Behavioral Corporate Finance

Behavioral Corporate Finance

Outline Rational Corporations in Irrational Markets
Financial Decisions: Equity offerings, Buybacks, Debt issues, and Dividend policy Investment Decisions: Real investment

Rational Corporations-Financial decisions
In chapter 7, corporate managers are assumed to behave rationally and attempt to take advantage of investors’ irrationality and temporary market anomalies. Financial Decision Financial decisions of rational managers in the irrational markets are about catering to investor taste and market timing, that is, supplying the market with instruments that investors are particularly fond of at a given moment in time and taking advantage of temporary mispricing.

Equity Offerings 1. IPO Starting with Ibbotson and Jaffe (1975), a number of studies have demonstrated that IPOs tend to cluster both in time and in sectors. Rational explanation IPO clustering could be potentially due to the clustering of real investment opportunities. However, empirical evidence suggests that the connection to real investment is weak.

Behavioral explanation Decisions on equity issue seem to be driven mainly by temporary overvaluation and market timing attempts. The IPO market timing hypothesis is supported by the evidence of poor post-IPO performance both in terms of operational results (Jain and Kini, 1994; Mikkelson et al., 1997; Pagano et al., 1998), as well as negative abnormal long-term post-IPO stock returns (Ritter, 1991; Loughran and Ritter, 1995).

2. SEOs (seasoned equity offerings) SEOs also tend to be driven by temporary market valuation. The market timing and overvaluation hypothesis for SEOs are also supported by poor post- SEO returns (Loughran and Ritter, 1995; Spiess and Affleck-Graves, 1995; Lee, 1997; Ritter, 2003). Buybacks A number of studies carried out on the US data found positive long-term excess returns following buybacks (Dann, 1981; Lakonishok and Vermaelen, 1990; Ikenberry et al., 1995).

Market Overreaction. Peyer and Varmaelen (2009) observe that stocks experience the most significant positive long-run excess returns if the repurchase is triggered by a severe stock-price decline during the previous six months. They argue that the buyback anomaly is driven mainly by the market overreacting to bad news publicly available prior to the repurchase, rather than being a result of positive insider information held by the management.

Inside information of Managers. Babenko, Tserlukevich, and Vedrashko (2012) find a positive relation between insider purchases prior to buyback announcements and post-announcement short-term and long-term returns. Managerial manipulation. Gong et al. (2008) find that both post-repurchase abnormal returns and reported improvements in operating performance are driven by the management of pre-repurchase downward earnings rather than genuine growth in profitability.

Supporters of market efficiency argue that buyback anomaly is not really anomalous. There are several methodological issues that bias long-term abnormal returns and provide illusory results. Survivorship bias: companies that conducted a buyback and later went bankruptcy are not included in the sample. Risk-change hypothesis: companies after buyback are exposed to more financial risk. Liquidity hypothesis: a purchase reduces liquidity.

Debt issue Market timing of debt issuances is related to two general aspects—a decision to issue new debt when its cost is unusually low and a choice between issuing short- and long-term debts. CFOs interviewed by Graham and Harvey (2001) admitted that they issue debt when they think “rates are particularly low”. Their answers also indicate that the yield curve influences the maturity of new debt. The answers in the survey better fit the segmented market hypothesis.

Guedes and Opler (1996) confirm the survey responses with respect to maturity timing. In their sample consisting of 7,369 debt issues in the United States between 1982 and 1993, debt maturity shows a strong negative relation to the difference between long and short-term bond yields (term spread). Similar results in aggregate data are documented by Baker, Greenwood, and Wurgler (2003). They find a negative relation between the cumulative share of long-term debt issues in total (long and short) debt issues and the term spread.

Dividend Policy There is common agreement on some empirical facts about dividends. Fama and French (2001) document that the proportion of dividend-paying firms has been declining since 1960s. They associate the decline in part with changing characteristics of publicly traded firms, which tilts toward small firms with low profitability and strong growth potential. Konieczka and Szyzka (2013) find that the declining trend persists when small and low-profit firms are excluded.

Dividends are primarily paid by large and well- established firms with low idiosyncratic risk and relatively lower market risk. In 2011, dividend payers constituted only 55 percent of Konieczka and Szyzka (2013) sample, but contributed to over 74% of market capitalization. Investors consider dividend initiation (omissions) as a good (bad) signal. Stock prices react positively to dividend initiation and negatively to announcements of dividend omissions. The negative reaction is much stronger (Michaely et al., 1995).

Because of the strong adverse market reaction to dividend omissions or declines, managers are cautious about initiating or increasing dividend payments unless they are convinced that the firm will be able to maintain the payout policy. They also tend to smooth the payments over time. In the result, dividend volatility is far lower than the volatility of earnings and lower than the volatility of stock prices (LeRoy and Porter, 1981; Shiller, 1981; Campbell and Shiller, 1988).

The catering theory of dividend proposed by Baker and Wurgler (2004a) might be seen as a special case of managers adapting their policy to the clientele, where the “clientele” is changing due to its own dynamic preferences. Investor sentiment and demand for dividend stocks vary over time causing differences in relative valuation of payers and non-payers. Trying to exploit this mispricing, managers respond with shifts in their dividend policy.

Baker and Wurgler use a measure called the dividend premium, which is the difference between the average market-to-book ratios of payers and non-payers. They argue that firms initiate dividends when the existing payers are trading at a premium to non-payers. On the other hand, dividends are more likely to be omitted when payers are traded at a discount.

Baker and Wurgler see the dividend premium as a reflection of investor sentiment for “risky” non- paying growth firms versus “safe” dividend payers, since it falls in growth stock bubbles and rises in crashes. Fuller and Goldstein (2011) show explicitly that payers outperform in market downturns.

Rational Corporations-Investment decisions
Real investment There are various ways in which irrational investor sentiment may influence real investment decisions of rational managers. 1. Stock and debt markets affect investment through their influence on the cost of funds. 2. Managers may make their decisions catering to investors’ beliefs and temporary preferences. Generally, catering may take the form of increasing the scale of investment when investors favor growth, and under-investing when investors are skeptical.

The empirical evidence on the direct link between stock prices and investment is mixed. 1. Morck, Shleifer, and Vishny (1990) find the explanatory power of stock returns on investment is weak after considering changes in firms’ fundamentals, such as growth rate in cash flow and sales. Blanchard, Rhee, and Summers (1993) also find that non-fundamental residuals of stock price changes have little predictive power for the level of investment. On the other hand, Galeotti and Schiantarelli (1994) document that both fundamental and non-fundamental parts of stock price changes have significant effects on firms’ level of investment.

2. Another approach uses various proxies for mispricing and then examine the relations between these proxies and investment. Polk and Sapienza (2009) use discretionary accruals to identify mispricing. Firms with high discretionary accruals have subsequently relatively low stock returns, suggesting that they are overpriced. Polk and Sapienza regress firm-level investment on discretionary accruals and find a significant positive relation between the two variables.

Baker and Wurgler (2007) propose the sentiment index as a proxy for misvaluation. McLean and Zhao (2014) use that measure and show that investor sentiment has a significant impact on firms’ investment decisions. The relation between internal cash flow and investment declines with the growth of sentiment. When the sentiment is low, more projects are forgone due to financing constraints. If managers are careful to select the few most profitable projects, then the average return on investment is high.

On the other hand, firms tend to overinvest in high sentiment states, either because they cater to investors’ expectations, or because easy and cheap access to funding encourages acceptance of projects of lower quality. As a result, stock returns following investment made in high sentiment states are significantly lower than stock returns on investment made in low sentiment periods. Stein (1996) and Baker, Stein, and Wurgler (2003) show that mispricing driven investment is most sensitive in equity-dependent firms.

Behavioral Corporate Finance

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