Andrew W. Stark

Research and Development Activity and Expected Returns in the United Kingdom

Fama and French (1992) show that size and book-to-price dominate CAPM beta and other variables such as the price-earnings ratio and dividend yield in explaining the cross-section of US stock returns. Comparable evidence for the UK points to a book-to-price effect, but not a size effect (Chan and Chui, 1996; Strong and Xu, 1997). In this paper, our first contribution is to show that a measure of research and development (RD) helps explain cross-sectional variation in UK stock returns. Our cross-sectional results on the association between stock returns and RD are consistent with recent US evidence reported by Lev and Sougiannis (1996, 1999) and Chan, Lakonishok and Sougiannis (2001).Fama and French (1993, 1995, 1996) also show that a three-factor model captures a high proportion of the time series variation in portfolio returns, again for the US. Our second contribution is to show, for the UK, that a modification to the three-factor model to take account of RD activity can significantly enhance the explanatory power of the three-factor model. We show that, as a practical matter, estimated risk premia based on the modified three-factor model can differ considerably from risk premia estimated using the CAPM or the three-factor model. In particular, risk premia for industries in which few firms undertake RD activities tend to be over-estimated.

Linear Information Dynamics, Dividend Irrelevance, Corporate Valuation and the Clean Surplus Relationship

This paper adopts the linear information dynamics framework pioneered in Ohlson (1979) and Garman and Ohlson (1980) (and subsequently used in, in particular, Ohlson, 1989, 1995 and Feltham and Ohlson, 1995) for thinking about desirable properties of earnings numbers in the context of the market valuation of firms, where such valuations are fundamentally based on expected future dividends. The first purpose of this paper is to consider the valuation-relevance of clean surplus earnings when there are two distinct components of clean surplus earnings whose evolutions are governed, along with book value and dividends, by a system of linear information dynamics, and dividend irrelevancy holds. The system of linear information dynamics assumed ensures that corporate value is a linear combination of the two components of clean surplus earnings, book value and dividends. One question becomes—under what circumstances are clean surplus earnings (combined with book value and dividends) sufficient for corporate valuation without a knowledge of the breakdown of clean surplus earnings into its separate components? This paper develops the conditions defining these circumstances. At the other extreme, another question can be asked—under what circumstances is one component of clean surplus earnings irrelevant to corporate valuation? This paper identifies some conditions that identify these latter circumstances. The second purpose of the paper is to identify implications of these results for both the traditional arguments about the desirability of measuring earnings on a clean surplus basis and also the more contemporary issues surrounding FRS3. A third purpose is to discuss the implications of the overall analysis for the empirical testing of the relationship between market prices and earnings numbers, and for empirically-justified definitions of maintainable earnings.

The State of the Field in UK Management Research: Reflections of the Research Assessment Exercise (RAE) Panel

This paper reviews the state of the field of the sub-disciplines within UK management research, based upon the submissions of 94 UK higher education institutions to the Business and Management Studies Panel in the UKs 2001 Research Assessment Exercise (RAE). It offers observations on the UK model of the assessment of quality in, and funding of, research conducted in publicly funded higher education institutions.

The accruals anomaly – can implementable portfolio strategies be developed that are profitable net of transactions costs in the UK?

Abstract In this paper, we provide evidence related to the existence, or otherwise, of the accruals anomaly in the UK stock market. Specifically, we find that average annual abnormal returns generally decline as prior period accruals move from low to high. This outcome can be interpreted as broadly consistent with the accruals anomaly via which investors overweight the persistence of accruals and underweight the persistence of cash flows in predicting next periods earnings. Our results suggest that to make money out of any mispricing based upon ranking firms by accruals generally requires a portfolio strategy with long and, in particular, short positions in portfolios featuring relatively small capitalisation firms. When taking into account conservative estimates of trading costs, the investment strategy is seen to generate losses if an initially equally‐weighted investment approach is used or positive, but not statistically significant, abnormal returns if a value‐weighted approach is followed. Overall, we conclude that, whilst there is evidence of mispricing consistent with the accruals anomaly, the profitable exploitation of the anomaly is not necessarily possible when transactions costs are taken into account. Thus, the accruals anomaly is not so egregious in the UK as to challenge the semi‐strong version efficient markets hypothesis.

Information systems, incentives and the timing of investments

The purpose of this paper is to study the effects of introducing information systems into a model featuring managerial incentive problems and investment opportunities that are mutually exclusive over time. In a principal-agent model in which a manager (agent) has superior information about investment costs, we introduce information systems, the signals from which are available to both the manager and the owner of the investment opportunity, which allow the owner to decrease the managers informational advantage. We examine (i) the characteristics of the optimal information systems; (ii) the effects of such information systems on the owners investment and compensation choices and on the value of the investment opportunity to the owner; (iii) the effects of such information systems on the timing of investment; (iv) the effects of such information systems on the overall probability of investment; and (v) when the owner might want to improve the information system at a particular point in time.

Real Options, (Dis)Investment Decision-Making and Accounting Measures of Performance

This paper suggests that a residual income-type measure of performance can be designed which supports optimal investment and disinvestment decision-making in a real options framework involving the options to wait before investing and to abandon. The measure has a number of advantages and disadvantages. Nonetheless, the balance of advantage versus disadvantage for the proposed measure must be set against the inadequacies of other competing measures of performance and associated organisational designs. Even if the measure of performance suggested is not regarded as practically useful, it has another general advantage - it can be used as a benchmark against which to evaluate other performance measures with regard to their support of optimal investment and disinvestment decision-making in a real options framework. Copyright Blackwell Publishers Ltd 2000.

Intangibles and Research - an Overview With a Specific Focus on the UK

There were four papers presented at the 2007 Information for Better Markets Conference on Intangibles and Research. Basu and Waymire (2008) express extreme scepticism as to whether balance sheet recognition of intangibles is possible. Their argument, at least in part, is that intangibles are not separable from tangible assets. Further, the value of intangible assets, whether singly or in combination, is best judged by emphasising the forecasting of future profit streams, as opposed to explicit balance sheet recognition. As stated by the authors, ‘[v]aluing accounting intangibles on a stand-alone basis requires heroic assumptions about separability, highly uncertain estimates of ambiguous future benefits, and arbitrary allocations of jointly produced income.’ Further, intangible assets, when assessed at the macro-level for countries, are linked to government policies with respect to activities such as education and, as a consequence, it is difficult to identify them with specific firms. Skinner (2008) evaluates policy proposals and concludes that private incentives to disclose information about intangibles, over and above that disclosed in the US, are the best solution, with regulators, at best, providing guidance as to the forms that these disclosures could take. This is based upon an analysis that critically evaluates whether current US accounting can be associated with the claimed difficulties in the US (e.g. under investment, difficulties in raising capital, etc., primarily related to technology firms and research and development (R&D)) – he argues it cannot. Wyatt (2008) provides an extremely comprehensive analysis of the associations between financial and non-financial information on various types of intangibles and market value or returns (a real boon to academics!) – the work surveyed is global, although much of it emanates from the US. Whilst making recommendations for future research, she suggests, amongst others, that regulators might do better if more discretion were given to managers to recognise intangible assets (as in the UK and Australia prior to IAS adoption). She also suggests that disclosures could be enhanced to include more broad categories of expenditure. Ittner (2008) considers whether internal measurement systems for intangibles, primarily for reward and performance evaluation purposes, are associated with superior performance. He finds some evidence that the measurement systems are associated with superior performance – including stock market performance – but little evidence about particular measures. His review suggests the complexity of business models within which wealth generation is achieved via expenditures on activities thought to have the potential to generate intangible assets. Overall, the contents of the four papers suggest little reason to fundamentally change recognition practices, although arguments for small changes at the margin could be made (i.e. the allowing of discretion with respect to categories of development expenditures). Arguments are put forward for enhanced disclosure requirements with respect to items such as advertising expenditures. Voluntary disclosure mechanisms are seen as the most viable mechanisms for disclosures relevant to understanding the wealth creation possibilities of expenditures on potential intangible assets, if only because of the complexity and heterogeneity of the business models within which such activities are set. In this context, an argument could be made for accounting standard setters to provide general frameworks within which such voluntary disclosures can be made. Because much (but not all) of the evidence and arguments in the papers presented comes from the US, I will focus on the UK, particularly UK evidence that is available, and applying some of the arguments and recommendations to the UK. I will also focus on financial reporting and mandatory and voluntary disclosure possibilities and practices. Accounting and Business Research, Vol. 38. No. 3 2008 International Accounting Policy Forum. pp. 275-285 275

Cash recovery rates, accounting rates of return, and the estimation of economic performance

Abstract This paper has a number of objectives. First, a new and more general method for deriving estimates of economic performance from cash recovery rates is proposed, where economic performance is defined as the internal rate of return of the firm or organizational unit under consideration. This method allows for a wider range of cash flow profiles to be assumed in the estimation process than have been utilized previously in the literature on cash recovery rates. The characteristics of estimators of economic performance corresponding to various new cash flow profiles are then examined. Secondly, the properties of a new empirical definition of the cash recovery rate are investigated in conjunction with the new estimation method. Thirdly, a novel empirical test is proposed to test whether estimators of economic performance have a linear relationship with the internal rate of return. Results arising from the application of this test to a sample of 307 firms are presented.

Firm size, sector and market valuation of R&D expenditures

Significant market value effects of R&D are found for UK firms of all sizes. Sector-based analyses indicate large, positive and statistically significant influences of R&D on market values of UK firms in both manufacturing and nonmanufacturing sectors.

Incentive Problems and Investment Timing Options

We characterize optimal investment and compensation strategies in a model of an investment opportunity with managerial incentive problems, caused by asymmetric information over investment costs and the managers desire to consume slack, and flexibility over the timing of its acceptance. The flexibility over timing consists of the opportunity to invest immediately, delay investment for one period, or not invest at all. The timing option provides an opportunity to invest when circumstances are most favorable. However, the timing option also gives the manager an incentive to influence the timing of the investment to circumstances in which he gets more slack. Under the assumption that investment costs are distributed independently over time, the optimal investment policy consists of a sequence of target costs, below which investment takes place and above which it does not. The timing option reduce optimal cost targets, relative to the case when no timing option is present. The first cost target is lowered because the compensation function calls for the payment of an amount equal to the managers option to generate future slack, should investment take place. This increases the cost of investing at the first opportunity, thus reducing its attractiveness. In order to ease the incentive problem at the initial investment opportunity, the second target cost is also lowered, even though no further timing options remain. Making the additional assumption that costs are uniformly distributed, we generate additional insights. We find circumstances in which the profitability of investing initially exceeds the profitability of investing at the second opportunity, a result that is impossible in the first-best context. Second, we identify circumstances under which the initial target cost is increased by incentive effects. Third, we identify the conditions under which the option to wait is effectively shut down when incentive problems exist. The implications of relaxing several key assumptions, such as investment cost independence, the owners commitment to the manager and not to renegotiate, are explored.