatly from the amount distributed to equity holders.
– The persistence of distributions to DEBT is similar to ACCRUALS and ΔCASH
DRS(2008) thus decomposed income into the following ‘components’:
– ACCRUALS + (ΔCASH + DISTRIBUTIONS TO EQUITY + DISTRIBUTIONS TO DEBT)
If there are differences in persistence, does the market correctly price those differences
Most of the market mispricing relates to the ACCRUALS and ΔCASH components. These components represent the earnings retained in the business.
– Results suggest that the market over-estimates the return available on re-invested earnings,
– May imply that investors overestimate the persistence of historic ROE when BVE is growing strongly.
Not all people accept Sloan’s (and later) results as evidence of mis-pricing
Why
As is the case with many theoretical trading strategies, an accrual based strategy implies the ability to short-sell firms that tend to be a) small and b) have illiquid equity securities
– If you actually traded on the strategy, your demand would affect the price transacted and thus the returns to the strategy
Steps in the Overall Investment Advisory Process
– (1) Establish Investor’s Objective – (2) form expectations re future returns and risks of individual securities
– (3) use (2) to make investment decisions consistent with (1)
Steps in the Overall Investment Advisory Process
– (1) Establish Investor’s Objective – (2) form expectations re future returns and risks of individual securities
– (3) use (2) to make investment decisions consistent with (1)
If we are writing a report for many potential clients, it may be hard to establish their objectives
– So, we
– So, we do 2) assuming a moderate level of risk aversion, but provide plenty of detail regarding expected riskiness in the short and long-term
Analysts’ investment reports must consider (or at least acknowledge) the objectives of investors
Why
of the investors known or assumed to rely on the report •
Investor objectives are highly idiosyncratic and must be matched with the appropriate investment. •
For example, individuals vary in terms of their: – risk tolerance – tax exposure – stage of life – other assets held etc
Sell-Side Analysts
What do they work for
work for investment banks, brokerage houses (or brokerage arms of other institutions), specialist research firms (to sell info to investment or broker firms or large companies)
Sell side analysts
– Sell or otherwise provide their equity research to investors
Sell side analyst incentive
Analysts working for brokerage firms may have incentive to encourage share trading by their firm’s clients
• Incentive for positive bias?
– Major incentive is to identify mis-priced stocks
Buy-Side Analysts
Work for
Work for institutional investors (e.g. Mutual funds / unit trusts/Super funds
work for those who buy investments
Buy-Side Analysts
Role
Provide investment advice to their employing firm, who then use this to offer products customised to investor clienteles
Buy-Side Analysts
They still are interested in
Still interested in identifying mis-priced securities, but also considers the suitability of the security for particular investment funds:
– High Growth fund
– Income (Dividend paying) generating fund
– Index Fund (a fund designed to track a particular mkt index)
End Investors
They vary in
They may
Different risk profiles, investment horizons, tax status, existing portfolio etc will influence suitability of any particular equity security to that investor
• May conduct security analysis themself • Or:
– Acquire research from sell-side analyst source
– Invest in fund with characteristics suited to their objectives
What does an Analyst do each day?
- Selection of candidates to analyze
- Inferring market expectations
- Develop/refine our own expectations
- Develop Investment Recommendation with supporting forecasts, discussion of strategic risks, investment horizon etc.
What does an Analyst do each day?
Inferring market expectation
Identifying potentially mispriced securities requires a comparison of the analysts expectations with those of the market
Selection of Candidates to Analyse
Analysts tend to concentrate their coverage by
Analysts tend to concentrate their coverage by industry/sector
– Specialisation allows for knowledge spill- overs (what you learn from analysing a firm is relevant to analysing that firm’s competitors), economises on general research time/costs
Selection of candidates
Buy-side analysts choice of firms to cover will also be constrained by
the types of mutual funds offered by their employer (e.g. Growth, income, value etc)
Selection of candidates
Others first
first screen firms based on some indicator of potential mispricing (e.g. Firms that have received positive revisions in earnings forecasts), and then analyse these firms in depth
Inferring Market Expectations
we could infer market expectations about short-term or long-term growth in earnings if we know
Current price – Current cost of equity
• And have information or informed beliefs regarding either long-term profits or short- run profits
Develop Our Own Expectations
Using our original forecasts, refined by our initial valuation and our examination of differences between our expectations and those of the market, develop our final forecasts.
Investment report
Includes: – Investment Recommendation
(BUY/HOLD/SELL)
– Supporting forecasts and valuations, with
- underlying assumptions
– Description of firm’s activities
– Discussion of Strategic Risks and Opportunities
Factors Associated with The Performance of Security Analysts
Some recent research indicates that these analysts’ recommendations
analysts’ recommendations typically outperform market index and risk benchmarks
– Research indicates that analysts play an important role in market efficiency.
Factors Associated with The Performance of Security Analysts
analysts’ recommendations typically outperform market index and risk benchmark
Sell side?
sell-side analysts have incentives to be overly optimistic with their forecasts and recommendations
Sell-Side Analysts, Biased Forecasts,
Incentives
What do studies show
Some studies find evidence of systematic optimistic bias in analysts output
Some studies find evidence of systematic optimistic bias in analysts output
How
Tendency to issue more positive recommendations
– Earnings forecasts ‘too high’
realised actual earnings are lower than the forecast level of earnings
Some studies find evidence of systematic optimistic bias in analysts output:
Earnings forecasts ‘too high’
Time of the year influence this
Forecasts issued earlier in the reporting year more optimistic, gradual become less optimistic as reporting date approaches
Possible Incentives for Bias
‘Information Hypothesis’ / ‘Management Relations Hypothesis’
Analysts may believe that issuing ‘positive’ forecasts for a particular firm will win them favour with that firm’s managers, and give them access to private info, particularly in the case of firms for which they have issued a sell recommendation
the provision of ‘private briefings’ to analysts is
Following the Regulation Fair Disclosure Act in the US (effective October 2000), the provision of ‘private briefings’ to analysts is illegal
Following the Regulation Fair Disclosure Act in the US (effective October 2000), the provision of ‘private briefings’ to analysts is illegal
In Australia
Australia, such behaviour has been proscribed for a long-time (ASX Guidance Note 8 etc) though some firms continue to be sanctioned for ignoring this requirement.
Subsequent research (Eames et al 2002) using pre-Reg FD data, but which controlled for the level of actual earnings being forecast, found:
– Forecasts are systematically optimistic when
recommendation = BUY – Forecasts are systematically pessimist when
recommendation = SELL – NOT CONSISTENT with INFO HYPOTHESIS
Bias in Analyst Forecasts and Recommendations
Trading incentives
Where sell-side analysts work for a firm that offers brokerage services (i.e. Brokerage houses or investment banks with a brokerage function), more optimistic recommendations / forecasts may encourage trading (and thus transaction fees)
– Any investor can act on a ‘buy’ recommendation
– Acting on a ‘sell’ recommendation requires either that you already own the stock, or are able to ‘short-sell’ that stock
Bias in Analyst Forecasts and Recommendations
Objectivity Illusion
behavioural tendency to unconsciously process information in a manner that supports one’s goal
Bias in Analyst Forecasts and Recommendations
Objectivity Illusion
Example
– If I’ve issued a BUY recommendation, I may process subsequent info (e.g. Relevant to future earnings) in a manner that biases my forecasts upwards
– If I’ve issued a SELL, the opposite may be true.
Analyst Incentives Surrounding Particular Events
Investment Banking Incentives
In addition to evidence of general optimism in analyst forecasts, the investment banking business of some analysts’ employers may provide incentives to bias recommendations/forecasts
Investment Banking Incentives
Optimistic recommendations / forecasts for a firm expected to need advisory services may:
– Increase the chance that the analysts’ employer actually wins the tender for the advisory services
– If they do get the deal, optimism might increase the chance that the transaction is executed successfully
Analyst Bias and Seasoned Equity Offerings
When a listed firm issues additional equity to the market,
it is common to engage an investment bank to:
– Advise on price / terms of issue and help
market the issue – Underwrite the issue (i.e. Agree to purchase any unsubscribed stock)
Lin and McNicholls (1998) find that recommendations issued by analysts who work for the investment bank(s)
acting as underwriters for a firm are systematically more positive than the recommendations issued by ‘unaffiliated’ analysts
• Lin and McNicholls (1998) find that recommendations issued by analysts who work for the investment bank(s) acting as underwriters for a firm are systematically more positive than the recommendations issued by ‘unaffiliated’ analysts
When are recommendations observed
Recommendations observed immediately prior to the public announcement of the SEO and who is underwriting it
Investment bias
Sources of Bias
Strategic bias
Stronger recommendation before the SEO could increase the chance of winning the underwriting contract.
Investment bias
Sources of Bias
Non Strategic bias
Investment banks genuine positive beliefs about the client are more likely to bid for the underwriting offer.
Lin and McNicholls also found some (weak) evidence
evidence the stock market responds differently to the recommendations issued by affiliated analysts in the 2-year period following the SEO
– Market views ‘HOLD’ recommendations made by affiliated analysts as ‘optimistic’
• Found no bias in earnings forecasts
Post-Global Settlement
Appears that the GS has been effective in reducing the apparent bias in recommendations issued by affiliated analysts
– Kadan et al (2009) & Clarke et al (2009)
systematic difference in recommendations across affiliated and unaffiliated analysts has become smaller since GS. However, a difference persists
NYAG and SEC Investigations into Analysts
Following the Dotcom crash, the New York Attorney General, and the Securities Exchange Commission commenced inquiries into the behaviour of analysts at a number of investment banks.
SRO Rules 2002
At about the same time as the GS was being negotiated, the most important US self-regulatory authorities (NYSE, NASDAQ) introduced reforms to their rules regarding analyst conduct which mirrored several of the provisions of the Global Settlement, and applied to basically all analysts operating in the US.
Global Settlement 2002/03
Following evidence of widespread undue influence of investment banking (and trading) activities on research analyst behavior, the SEC, NYSE and NASD reached an agreement with 12 investment banks
– IBs to separate their research division from IB
and Trading arms – IBs to pay for the provision of independent
analyst reports for a period of 5 years – IBs to pay fines of approx $900m
The (semi-strong) EMH posits that
security prices reflect all publicly available information immediately and without bias.
A simple measure of the impact of accrual accounting is
Total Accruals = Net Profit - Cash From Operations
• E.g. Uncollected credit sale makes Profit higher, but does not affect CFO
Finding of Dechow Richardson and Sloan (2008)
First finding
- Only FCFE has greater persistence than accruals
Accruals, the Quality of Earnings and Stock Prices
Firms vary according to the extent to which
Firms vary according to the extent to which reported Net Profit is composed of CFO and Accruals
Change in cash + accruals represent
funds reinvested in firms
because both will become operating assets
Finding of Dechow Richardson and Sloan (2008)
second finding
- Change in cash and distribution to debt (FCF debt) have similar persistence with accruals
Finding of Dechow Richardson and Sloan (2008)
3rd finding
- investors misprice the funds reinvested / the proportion of free cash flow the firm retains
how to interpret the Dechow Richardson and Sloan finding
investors normally overestimate on the return on the funds reinvested in the company
Why would investors overestimate the return on the reinvested funds
If investors believe ROA/ROE will persist, they will overestimate the return
companies with high ROA/ROE will they be able to sustain
Not sustainable because of competition equilibrium
New competitors will come into market and share a proportion of profit –> reduce ROA/ROE
Why would FCFE have higher persistence than accruals?
Dechow Richardson and Sloan (2008)
High FCFE signals management’s positive view of the future
they believe will be able to sustain enough cash in future to distribute to shareholders as dividends
Suppose you observe two firm’s current annual financial statements. Firm A has net income of $100, comprising $10 of accruals, a $5 increase in the cash balance over the year, and distributions to equity (dividends) total $85. Firm B also has net income of $100, $10 of accruals, a $50 increase in the cash balance, and $40 of distributions to equity holders. According to DRS’s evidence, which of these firms is most likely to be able to sustain earnings of $100 next year? Again, according to DRS’s evidence, does the market appear to efficiently price the information contained in the components of earnings? Explain
Which company will have higher persistence for earnings?
Company A is more likely to sustain earnings next year because FCFE is higher and FCFE has higher persistence than cash balance and accruals
Suppose you observe two firm’s current annual financial statements. Firm A has net income of $100, comprising $10 of accruals, a $5 increase in the cash balance over the year, and distributions to equity (dividends) total $85. Firm B also has net income of $100, $10 of accruals, a $50 increase in the cash balance, and $40 of distributions to equity holders. According to DRS’s evidence, which of these firms is most likely to be able to sustain earnings of $100 next year? Again, according to DRS’s evidence, does the market appear to efficiently price the information contained in the components of earnings? Explain
How about company B
Company B, has a large increase in cash balance. Unless it immediately reinvests cash in operations, the ROA and ROE will drop. Why? cash balance earns lower rate than ROA and ROE
A firm’s net profit is composed of two elements
transactions for which a related operating cash flow occurred during the period, and accruals (such as uncollected credit sales):
Earnings = Cash From Operating Activities + Accruals
Earnings = cash from operations + accruals
Why might the relative magnitudes of Cash From Operations and Accruals in relation to Earnings affect the usefulness of current earnings for predicting future earnings
Higher accruals means earnings is less useful for predicting future earnings
What are some usually recommendations
Buy shares, sell shares or hold shares
What recommendation is the most effective
Buy because it is applicable to anyone. You
Why might sell analysts recommendations be subject to bias
to get info from management, improve relationship with management
Increase the chance of their employers having more contracts underwriting IPO
Increase chance of mergers and acquisition being executed
Boost the trading volume (or revenues) of employer so they get higher remuneration
Sloan’s paper showers
Chance of persistence for accruals is lower than cash flows
Want to predict earnings, more useful to use cash flow
Cash flow is more useful because persistence is higher
DRS 2008
what is cash equal to
If income + interest expense – accruals = cash
Regulation Fair Disclosure Act 2000
Purpose: Prevents companies from leaking private info to analysts
DRS 2008
Income =
Change of cash + distribution to debt (payment to loans) (FCF debt) + distribution to equity (FCFE)
Main provision of Regulation Fair Disclosure Act 2000
Companies must disclose market sensitive info to all investors at the same time
reduces incentive to bias recommendation
Regulation Fair Disclosure Act of 2000
What impact might this act have had on sell-side analysts’ incentives to intentionally bias their recommendations
If analyst doesn’t get private info from managers beforehand, they can only base forecast on calculation
In 2002 two related regulatory reforms were effected in the US
Global Research Settlement and SRO Rules
Explain the major provisions of Global Research Settlement
separate investment banking decision with research division.
Applies to all investment banks
so that they do not get info from research division, reduces conflict of interest
- separate analyst compensation from investment banking outcomes so they wont get high pay if company gets high revenue –> less incentive to bias recommendation and forecast
Fixed salary
In 2002 two related regulatory reforms were effected in the US
Global Research Settlement and SRO Rules
Explain the major provisions of SRO Rules
separate analyst compensation from investment banking outcomes so they wont get high pay if company gets high revenue
Fixed salary
For US based analysts and brokers
Dechow, Richardson and Sloan (2008) extended the Sloan (1996) analysis, to study the relationship between
earnings persistence, and the following components of current year earnings: accruals (the increase in net operating assets), the increase in the cash balance held, distributions to equity holders, and distributions to debt holders.
Accurals vs cash flows
accruals are less persistent than cash flows, i.e., conditional on earnings
today, firms with higher accruals tend to be less profitable in the future
Explain why accruals have low persistence
reason 1
accruals contain transitory measurement error that inflates today’s earnings at the expense of future profits
Explain why accruals have low persistence
reason 2
the second is that accruals are closely linked to investment and predict lower
future profitability because of diminishing marginal returns, adjustment costs associated with investment, or
conservatism in accounting
what did sloan’s study 1996 say about accruals
accruals might contain transitory measurement error that reduces
the persistence of accruals relative to cash flows.
implications of accruals having a transitory measurement error
b/c accruals contain transitory measurement error high accruals are a sign that earnings are inflated and will likely drop in the future.
the measurement-error hypothesis also implies
that accruals should predict earnings more strongly in the short
run than in the long run.
Explain how accruals are a poor predictor of profit with reference to competition
in the short term
firms sell differentiated products and can earn temporary abnormal profits because of product innovation or an increase in demand. When this happens, the firm should grow—sales, working capital, and long-term assets would all increase
Explain how accruals are a poor predictor of profit with reference to competition
in the long term
—because of growth in sales, WC, LA, will also attract new competition that would be expected to reduce subsequent profit
margins.
high accruals today might predict a profit decline in the future as margins are driven
down by new competition.
Stock prices do not
stock prices would appear not to respond
completely and immediately to information as visible and freely available as
publicly announced earnings
As Bernard and Thomas note, the evidence is consistent with a
market that
As Bernard and Thomas note, the evidence is consistent with a
market that ‘fails to adequately revise its expectations for quarter t + 1
earnings upon receipt of the news for quarter t’
Post earnings announcement drift
Firms’ stock prices move predictably after earnings announcements
Tendency for stock prices react quickly to earnings reports, but continue to drift in the same direction for three quarters and then
partially reverse in quarter four.
PEAD is the tendency of a share price to drift
downwards weeks after a company has announced an earnings downgrade (or to drift upwards after a company has
announced an earnings upgrade
Finding by Bernard and Thomas
on average, companies that announced
the greatest positive earnings surprise tended to outperform
the general market by 2% in the following 60 days.
companies with the largest negative earnings surprise tended to under perform the market by 2% in the following 60
days
What causes PEAD
A company’s results simply don’t switch from one quarter to another. Good and bad trading results tend to flow on for several quarters.
analysts who are surprised two
or three times by a company’s downgrade announcements learn to factor it into their estimates, to the point where they
tend to over-compensate in their estimates.
Sloan shows that
investors act as if
if they do not anticipate the lower persistence of the accrual component
of earnings, resulting in significant security mispricing
Sloan argues that the key factor driving the different properties of the accrual and
cash flow components of earnings is
the greater subjectivity involved in the estimation of accruals.
Accountants more typically refer to the degree of subjectivity involved in an accounting measurement in terms of the verifiability of that measurement
Sloan defines accruals as
Non cash working capital less depreciate expense
Findings of Sloan
accrual portion of earnings is less persistent than cash portion
profitability drops when accrual reverses
Results of Sloan’s findings
Current earnings is less likely to persist if it is attributable to accrual portion rather than cash portion
DRS demonstrate that the persistence of the free cash flow component of
accounting earnings depends
on how the firm chooses to distribute (fund) free cash flow
surpluses (deficits)
Earnings or net income reported under the accrual accounting basis is
a combination of
cash flow from operations and accrual components (Sloan; DRS)
share prices do not fully differentiate
the information content between
accruals and cash flows information (Sloan 1996
Persistency means
the degree in which the current period components transpire again in
the future periods
lower persistence of accruals in future periods may be due to
the poor
reliability aspect of accruals resulting from estimation errors or intentional opportunistic manipulations
also lower accruals persistency is not due to earnings management or manipulations, but
instead associated with
economic growth factors, such as diminishing marginal returns
from increasing level of investments rather than accounting distortion
Market and accruals
the market systematically over-estimates the persistence of accruals that
have a tendency to reverse and under-estimates the persistence of cash flows.
Sloan who argued
that investors are
unable to distinguish between the more persistent cash component of earnings and the accrual component of earnings that has a greater tendency to reverse.
Dechow, Richardson, & Sloan (2008) observed that
observed that a company’s free cash flows could be alternately paid
out to investors as dividends or stock repurchases, used to retire company debt, or retained within the company as
cash balances.
Dechow, Richardson, & Sloan found that cash paid out to
investors was most valuable
Dechow, Richardson, &
Sloan offered four conclusions from their research: First,
earnings alone were an insufficient benchmark with which
to evaluate a company.
DRC
Second,
cash retained by a company for its projects was less valuable than cash paid out to
investors or used to retire debt.
DRC
Third
companies with large accruals had lower earnings persistence and lower
future returns to investors than companies with relatively higher cas
DRC
Fourth
in valuing a company, cash retained
within the company was less valuable than cash paid out.
What is the global settlement
is an enforcement agreement that took effect in 2003 between SEC, NAD, NYSE, New York Attorney General and 10 of the largest investment firms
As part of the Global Settlement, the Settling Firms
agreed to
several rules designed to prevent abuse
stemming from pressure by investment bankers on research analysts to provide favorable coverage of specific issuers or securities
Rules arising from Global Settlement
Settling Firms were required to separate their Investment Banking and Research departments from each other both physically
and with information “firewalls.”
Another rule of Global Settlement
budget allocation for Research was to be independent of
Investment Banking
Objective of global settlement
promote analyst independence, additional disclosure re conflicts
What did SRO do
rules and safeguards to separate research
analysts from the review, pressure and oversight of investment banking sector
Object of SRO
intended
to ensure the integrity of research, and to protect investors from being misled as a result of a failure to
disclose potential conflicts of interest.
