Allen Michel

Does Business Diversification Affect Performance

* In spite of the trend toward diversification during the past decade, relatively little is known about the relationship between financial performance and the extent to which a firm diversifies. This study relates several measures of financial performance to the degree of relatedness of a firms operations. The empirical question of whether shareholder value is increased through increasing amounts of diversification is investigated. The study concludes that firms diversifying into unrelated areas have been able to generate superior performance over those with predominantly related businesses.

Municipal Bond Ratings: A Discriminant Analysis Approach

The financial dilemmas faced by large municipalities, due in general to decreasing tax bases, increasing public services, inflationary pressure and in some cases fiscal irresponsibility, have brought increased attention to the subject of municipal bond ratings. In order to gain insight into those factors which are most significant in explaining the ratings, a set of financial ratios is investigated. Such ratios are frequently used to describe characteristics of the risk of municipal obligations. This paper attempts to determine if these ratios can be effectively used to predict ratings.

Evaluating Merger Performance

This article surveys the available empirical evidence assessing merger performance; its conclusions are important to the senior management of both potential acquirers and firms seeking to be acquired. The authors examine relative gains to the merging units, changes in their risk characteristics, and changes in the operating results of the merging firms.

Not All Buybacks are Created Equal: The Case of Accelerated Stock Repurchases

This paper investigates the new and growing practice of accelerated share repurchases (ASRs). In an ASR a firm hires an investment bank to borrow shares from existing investors. The investment bank delivers these shares to the firm, and the firm eliminates the shares immediately. The bank then repurchases shares in the open market over a period of several months and returns them back to the lenders. We document the characteristics and market performance of ASR stock. ASRs are primarily used to accelerate existing open-market repurchase programs. While the announcement return on ASRs is positive, it is very small when compared to other repurchase methods. Interestingly, the post-announcement performance of ASR stock is poor, unlike that documented in the literature for other repurchase methods. Our findings suggest that ASRs do not signal undervaluation, a motivation frequently suggested by analysts and academics for repurchases. The firm is getting the shares today but only will pay tomorrows price.

Stock Repurchases and the EPS Enhancement Fallacy

A common belief among practitioners and academics is that the increased EPS associated with a stock repurchase creates value for a firm’s shareholders. This belief is flawed. With the use of a numerical example and an analysis of ExxonMobil’s recent stock repurchases, this article demonstrates the magnitude of the distortion that arises from using EPS to make such repurchase decisions. The effect of share repurchase is also compared with the effects of alternatives—payment of dividends and cash accumulation. Relative to cash accumulation, neither the negative effect of dividends nor the positive effect of repurchases on EPS is associated with changes in the wealth of shareholders at time zero. Record numbers of firms have carried out share repurchases in the past several years. Recently, firms as diverse as 3M, Capital One Financial, Caterpillar, CBS Corporation, and Accenture announced repurchases of more than

Have We Learned from Previous Stock Meltdowns

1 billion each. A commonly cited reason in firm press releases and executive surveys for the increased use of share repurchases is to increase EPS. This article addresses the effect of stock buybacks on both a firm’s earnings per share and the value of an investor’s holdings. We demonstrate an important but generally ignored effect of increasing a firm’s EPS growth through share repurchase: Although buying back shares increases EPS, it leaves the value of an investor’s holdings unchanged. Furthermore, we demonstrate that the EPS increase associated with a buyback is merely a risk–return trade-off. The reason is that in a repurchase, the firm retires safe cash and, as a result, its assets become riskier than before the repurchase. With the increased risk, the expected return increases, and this effect is what is reflected in the higher expected EPS. Firms generally choose among several alternatives for using their excess cash. Options typically include dividend payment, share repurchase, and cash accumulation (no payout). We consider each of these alternatives. We show that the value of an investor’s holdings is invariant with respect to the choice of payout policy but that each alternative provides a unique risk–return trade-off that is reflected in the EPS path over time. These results conflict with the commonly accepted intuition that increasing EPS through repurchase creates economic value for the investor. Miller and Modigliani (MM) demonstrated that in a perfect world, payout policy does not matter. The literature that followed their seminal work focused on explaining how market imperfections, however, make payout policy relevant. A broad range of reasons have been given for a firm’s repurchases. They include signaling of undervalued equity in conditions of information asymmetry, reducing the agency costs of having free cash, substituting repurchases for dividends to lower taxes, and capital structure adjustments. We abstract from these motivations and focus on EPS growth. Although MM is well known, managers continue to use EPS as a significant input into their repurchase decision. We show, however, that even in a perfect world, payout policy affects the EPS path but that this result should not be confused with the creation or destruction of value for shareholders. Our analysis thus demonstrates the magnitude of the distortion from using EPS to make share repurchase decisions. At the same time, it guides financial analysts in how to interpret EPS changes—namely, to distinguish between EPS changes that are associated with changes in expected shareholder wealth from EPS changes that are not. As an application, we consider the effect that alternative payout policies would have had on ExxonMobil’s EPS in the 2002–06 period. In this period, ExxonMobil made sizable share repurchases and large dividend payments. We compare the results of our hypothetical policies with ExxonMobil’s actual payout policy. We show that more than 16 percent of the firm’s EPS growth over the past four years is an artificial result of its repurchase program and cannot be associated with improvement in operating performance. Our results have important implications beyond the effect of share repurchase on EPS. For example, many managers suggest that their firm repurchase shares to reverse the share dilution of employee stock and option compensation. Our results suggest that, although repurchasing shares prevents dilution of EPS, it does not prevent dilution of value to shareholders. The reason is that the granting of stock and option compensation does dilute value, but repurchases do not enhance value. Similarly, the newly popular practice of “accelerated repurchase” does not enhance value. In an accelerated repurchase, the firm borrows a large quantity of shares from its shareholders through an investment banker and retires those shares upon receipt. Then, over time, the investment banker buys shares in the open market on behalf of the firm and returns them to the lending shareholders. The practice enables a firm to quickly increase EPS while repurchasing shares slowly over time. The results in this article imply that boosting EPS in this manner does not create value for shareholders.

Investment Analysis of Autocallable Contingent Income Securities

We have witnessed three major stock market meltdowns over the past three decades. This paper assesses the market shocks of 1987, 1997 and 2008. In particular, we review the history of modern finance and assess whether the role of quantitative finance has developed to reduce the likelihood of future meltdowns. We see that the role of models based on historical price movement often ignore the possibility of fat tails, that risk free arbitrage may exist in normal, but not tumultuous markets and that asset returns and correlations result in extreme values more frequently than predicted by the standard bell curve. Moreover, the desire for outsized returns has driven many money managers to leverage their returns beyond prudent levels, dramatically increasing portfolio risk. In addition, many in Wall Street sell and create new derivative products that are often sold without the necessary due diligence and properly conducted stress tests. The same quantitative courses are taught and similar derivative products are sold as during the three previous meltdowns. Unfortunately, the SEC and academia have taken little permanent action to reduce the odds of further stock meltdowns.

Planning for repetitive cycles using an infinite horizon linear program

Autocallable contingent income securities, or autocalls, are a relatively new type of structured finance security whose payout is contingent on the performance of an underlying asset and that give investors an opportunity to earn high yields in a low interest environment. We collect data on autocalls issued in the US and describe their contractual properties and the properties of their underlying assets at issuance. We find that autocalls are issued on underlying assets displaying high volatility, negative skewness and high prices. We then model a typical autocall under different assumptions about the price of the underlying asset and (i) analyze the rationale behind the characteristics of the underlying asset at issuance, and (ii) discuss valuation of autocalls in the various models. While the literature consistently finds that structured products are overpriced, we find that incorporating stochastic volatility into the pricing model can help explain some of the overpricing routinely reported in prior studies.

Index correlation: implications for asset allocation

SummaryTermination conditions are often difficult to model in a linear program. This paper discusses the use of an infinite horizon linear program which may enable the termination conditions to be modeled more accurately. It can be applied situations where a repetitive cycle (i. e. season) exists and generates steady state values of the decision variables. Examples are then given illustrating the use of the infinite horizon linear program.ZusammenfassungVielfach ist es schwierig, Abschlußbedingungen in ein LP-Modell einzubauen. In diesem Aufsatz wird die Verwendung eines linearen Modellansatzes mit unendlichem Horizont diskutiert, der es ermöglicht, Abschlußbedingungen auf sehr sorgfältige Weise zu formulieren. Er kann in solchen Fällen verwendet werden, in denen ein sich wiederholender Zyklus (z.B. Saisonzyklus) gegeben ist, und liefert stabile Werte für die Entscheidungsvariablen. Es werden Beispiele zur Anwendung des linearen Modellansatzes mit unendlichem Horizont gegeben.

The Inflation Audit

Purpose - – The cornerstone of Modern Portfolio Theory with implications for many aspects of corporate finance is that reduced correlation among assets and reduced standard deviation are key elements in portfolio risk reduction. The purpose of this paper is to analyze the conditional correlation and standard deviation of a broad set of indices with the S & - P 500 conditioned on market performance. Design/methodology/approach - – The authors examined volatility and correlation for a set of indices for a 19-year period based on weekly data from July 2, 1993 to June 30, 2012. These included the NASDAQ, MSCI EAFE, Russell 1000, Russell 2000, Russell 3000, Russell 1000 Growth, Russell 1000 Value, Gold, MSCI EM and Dow Jones UBS Commodity. The data for the Wilshire US REIT, Barclays Multiverse, Multiverse 1-3, Multiverse 3-5 and Multiverse 10+ became available starting July 2, 2002. For these indices the authors used weekly data from July 1, 2002 through June 30, 2012. For the iBarclays TIPS, the authors used weekly data from the time of availability, namely, for the period December 12, 2003 through June 29, 2012. Findings - – The findings demonstrate that both the conditional correlations and standard deviations vary as a function of market performance. Moreover, the authors obtain a Originality/value - – While it has been observed that asset classes move together, this paper is the first to systematically analyze the nature of these asset class correlations.