Bingsheng Yi

Pre-Issue Investor Optimism and Post-Issue Underperformance

Prior studies have documented long-run stock market underperformance after security offerings. Some studies conjectured that the post-issue underperformance might be the result of pre-issue investor optimism. The study reported here investigated (1) whether investor optimism is associated with post-issue underperformance, (2) how investor optimism changes in the one-year period surrounding the security-offering month, (3) whether investor optimism differs between equity issuers and debt issuers, and (4) whether such differences affect companies’ financing choices. We confirmed underperformance of debt and equity issuers and found that the post-issue buy-and-hold abnormal returns are negatively associated with pre-issue investor optimism. We found little evidence, however, that investor optimism affects companies’ financing choices. Poor post-issue performance has been well documented for both equity issuers and debt issuers. Moreover, in prior studies, the equity issuers had worse performance than the debt issuers. These effects have been attributed to investor overoptimism—perhaps, combined with corporate managers’ opportunism in taking advantage of investor overoptimism by issuing overpriced securities. No prior studies have directly tested the relationship, however, between pre-issue investor optimism and post-issue stock market performance after seasoned equity offerings and straight-debt offerings. To fill this gap, we report an examination of (1) whether investor optimism is associated with post-issue underperformance, (2) how investor optimism changes in the one-year period surrounding the security-offering month, (3) whether investor optimism differs between equity issuers and debt issuers, and (4) whether such differences affect companies’ financing choices. Assuming that financial analysts’ opinions represent those of investors, to measure investor optimism, we used analyst forecast errors (defined as the mean annual Thomson I/B/E/S consensus EPS forecast minus the actual annual EPS divided by the absolute value of the mean annual consensus EPS), the I/B/E/S consensus analyst forecasts for long-term earnings growth rates, a recommendation revision ratio (that is, the ratio of the number of analysts making upward revisions to their EPS forecasts to the number making downward revisions to their forecasts), and an “investor optimism index.” This index is the equally weighted average of the rank of analyst forecast error, the forecast of long-term EPS growth rates, and the recommendation revision ratio; it has values ranging from 0 to 1. A larger value of the investor optimism index indicates that investors were more optimistic. We applied these measures to seasoned issuers of equity and issuers of straight debt in the 1984–2002 period and found the following: (1) Before the securities were issued, investors appear to have been more optimistic about equity issuers than about debt issuers; we found a score on the pre-issue mean investor optimism index of 0.535 for equity issuers and 0.456 for debt issuers. (2) Somewhat surprisingly, after issue, although the investor optimism index dropped for debt issues (from 0.456 to 0.451), it increased for equity issuers (from 0.535 to 0.573), indicating a continuation of investor optimism about equity issuers; we found both of these changes to be statistically significant at the 1 percent level. (3) For both equity and straight-debt issuers, the post-issue buy-and-hold abnormal returns were negatively associated with pre-issue investor optimism. And this relationship was more negative and statistically more significant for equity issuers than for debt issuers. For example, the results in multiple regressions showed that, after we held other variables constant, for equity offerings, a 1 percent increase in investor optimism was significantly related to a 1.30 percent decrease in the three-year buy-and-hold abnormal return. For straight-debt offerings, however, a 1 percent increase in investor optimism resulted in only a 0.18 percent decrease in the three-year buy-and-hold abnormal return; this impact was statistically insignificant. (4) We found little evidence that investor optimism affects companies’ financing choices. (5) Finally, although multiple issuers have better performance than single issuers, the sequence of the issuance was found to be negatively related to post-issue performance. These findings provide fresh insights into the new-issue process as related to investor sentiments. The results have important implications for both the investment public and the analyst community. For example, the conventional wisdom is that managers’ attempts to sell overpriced equity may be used as a signal for short selling. Our results do not support such a trading strategy. To the contrary, our finding that the post-issue underperformance is positively associated with pre-issue investor optimism may be used as a signal in a strategy of selecting stocks with high pre-issue investor optimism for short selling.

Does Adoption of Compensation Committee Benefit Shareholders? Evidence from Taiwan

Research on the effectiveness of compensation committee is limited and inconclusive. In Taiwan on Nov 5th, 2010, news on the passage of a new legislation was announced that all firms with stocks traded in Taiwan Stock Exchange or OTC should set up a compensation committee within one year period. We examine how the Taiwan stock market reacted to this announcement and factors that may affect the market reaction. We find Taiwan stock market reacted negatively on the announcement of the mandatory setup of compensation committee in the board of directors. All the mean (median) abnormal and cumulative abnormal returns around the announcement date are significantly negative at 1% significance level. Such results suggest that, in general, investors in Taiwan do not believe that the adoption of compensation committee in Taiwan helps to protect shareholders benefits. The multiple regression results show that director compensation has significantly positive impact on the abnormal returns, while board independence is negatively related to market reaction.

DIRECTORS AND OFFICERS LIABILITY INSURANCE AND COST OF DEBT

Using hand-collected data on directors’ and officers’ liability insurance (D&O insurance), we analyze the effect of D&O insurance on the cost of debt. We find that higher levels of D&O insurance coverage are associated with higher at-issue bond yields (to maturity) and higher loan spreads. This evidence suggests that debtholders view D&O insurance coverage as increasing credit risk (potentially via moral hazard and/or information asymmetry). Further analyses show that higher levels of D&O insurance coverage are associated with greater risk taking and higher probabilities of financial restatement due to aggressive financial reporting. The greater use of D&O insurance appears to raise the cost of debt financing. * We would like to thank conference participants at the 2011 International Conference on Corporate Finance and Financial Market in Hong Kong, and seminar participants at the University of Hong Kong and the University of International Business and Economics for helpful comments. We greatly appreciate research assistance by Joyce Li, Hoi Lo, and Chunning Ma.

INTERPLAY AMONG THE LARGE INVESTOR GROUPS AND THE OWNERSHIP-PERFORMANCE RELATIONSHIP

This paper applies several methodologies to examine the interplay among large shareholders. We find that firm performance is positively associated with insider and institutional ownership, but negatively associated with blockholder ownership. More importantly, we find that insider and institutional ownership are negatively related to each other, functioning as substitutes. However, they are both positively related to blockholder ownership, indicating that the endogenous optimal ownership requires higher insider and/or institutional ownership when there is high blockholder ownership. Methodologically, we find that using residual ownership reduces or eliminates spurious variations in the non-linear relationship between firm performance and insider ownership, and industry adjustment generates more reliable estimates. This paper sheds light on the complex interplay among these various types of large investors.