Lisa K. Meulbroek

Short-sellers, fundamental analysis and stock returns *

Abstract Firms with low ratios of fundamentals (such as earning and book values) to market values are known to have systematically lower future stock returns. We document that short-sellers position themselves in the stock of such firms, and then cover their positions as the ratios mean-revert. We also show that short-sellers refine their trading strategies to minimize transactions costs and maximize their investment returns. Our evidence is consistent with short-sellers using information in these ratios to take positions in stocks with lower expected future returns.

The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options

To properly align incentives using equity-linked compensation, the firm’s managers must be exposed to firm-specific risks, but this forced concentrated exposure prevents the manager from optimal portfolio diversification. Because undiversified managers are exposed to the firm’s total risk, but rewarded (through expected returns) for only the systematic portion of that risk, managers will value stock or option-based compensation at less than its market value. This paper derives a method to measure this deadweight cost, which empirically can be quite large: managers at the average NYSE firm who have their entire wealth invested in the firm value their options at 70% of their market value, while undiversified managers at rapidly growing, entrepreneurially-based firms, such as Internet-based firms, value their option-based compensation at only 53% of its cost to the firm. These estimates prompt questions of whether compensation plans in such firms are weighted too heavily towards incentive-alignment to be cost effective.

Shark Repellents and Managerial Myopia: An Empirical Test

Since the proxy fights of the 1950s, commentators have debated the welfare implications of corporate takeovers. Although observers such as Manne (1965), Jensen and Meckling (1976), Fama (1980), and Jensen and Ruback (1983) argue that the market for corporate control promotes efficiency and enhances wealth, some critics, such as managers of firms subject to hostile takeover attempts, contend that takeovers destroy firm value. The critics frequently assert that takeover pressure forces managers to sacrifice profitable, but slowyielding, long-term investments in favor of less productive short-term investments that offer immediate returns. While the evidence supporting takeover-induced shortsightedness is largely anecdotal, a recent paper by Stein (1988) develops a formal

The Promise and Challenge of Integrated Risk Management

INTRODUCTION In the past, risk management was rarely undertaken in a systematic and integrated fashion across the firm. Integrated risk management has only recently become a practical possibility, because of the enormous improvements in computer and other communications technologies, and because of the wide-ranging set of financial instruments and markets that have evolved over the past decade. A sophisticated and globally tested legal and accounting infrastructure is now in place to support the use of such contractual agreements on a large scale and at low cost. Equal in importance to this evolution in capital markets is the cumulative experience and success in applying modern finance theory to the practice of risk management. Today, managers can analyze and control various risks as part of a unified, or integrated, risk management policy Integrated risk management is the identification and assessment of the collective risks that affect firm value, and the implementation of a firm-wide strategy to manage those risks. Integrated risk management, then, looks well beyond the set of traditionally insurable risks, seeking to address all of a firms risks within an organized and coherent framework. At the foundation of risk management is the integration of the three ways that a firm can alter its risk profile. These fundamental ways that a firm can implement risk management objectives, by modifying the firms operations, by adjusting its capital structure, and by employing targeted financial instruments, interact to form the firms risk management strategy. Managers must weigh the advantages and disadvantages of any particular approach in order to find an optimal mix of the three. Traditional insurance, then, a type of targeted financial instrument, is but one tool available to the firm. This article presents a managerial overview of integrated risk management, investigating the range of management decisions that it can influence and the benefits for the firm from its implementation. To illustrate these concepts, the article places a special focus on one firm, Honeywell Inc., and its first steps toward integrating traditionally insured risks with other treasury-based risks. WHAT IS RISK MANAGEMENT? Traditionally, risk managers focused on insurable risks and loss control. To those outside the insurance industry, however, risk management tends to evoke thoughts of derivatives and strategies that magnify, not reduce, risk. While todays risk management may use derivatives, derivatives, as a risk management tool, are only a small part of the integrated risk management process. Moreover, a proper risk management strategy does not involve speculation, or betting on the future price of oil, corn, currencies, or interest rates, and indeed is antithetical to such speculation. Instead, the goal of integrated risk management is to maximize value by shaping the firms risk profile, shedding some risks while retaining others. By applying integrated risk management, managers will benefit from new insights about the interplay among different types of risk and traditional financial decision areas, connections easily missed without a comprehensive framework. Because the three ways to manage risk are functionally equivalent in their effect on risk, their use connects seemingly unrelated managerial decisions. For instance, because capital structure is one component of a firms risk management strategy, effective capital structure decisions cannot be made in isolation from the firms other risk management decisions. Consequently, a firms capital structure choice is inextricably linked to its capital expenditure plans, along with many other operational decisions. This articles discussion of the integrated risk management framework emphasizes the connection among the ternary mechanisms to alter the firms risk profile and offers guidance on their practical application. BENEFITS OF INTEGRATED RISK MANAGEMENT A cascade of basic decisions about objectives faces the manager who seeks to implement a risk management program. …

The Effect of Illegal Insider Trading on Takeover Premia

This paper empirically investigates whether illegal insider trading increases the premium a bidder pays for a target. Illegal insider trading is trading by traditional corporate insiders, as well as others in a position of trust and confidence (e.g. investment bankers, lawyers), based on material, non-public information (‘inside information’). The paper examines the premia of takeovers with known illegal insider trading and compares them to a control sample of takeovers matched by industry, time period, and size that do not have detected illegal insider trading. After controlling for differences in merger characteristics, such as number of bidders, type of offer, form of payment, etc., we find that takeovers with detected illegal insider trading have takeover premia which are approximately 10 percentage points, or almost one-third, higher than the control sample. We conduct additional tests in an attempt to determine the direction of causality between illegal insider trading and takeover premia size and explore the effect of potential detection bias. The results suggest both that illegal inside traders base their trades on factors other than premia size, and that illegal insider trading in takeovers with large premia is not necessarily more likely to be detected. Our findings are consistent with the hypothesis that the illegal insider trading itself tends to create larger takeover premia.

Short Interests, Fundamental Analysis, and Stock Returns

Firms with low ratios of fundamentals (such as earnings and book values) to market values are known to have systematically lower future stock returns. We document that short-sellers position themselves in the stock of such firms, and then cover their positions as the ratios revert to normal levels. We also show that short-sellers avoid firms where the transaction costs of short-selling are high and where the low ratios are due to temporarily low fundamentals, rather than temporarily high prices. Our evidence suggest that short-sellers use information in these ratios about either (i) temporary mispricing, or (ii) unknown risk factors, to boost their investment returns.