... tète-à-tète in the tent: strategies devise in a tent get victory 1000 li away ... 运筹帷幄之中决胜千里之外

Lion Infrastructure is the way to go, Business Times, 30 Dec 2010

2010-12-30T05:29:00.000-08:00

http://www.businesstimes.com.sg/sub/views/story/0,4574,419680,00.html

Business Times Singapore
Published December 30, 2010
Lion Infrastructure is the way to go
To reach a US$2 trillion GDP in 2065, Singapore must create and build commercial assets with a special quality
By TAN SENG HOCK AND KEE KOON BOON
HUNDREDFOLD. That's the breathtaking growth of Singapore's gross domestic product (GDP), from US$1 billion after its independence in 1965 to US$100 billion in 2004 when Prime Minister Lee Hsien Loong took over the reins from his predecessor, Senior Minister Goh Chok Tong.
Another tenfold increase in value creation in the years to 2065 (that is, 100 years since its independence) - from an estimated US$200 billion GDP in 2010 to around US$2 trillion then - and Singapore may well surpass the present level of US$2.2 trillion GDP of the UK, its former colonial master. This will likely take place, particularly as Asia successfully seizes the growth opportunity to be the global leader, in economic and cultural terms, in this century.
Consider the case of Procter & Gamble (P&G). Founded by English storekeeper William Procter and candle maker James Gamble, P&G surged more than hundredfold in 'Stage 1' since its incorporation as a company in 1890 to S$20 billion in 1987. The company found itself in an advanced phase of market maturity with its products and battling on all fronts with intensifying competition from competent rivals. Yet, P&G grew by another tenfold in 'Stage 2' to current S$230 billion.
Consider the case of Nestle. The famous company grew more than hundredfold since Frankfurt-born pharmacy assistant Heinrich Nestle left his hometown to set up the Nestle shop in Switzerland in 1866, to S$20 billion in 1980s, and again by another tenfold, to current S$250 billion.
Most competent 'Stage 1' companies do not cross the chasm to 'Stage 2' because they lack the Lion Infrastructure - the teamwork, the knowhow, the necessary institutional structures and the culture - in order to not only survive but also thrive upon changes in the marketplace to become multibagger Lions.
Sustained performance
These Lions are akin to the Berkshire Hathaway, Singapore, Apple and The Capital Group Companies that generate a sustained and outsized investment management performance, as discussed in our earlier BT articles on May 15 and June 10. Value investors take delight in understanding what urges and qualifies an entrepreneur to perform acts that lead to the building of a Lion Infrastructure in a business.
In 'Stage 2', the Lion Infrastructure and culture are the sails that determine the course, not the wind. P&G cultivated 23 billion-dollar brands, while Nestle groomed 27 such brands with over US$1 billion in sales. These multibagger billion-dollar brands are profound sources of vitality to sustain the competitive edge and value relevance at P&G and Nestle.
A company creates value at different stages of its corporate life cycle, arising from the relentless and eternal pursuit of excellence to perfect its offerings to the marketplace.
In the context of Asia, a competent entrepreneur in 'Stage 1' may be able to build his or her business from a size of under S$100 million to S$1 billion. This is achieved with the right emotional incentives aligned to encourage decisive stewardship in the process to create lasting cost or demand advantage over competitors.
However, to be able to build up the enterprise further to S$10 billion and beyond in 'Stage 2', sacrifice and stable capital in long-term investments since 'Stage 1' - to build a cohesive team and a Lion Infrastructure, which include governance, operational and financial management system - are required.
Most 'Stage 1' companies are content - and may even display smugness - to conserve the sizeable gains that they have achieved and fail to invest to build an ongoing and lasting business.
Investing in the team and a Lion Infrastructure slows down the lone, powerful Hyena entrepreneur; he or she prefers to continue to capitalise on short-term opportunistic quick gains. The difficulty is often closest at the finishing line; these companies remain in the lower gears, even risking blowing up, when they are, in fact, at the tipping point to enter 'Stage 2'.
Take the case of the quintessential supply chain manager and asset-light business model, Li & Fung, also one of the best-performing stocks in Hong Kong, that catapulted nearly hundredfold from S$290 million to S$28 billion since its listing in 1992. Li & Fung produces S$20 billion in garments and other goods for the world's top brands and retailers - without owning a single factory.
Penang, Malaysia-born CFO Frank Leong played an important role in helping the visionary Fung brothers, running the OSG (Operation Support Group) from 1995 until his retirement in 2004. OSG keeps a database of more than 8,000 factories, suppliers and clients around the world and uses it to orchestrate the various members in its network so that they can compete like a pride of Lions to generate a greater quantum of profits for all partners and developers around its core offerings.
OSG oiled the machinery that enabled the entrepreneurial leaders in Li & Fung's multiple business units to focus on its core competencies to meet the needs of customers and fighting battles with competitors, growing multibaggers in the process.
The Lion Infrastructure at Nestle propelled the Swiss enterprise to become the world's biggest food company, helping the Swiss economy, which has 7.8 million people, grow at twice the rate of the European Union. On a per capita basis, Switzerland hosts about eight times more of the world's 500 largest publicly traded companies than Germany, the region's biggest economy.
Seventeen of the world's 500 biggest companies are Swiss, amounting to about one for every 500,000 residents, compared with one for every four million people in Germany. These multibagger Lions in Switzerland are a major asset to the country; they helped the economy to prosper by boosting exports, creating jobs and spurring consumption.
Powerful magnet
For Singapore to reach a US$2 trillion GDP in 100 years since independence, it must create and build commercial assets with a 'special' quality. Like the 'special' Nestles, these commercial assets cannot be taken away or destroyed by foreigners and become even more valuable with the participation of multinational talents.
They possess values which are not determined by the arbitrary fluctuations in the foreign currency of any one country, such as the US dollar. The company assets are also not like land values influenced by foreign demand or reap transient windfall gains when sold to foreigners at high prices. These are intangible assets representing real wealth to sustain a nation, not just tangible monetary assets which can be brittle.
Singapore has been a powerful magnet in attracting global capital flows and multinational corporations (MNCs) to capital-deepen its economy, demonstrating exemplary efficiency in organising the resources and tangible infrastructure to execute the strategy, resulting in the hundredfold value creation in 'Stage 1'.
In 'Stage 2', we need hundreds of Nestles more than we need hundreds of billions of US dollars or gold; we need the golden goose and not just rely on eggs from other people's golden goose.
If Singapore can cultivate 10 S$100 billion companies and 50 S$20-billion companies of such Lion calibre in the next half a century, a S$2 trillion GDP economy may well be achievable.
The writer is the Group CEO and CIO of Aegis Group of Companies, a Singapore-based investment management organisation since 2000. Kee Koon Boon is a lecturer of accounting at the Singapore Management University and a director of Aegis Group of Companies.

Reforming corporate governance, Business Times Singapore, November 25, 2010

2010-12-12T07:58:00.001-08:00

http://www.businesstimes.com.sg/sub/storyprintfriendly/0,4582,414782-1290715140,00.html?

Reforming corporate governance
Business Times Singapore
Published November 25, 2010
Investors need to understand interaction between underlying business model dynamics and those running the enterprises
By KEE Koon Boon
Snatch. The action undertaken by Harpies, the spirits of sudden, sharp gusts of wind in Greek mythology who would snatch away (harpazô) things from the earth. They had plagued the old blind King Phineus such that whenever a plate of food was placed before him, the winged Harpies would swoop down and snatch it away, befouling any scraps left behind.
CORPORATE governance, as elucidated by leading finance researchers Andrei Schleifer and Robert Vishny, 'deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. How do they make sure that managers do not steal the capital they supply or invest in bad projects?'
A formerly popular group with retail and institutional investors of around 150 Singapore-listed Chinese companies, the worth of the S-chips has dwindled significantly from around S$40 billion in market value by more than half due to the continuous gust of cold wind in mis-governance and accounting scandals blowing across these firms.
Attention and discussion on corporate governance reforms in minimising managerial agency costs and to align managerial interests with the shareholders had centred, perhaps narrowly, on the 'agents' or the 'chess pieces', some of which include the independence and quality of the independent directors in their monitoring efforts.
We need to step back and look instead at the 'chess board', the rules of the game in Asia that influences ownership behaviour and the accounting mechanism, in order to avoid the plight of Phineus with managers or controlling owners leaving defiled returns for the minority shareholders and an awful mess for the authorities to clean up.
Wedge. The word to understand the Game. That sharp divergence between cash-flow or equity rights and control rights in the typical Asian firms. Controlling owners are tempted to tunnel assets out of firms where they have low cash-flow rights but high controlling rights to firms where they have both high cash-flow and controlling rights, oftentimes their closely held private firms in which they are the dominant shareholders.
Let's take the case of Satyam to understand the Wedge.
Ramalinga Raju tunnelled out US$1 billion in cash and assets from his listed vehicle Satyam, where he and his family held around 8 per cent equity rights, to his 100 per cent owned private property firm Maytas, to participate in Hyderabad's property market. With Maytas, they can get 100 per cent of the cash flow as compared to 8 per cent in Satyam.
When the credit crunch started to melt away the prospects faced by his private firms, especially as Hyderabad's property market cooled with prices and rents falling more than 30 per cent, he could not bring the dwindling money back to Satyam from his 300-odd private business vehicles for accounts-keeping and maintenance of a competitive dividend yield.
Raju decided to raise cash from investors to make up for the bogus US$1 billion in cash and assets by injecting some of his private assets into the listed Satyam. The price tag of the acquisition to 'de-risk' the business? US$1.6 billion.
Minority shareholders rejected his plan, decrying a 'woeful misuse of cash'. Past enamoured investors abandoned Satyam one by one, and share prices fell, which triggered the margin call in Raju's personal pledged shares. Bankers force-sold his shares, resulting in the price to plunge further.
Like Raju, many of the S-chip controlling owners have multiple private business interests, property development in particular, outside of their listed vehicles.
How did the distorted incentives in the Wedge work its way to be manifested in the accounts?
First, the controlling shareholders will engage in 'propping' activities to artificially inflate the sales and assets of the listed firms through related-party transactions (RPTs) to entice the funds of investors who did their 'fundamental analysis' of the firms. Artificial accrued sales are booked under 'other receivables', while the bogus cash-based sales stay hidden in the 'cash & cash equivalents'.
After 'propping', 'tunnelling' or expropriation of these assets out of the listed firm follows, engineered through related-lending and transfer activities which are rarely paid back by the controlling shareholders. These cash transfers are done artfully, often in short-term transactions in order to be qualified as 'cash equivalents'. That explains why most of the artificial cash balances in these firms typically earn low average interest rates, at below one per cent, when the typical bank rate in China varies between 5 and 10 per cent.
In other words, there is left-side in via propping, and right-side out via tunnelling.
Take the case of the high-profile and 'highly profitable' S-chip Sino-Environment. Footnote 12 of their 2008 Annual Report revealed that the average interest rate earned from their 728 million yuan (S$143 million) cash in the balance sheet is merely 0.56 per cent. In Footnote 13, the amount due and dividend receivable from its subsidiaries in the company accounts is 282 million yuan. In their group accounts, the amount of non-trade receivables is 240 million yuan out of the 276.5 million yuan in total receivables.
From Footnote 12, Sino-Environment possibly made dubious related-party acquisitions, financed by the IPO and secondary equity offerings, to cancel the artificial receivables that were created in collusion with the related parties, and booking the set-off as goodwill and intangible assets which stood at 228 million yuan.
In a Raju-deja vu fashion, property was involved. According to news articles reporting about the firm's situation, its chairman Sun Jiangrong reportedly tried to siphon away a 100 per cent stake in Chongqing Daqing Property, which owned properties in China worth 10 billion yuan, to his Hong Kong private firm called Top One Property Group, and later to a Chinese firm owned by his brother.
Thus, rather than hearing again that inevitable lament why boards - often skin-deep installations - work so poorly so often, regulators should thrust the corporate governance stake right into the heart of perverse behavioural incentives where it matters most: by having mandatory disclosure of the ultimate unseen ownership and private business interests of the controlling owners at these Asian firms to hopefully curb the growing opaqueness in the Wedge between ownership rights and cash-flow rights disguised under the increased usage of nominee shareholdings and non-disclosure.
While controlling owners may view the tunnelling of that $1 out of the firm to be enhancing or protecting their own interests - albeit at the detriment of the minority shareholders - particularly in bad times when they fear losing the value of what they have built, they need to appreciate that they are putting to risk the going concern of their companies to enjoy that elusive valuation premium of a multibagger that usually comes from putting that $1 - and more - back into a single, focused business vehicle, and riding through the ups and especially downs of the business cycles with their reputations intact.
Investors should take heed of the rules of the game, and pay due respect in seeking to understand the interaction between the underlying business model dynamics and the people running the enterprises. It would be premature to speak of 'fundamental' analysis using possibly rigged or incomplete accounting numbers due to propping and tunnelling to fashion elaborate, but garbage-in-garbage-out, valuation models, or 'technical' analysis of possibly manipulated prices and volume.
When value investing is applied properly and rigorously in Asia to identify the right entrepreneurs and managers who are serious in building their business model into a legacy, and to protect, to guard, to preserve the assets of the investors, the rewards can only be bountiful, especially in a tempest-tossed environment.
The writer is a lecturer of accounting at Singapore Management University, and a director of Aegis Group of Companies, a Singapore-based investment management organization

Why ‘Democracy’ and ‘Drifter’ Firms Can Have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers

2010-12-12T03:16:00.000-08:00

Will be in Sydney to present my research paper in the 23rd Australasian Finance and Banking Conference from 13-24 Dec.

Why ‘Democracy’ and ‘Drifter’ Firms Can Have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers
K.B. Kee*
ABSTRACT
Do managers exercise accounting discretion in an opportunistic or efficient manner? Good governance structures, which mitigate agency costs, are necessary to ensure that the accounting information supplied by management is not opportunistically manipulated. The output of quality accounting information, in turn, serves as an input to better governance structures. Thus, governance and earnings quality (EQ) are inexorably linked through a complementarity relationship. This suggests two previously unexamined relationships. Firstly, the governance effects on performance in the influential paper by Gompers, Ishii and Metrick (2003) is overrated without good EQ, measured by the magnitude of abnormal accruals (AA), as an input. I find evidence that removing firms with Low AA attenuates the good governance (Democracy) portfolio returns to no different from zero over the period of 1991-2008. Good governance per se no longer pays off. Isolating the long portfolio of Democracy firms with Low AA generates a positive abnormal return of 10.5 percent per year from 1991 to 2008. Secondly, the uncertainty associated with the abnormal accruals signal is interactively resolved with information about the firm’s governance structure, and the unique pairing of the signals contains unique information about the future prospects of the firm. Thus, firms with high or extreme income-increasing AA, when accompanied by weak (Dictatorship) and mixed (Drifter) governance structures, have negative abnormal future returns as predicted in the seminal paper by Sloan (1996), but Democracy firms have positive abnormal returns. The results suggest either that abnormal accruals are a coarse measure of EQ or earnings manipulation for good governance firms, or that their shareholders benefit from “earnings management” because the high abnormal accruals signals future performance. Overall, the results highlight the joint importance of governance and abnormal accruals in contributing to the total information environment to separate winners from losers.
JEL classification: G10, G11, G12, G30, G34, M4
Keywords: Corporate governance, abnormal accruals, earnings quality, contextual information, returns predictability, special items

1. Introduction and Motivation
Investors willingly part their capital with managers on the assurance that the self-serving managers will exercise their discretionary rights appropriately to increase shareholders’ wealth and not expropriate assets away. Managerial discretion can be used to make reported earnings a precise signal of firm value and managerial performance, enhancing the value of accounting as a language to communicate with the investors. Consequently, the allocation and utilization flow of capital is made more responsive since financial accounting information provides investors an important source of information to help them better evaluate the relative health and worth of the enterprise and to make better investment decisions. However, managerial discretion can also be used to engage in earnings management to conceal poor performance or to exaggerate good performance, either for career concerns or compensation reasons. Healy (1996) termed the former motive to be the Performance Measurement (or Efficient Contracting) Hypothesis, and the latter to be the Opportunistic Hypothesis.
Accruals in accounting are estimates of future cash realizations, with considerable room for managerial discretion in their reporting. Most accruals reverse when the cash consequences they anticipate are realized and the subsequent realization of the cash has no impact on earnings. However, since accruals are estimates of expected future cashflows, the original accrual may not always equal the subsequent cash realization. In such cases, the difference between the original accrual and the associated future cash realization must be recognized in future earnings. Since the intriguing results in the seminal paper by Sloan (1996) that high or income-increasing (low or income-decreasing) accruals are related to negative (positive) future stock returns, evidence of high or income-increasing accruals have been widely interpreted and justified as bookkeeping mischief and a signal of low earnings quality (EQ), in favor of the Opportunistic Hypothesis. For instance, a big increase in inventory accruals is interpreted as signalling a greater likelihood that inventories overstate their associated future benefits, and implied a greater likelihood of subsequent inventory write-downs to be reflected in future earnings.
Yet, accruals may also serve as leading indicators of changes in a firm’s prospects, without any manipulation by managers. Since management presumably have superior information about their firm’s cash generating ability, the discretion provided by GAAP in estimating accruals can be used by management to signal their private information to investors, so that reported earnings will more closely reflect firm performance than realized cashflows (Holthausen and Leftwich, 1983; Watts and Zimmerman, 1986; Holthausen, 1990; Healy and Palepu, 1993; Subramanyam, 1996; Bartov, Givoly, and Hayn, 2002). Thus, a credible signal will reduce information asymmetry, in support of the Performance Management Hypothesis. Given the overwhelming support of the Opportunistic Hypothesis, management is deemed with having nefarious intentions for purchasing inventory above beginning inventory levels even if this was a positive net present value decision. Joshua Livnat, accounting professor at the New York University’s Stern School of Business commented that “I don’t think you can use accruals to decide whether management is acting in the best interests of shareholders,” and that he is “usually not happy second-guessing management or attributing to them a lot of sinister motives” (Trammell, 2010).
As the output of financial accounting information is produced by management, it suggests that good governance structures, which mitigate agency costs and shown to be important in determining firm value in the influential paper by Gompers, Ishii, and Metrick (GIM, 2003), are necessary to ensure that the accounting information supplied by management is not opportunistically manipulated in response to a variety of incentives, and hence the signals produced by management can be reliably assessed by external parties. The output of EQ, in turn, serve as an input to better governance structures and corporate control mechanisms to improve the productivity of investments through three channels: one, by increasing the efficiency with which the assets in place are managed (governance channel); two, by reducing the error with which managers identify good versus bad investments (project identification); and three, by reducing the information asymmetries among investors and the expropriation of investors’ wealth (adverse selection) (Bushman and Smith, 2001; Sloan, 2001).
Thus, it is clear that corporate governance and financial accounting are inexorably linked through a complementarity relationship. Complementarity, as pointed out by Ball, Jayaraman and Shivakumar (2010), implies that “financial reporting usefulness depends on its contribution to the total information environment, whereas substitutability implies usefulness depends on the new information it releases on a stand-alone basis.” Thus, both governance and accruals information are jointly informative; each may contain information not contained in the other about the future prospects of the firm. Importantly, this suggests the possibility of two previously unexamined relationships that will be explored further in this paper.
Firstly, I posit that governance could be overrated without abnormal accruals (AA) as an input. The results in GIM (2003) indicate that the hedge portfolio of buying firms with strong governance (Democracy), and selling firms with weak governance (Dictatorship), can generate significant long-term abnormal return of 8.5 percent per year over the sample period from September 1990 to December 1999. The hedge returns are asymmetrically positioned, with 3.5 (5.0) percent from the long (short) position of the Democracy (Dictatorship) firms. In particular, I argue that it is possible that the good governance associated with future positive abnormal stock returns could be attenuated when the subset of Democracy firms with low or extreme income-decreasing AA is removed. Thus, good governance per se does not lead to future positive abnormal return, contrary to the findings in GIM (2003). In other words, good governance on a stand-alone basis no longer pays off. Isolating the Democracy firms with Low AA should also enhance significantly the governance effects on future positive abnormal return. In addition, mixed governance (Drifter) and Dictatorship firms with Low AA should have positive abnormal return.
In support of this view, with AA estimated as the residual in the Dechow and Dichev (2002) model, I find evidence that removing firms with low or extreme income-decreasing AA will reduce the Democracy portfolio return to no different from zero statistically over the period of 1991-2008, and over the sub-period of 1991-1999 that was examined in GIM (2003). In addition, the portfolio of Democracy firms with Low AA generates a positive abnormal return of 10.5 percent per year from 1991 to 2008, which is not only economically larger (700 basis points) than the long position documented in GIM (2003), but is also 200 basis points more than the entire hedge return. In addition, the incremental value in the good governance and Low AA signal yields 3.9 and 7.0 percent abnormal return per year respectively. Specifically, these Democracy-Low AA firms (dubbed Super-Performers) significantly outperform the unconditional Low AA (Democracy) firms, revealing incremental value in the good governance (Low AA) signal, thus lending weight to the intuition behind a complementarity relationship between the two signals. Interestingly, some of these Super-Performers include well-known, institutional big-cap stocks, such as Coca-Cola Co, AT&T, Hewlett-Packard, Wyeth, Nordstrom, Lowe’s, Home Depot, and EMC, formed in the portfolio at various months in the sample period. Drifter firms with Low AA deliver abnormal return at 6.2 percent per year; Dictatorship firms with Low AA have positive, albeit statistically insignificant, abnormal return.
Of great interest and debate in the literature is the question of whether investors are able to “see through” transitory distortions in accrual accounting numbers. The explanation by Sloan is that investors are thought to be overly-fixated on earnings (the Earnings-Fixation Hypothesis), misinterpreting the transitory nature of the accruals information, only to be systematically surprised when accruals turn out, in the future, to be less persistent than cashflows. Consequently, abnormal stock returns result as corrections to the initial overreaction in the year immediately following extreme accruals. Thus, Sloan views future reversals to be a result of aggressive or “bad” accounting that originally inflate accruals. Accordingly, a hedge portfolio that buys (sells) firms with low (high) accruals can generate annualized abnormal return of 10.4 percent, with 4.9 (5.5) percent from the long (short) position in the subsequent year. Further evidence by Xie (2001), DeFond and Park (2001), and Chan, Chan, Jegadeesh, and Lakonishok (2006) indicate that this “accruals anomaly” is related to abnormal, or sometimes called discretionary, accruals. They argue that certain discretionary actions on the part of managers induce a transitory element to accruals, with stronger mean-reverting tendency of discretionary accruals, defined using the Dechow et al (1996) modified Jones model, leading to an overpricing of aggregate accruals. However, a limitation of Sloan’s study is that the returns predictability could be attributed to unidentified risk factors that is correlated with accruals or unknown research design flaws (Kothari, 2001). Healy (1996) pointed out that one major deficiency is the inability of these accruals model to “adequately incorporate the effect of changes in business fundamentals.” Healy and Whalen (1999) also highlighted their inadequacy to “further identify and explain which types of accruals are used for earnings management and which are not”.
Therefore, and secondly, I argue that the conventional interpretation of EQ, measured by the magnitude of abnormal accruals, could vary across governance structures. The uncertainty associated with the abnormal accruals signal - that is, managerial discretion could be interpreted as either opportunistic or conveying credible private signal about firm performance - is interactively resolved with information about the firm’s governance structure, and the unique pairing of the signals contains unique information about the future prospects of the firm. Abnormal accruals, when accompanied by good governance, become more informative and the interactive combined signal corroborates with the Performance Management Hypothesis. In particular, firms with high or extreme income-increasing AA, usually interpreted as evidence of earnings management, will not have negative future abnormal return if they happen to be also Democracy firms, contrary to the predictions in Sloan (1996). Such an interpretation will be strengthened in an additional test if there is evidence such that when the portfolio of firms with revelation of high or extreme income-increasing accruals in period t experiences the biggest magnitude in accruals reversal in period t+1, those who are also Democracy firms will have positive future abnormal return, not negative return as was predicted under Sloan’s hypothesis. The trend of reported earnings and the subsequent accruals reversals at these firms are interpreted as credible private signals of firm performance by the managers, resulting in larger positive future stock return, as it has been shown that earnings trend consistency is valued at a premium by the market (Barth, Elliott, and Finn, 1999), as is consistency in benchmark performance (Bartov et al, 2002; Kasznik and McNichols, 2002; Koonce and Lipe, 2010). Firms with extreme income-increasing accruals, when accompanied by Dictatorship and Drifter governance structures, have negative future stock returns, consistent with Sloan’s predictions.
Corroborating evidence indicate that firms with high or extreme income-increasing AA and who are also Democracy firms have positive, albeit insignificant, annualized abnormal return of 3.2 percent per year over 1991-2008. In addition, the portfolio of stocks with revelation of high or extreme income-increasing accruals in period t and experiences the greatest magnitude in accruals reversal in period t+1, and who are also Democracy firms, have positive annualized abnormal return of 10.8 percent. Unsurprisingly, firms with high or extreme income-increasing AA with Dictatorship and Drifter governance structures have negative abnormal annualized returns of 0.9 and 7.5 percent respectively, which are as predicted by Sloan (1996).
The viewpoint in Sloan (1996) that high accruals is associated with negative future stock returns has far-reaching consequences, suggesting that it may be necessary to limit managers’ discretion with respect to accounting accruals, since investors cannot unravel the valuation effect of reported earnings in a timely manner under current reporting standards. Such an interpretation may be premature. My results raise doubts that investors respond in the same manner to abnormal accruals, since Democracy firms with high or extreme income-increasing AA have positive future returns. This suggests two things: one, the level of abnormal accruals is a coarse measure of earnings manipulation for these set of firms, although it appears to remain a reasonable proxy of earnings management or EQ for firms with mixed or poor governance structures; and two, their shareholders benefit from “earnings management” because the high or extreme income-increasing accruals signals future performance (e.g. Subramanyam, 1996; Chanel et al, 1996). The evidence helps in the understanding of investor behavior and whether the policy recommendations in Richardson, Sloan, Soliman, and Tuna (2005, 2006) and FASB to curtail the use of “less reliable” components of accruals are appropriate, especially for the Democracy firms. If the joint interactive signal of governance and abnormal accruals can be a more informative measure of firm performance, reforms to limit managerial flexibility may be counterproductive.
This paper can be viewed as an attempt to integrate two streams of research in financial accounting and finance. The first stream consists of a long string of papers, sparked by the influential GIM (2003), which examines the governance effects on firm performance. The second stream consists of valuation-oriented papers, since the seminal paper by Sloan (1996), which shows that accruals predict future returns. Overall, the results in the two previously unexamined relationships highlight the joint importance of governance and abnormal accruals in contributing to the total information environment to separate winners from losers.
The rest of the paper is organized as follows. Section 2 reviews the literature and develops the hypotheses. Section 3 describes the data, variable description and construction, and research methodology. Section 4 presents the empirical results, while Section 5 looks at the robustness test. Section 6 concludes.
2. Literature Review and Hypotheses Development
"If money is the blood and markets are the circulatory system of the global economy, then double-entry accounting ledgers are the nerve cells that control and respond to changes in the flow of money."
- Gordon Gould (2000) on "Double-Entry Accounting" in the book “The Greatest Inventions of the Past 2,000 Years” which is edited by John Brockman who asked the world's leading thinkers to name the one invention that each thought made the greatest impact on civilization in the last 2,000 years.

"Financial statements are a central feature of financial reporting - a principal means of communicating financial information to those outside an entity"
- FASB (1984), paragraph 5

“Future research can also contribute additional evidence to further identify and explain which types of accruals are used for earnings management and which are not. Future research is also needed to determine the conditions in which discretion in financial reporting is primarily used to improve communication vs. manage earnings.”
- Healy and Whalen (1999), p368

Agency costs, which result from the separation of management and financing, come in many guises. Managers may shirk or waste resources, invest extravagantly, build empires to the detriment of shareholders, and engage in self-dealing behavior such as consuming perks and generating private benefits (Jensen and Meckling, 1976; Jensen, 1986; Djankov, La Porta, Silanes, Shleifer, 2008). Managers may also seek to entrench themselves by designing complex cross-ownership and holding structures with double voting rights that make it hard for outsiders to gain control (Demsetz and Lehn, 1985; Ang, Cole, and Lin, 2000; La Porta, Silanes, Shleifer, and Vishny, 2000; Gompers, Ishii, and Metrick, 2010), or by routinely resisting hostile takeovers, as these threaten their long-term positions (GIM, 2003; Bebchuk, Cohen, and Farrell, 2009).
Information asymmetries between management and financiers create a demand for an internally generated measure which is an early or timely signal of firm performance to be reported for stewardship assessments that is not yet garbled by the future environmental noise that accrues after the signal is revealed but before the final outcome is realized. Financial accounting information is an important source of information and firm output on firm performance for ex ante resource allocation decisions. Standard setters define the accounting language that management uses to communicate with the firm's external stakeholders. By creating a framework that independent auditors and the SEC can enforce, accounting standards can provide a relatively low-cost and credible means for corporate managers to report information on their firms' performance to external capital providers and other stakeholders (Healy and Whalen, 1996). Ideally, financial reporting therefore helps the best-performing firms (winners) in the economy to distinguish themselves from poor performers (losers) and facilitates efficient resource allocation and stewardship decisions by stakeholders.
Over finite intervals, reporting realized cash flows is not necessarily informative because realized cash flows have timing and matching problems that cause them to be a “noisy” measure of firm performance. Accounting accruals, guided by the revenue recognition and matching accounting principles, overcome this problem that comes from measuring firm performance when firms are in continuous operations by altering the timing of cashflow recognition in earnings. Invented in 1494 by a Franciscan monk named Luca Pacioli, accruals accounting was designed to be the “nerve cell” to help the flourishing Venetian merchants manage their burgeoning economic empires and to serve as a communication tool with external parties. Dechow (1994) provide evidence that accrual accounting earnings are superior to cash accounting earnings at summarizing firm performance.
Yet, as financial accounting information is a managerial output, management has discretion over the level of accruals (McNichols and Wilson, 1988). Since the seminal paper by Sloan (1996) documenting the influential result that high accruals are associated with negative future returns, most literature have held a scathing view on the role of accounting accruals as a discretionary device allowed under GAAP to give managers the flexibility to manage earnings opportunistically to entrench themselves (Shleifer and Vishny, 1989), either for career concerns (Murphy and Zimmerman, 1993; Pourciau, 1993; Smith, 1993; Farrell and Whidbee, 2003) or for compensation reasons (Matsunaga, 1995; Balsam, 1998; Matsunaga and Park, 2001; Bartov and Mohanram, 2004; Cheng and Warfield, 2005; Bergstresser and Philippon, 2006; Burns and Kedia, 2006; Cornett et al, 2007), especially with popular anecdotes of earnings management in well-publicized accounting scandals such as Enron and WorldCom. Thus, while accrual accounting is superior to cash accounting in summarizing performance, the accrual component of earnings should receive a lower weighting than the cash component of earnings in evaluating firm performance, due to the greater subjectivity involved in the estimation of accruals. This interpretation was reinforced by an earlier paper by Dechow et al (1995) who carried out an ex post analysis of a sample of earnings manipulations subject to SEC enforcement actions and find that those earnings manipulations are primarily attributable to accruals that reverse in the year following the earnings manipulations. As a result of this interpretation, the use of abnormal accruals as a proxy of earnings management or earning quality is prevalent in a long list of literature (for examples, see the survey paper on earnings quality by Dechow, Ge, and Schrand, 2009 ).
However, accounting discretion in accruals can be used by management, who have superior information about their firm’s cash generating ability, to signal their private information (Beaver et al, 1989; Wahlen, 1994; Subramanyam, 1996; Beaver and Engel, 1996; Arya et al, 2003; Louis and Robinson, 2005) to enhance credibility and reputation (Desai et al, 2006) and consistent with shareholders’ wealth maximization as efficient contracting would suggest (e.g. Malmquist, 1990). Also, earnings trend consistency is valued at a premium by the market (Barth, Elliott, and Finn, 1999), as is consistency in benchmark performance (Bartov et al, 2002; Kasznik and McNichols, 2002, Koonce and Lipe, 2010). Skinner and Sloan (2002) showed that when a firm’s earnings fall short of the analyst consensus forecast by even a small amount, it triggers a large negative stock price reaction. In addition, managers can manage earnings to avoid violating accounting-based debt covenants that would otherwise increase the cost of capital for the firm (Watts and Zimmerman, 1986, 1990; Smith, 1993; Sweeney, 1994). Managing earnings “appropriately” to smooth earnings can “save” current earnings for possible use in the future (DeFond and Park, 1997), increasing the informativeness of future earnings (Tucker and Zarowin, 2006); reduce the variability in reported earnings more when firms operate in high uncertainty (Ghosh and Olsen, 2009); and portray a less risky image of the firm (Gul et al, 2003), reducing the perceived bankruptcy probability of the firm and, hence, the firm’s borrowing cost (Trueman and Titman, 1988), and these earnings smoothing actions can be beneficial to the firm’s shareholders (Goel and Thakor, 2003). Demski (1998) argued that managers communicate acquired expertise through earnings smoothing . Chaney, Jeter, and Lewis (1996) suggest that discretionary accruals smooth earnings and they interpret their findings as evidence that discretionary accruals are not opportunistic but that they communicate information about the firm’s long-term (permanent) earnings to equity markets.
Accounting accruals also serves as an input to help curb the agency problems, and to better governance structures and corporate control mechanisms to improve the productivity of investments (Bushman and Smith, 2001; Sloan, 2001). Accounting information can be used to indicate whether governance actions against management are required. For instance, the board uses accounting earnings performance as an input into their firing decisions (Weisbach, 1988). Managers also may not wish to inflate accruals since they are associated with heightened litigation risk (Dechow et al, 1996; DuCharme et al, 2004).
Still, we do not have sufficient and conclusive evidence on whether managers exercise accounting discretion in an opportunistic or efficient manner (Dechow et al, 2009), which has been one of the long-standing questions of positive accounting research (Watts and Zimmerman, 1978, 1990). There is a missing “deciphering key” that does not allow the contracting manager to describe ex ante the meaning of “good performance”; it is only later when the uncertainty unfolds that it becomes clearer what a good performance means. If accounting discretion in reporting firm performance could be abused by managers to entrench themselves for job security or compensation reasons, then it is possible that the effectiveness of internal controls, which include efficient contracting mechanisms that seek to align managerial interests with those of the shareholders, could curb these miscreant intentions. However, Shleifer and Vishny (1988) argued that: “In sum, internal control devices are not especially effective in forcing managers to abstain from non-value-maximizing conduct. In these circumstances, it is not surprising that external means of coercion such as hostile takeovers can come to play a role.”
Thus, I argue that the missing “deciphering key” to interpreting when accounting accruals are used opportunistically or efficiently by managers, and even shed light on Healy’s (1996) unanswered question on “which types of accruals are used for earnings management and which are not”, is the governance structures of the firm. One potential measurement of the “external-based” governance that is in the spirit of Shleifer and Vishny (1988) is the G-Index in GIM (2003), since it signals entrenchment via anti-takeover protections against managerial turnover. Put in another way, variation in the G-Index is correlated with the quality of mechanisms (i.e. the external market discipline imposed on managers from potential hostile takeovers) that specifically affect earnings management opportunities or incentives.
Unsurprisingly, this is hardly a “new” idea. Dechow et al (1996) provide evidence on the corporate governance structures most commonly associated with the earnings manipulations. Given an incentive to manipulate, they find that having a weak governance structure is more likely to lead to the firm to actively engage in earnings management. Specifically, they document that firms subject to SEC enforcement actions are less likely to have an audit committee, more likely to have an insider-dominated board, more likely to have a CEO who is a company founder, and more likely to have a CEO who is Chairman of the board. Prior literature had also investigated the association between accounting discretion and governance, and interpreted a negative association as evidence of managerial opportunism (Becker, DeFond, Jiambalvo, and Subramanyam 1998; Gaver, Gaver, and Austin, 1995; Chen and Lee 1995; Guidry, Leone, and Rock, 1999; Healy, 1999; Frankel, Johnson, and Nelson 2002; Klein 2002; Menon and Williams, 2004; Peasnell et al, 2005). García, García, and Penalva (2009) find a positive association between commonly used governance proxies for effective monitoring and timely loss recognition. However, all of these studies do not show that (less) excess accounting discretion has (positive) negative consequences for shareholders’ wealth, or even the possibility that excess discretion can have positive shareholders’ wealth effects.
In one of the early important study by Christie and Zimmerman (1994), they assume that the takeover market would discipline opportunism and use this to identify a sample of firms that are likely to be opportunistic. They do not find evidence of accounting opportunism, thus discounting the Opportunistic Hypothesis and bending towards efficiency explanations. In a recent important update of the efficiency view using an interesting research methodology, Bowen et al (2008) find that managers do not systematically exploit poor governance to use accounting discretion for opportunistic purposes; in fact, accounting discretion is used to increase shareholder wealth, consistent with efficient contracting motivations. Their conclusion was based upon their interpretation of the evidence, uncovered in a two-stage regression model, of a positive association between predicted excess accounting discretion due to governance (or the portion of accruals associated with poor governance in the first-stage regression) and subsequent performance as measured by future cash flow from operation and return on assets, in contrast to the findings in prior literature. In other words, greater accounting discretion is not associated with poor firm performance. Thus, the study by Bowen et al (2008) was the first to go a step further to document the consequences of excess accounting discretion that is due to poor governance on subsequent firm operating performance.
I argue that these studies, whether in favor of the Opportunistic or Performance Management (or Efficient Contracting) story, have two limitations. Firstly, with the exception of the recent paper by Garcia et al (2009), most, if not all, of the studies in the past had concentrated on or were seduced by the “dark side” of the governance, that is, the association between accounting discretion and poor governance (and its consequences on subsequent firm performance as examined in Bowen et al, 2008), but missed out on exploring the “light side”, that is, the discretionary actions undertaken by the efficient managers when connected to the good governance mechanism, and the consequent implications on shareholders’ wealth. Secondly, and surprisingly, none of the studies thus far had investigated the possibility of how accounting accruals discretion and governance can interactively combine to become a more informative unique signal, beyond what each signal can reveal individually, to impact shareholders’ wealth. This latter point will be elaborated upon in the next paragraphs to lead to the main hypotheses of the paper. An interpretation and conclusion on whether there is managerial opportunism or efficiency from accounting discretion will be incomplete and premature without addressing these two concerns.
Financial accounting information is an output produced by management. This suggests that the presence and input of good governance structures, which mitigate agency costs and shown to be important in determining firm value in the influential paper by GIM (2003), are necessary to ensure that the accounting information supplied by management is not opportunistically manipulated in response to a variety of incentives. Signals produced by management can therefore be reliably assessed by external parties. The output of earnings quality (EQ), in turn, serve as an input to better governance structures and corporate control mechanisms to improve the productivity of investments through three channels: one, by increasing the efficiency with which the assets in place are managed (governance channel); two, by reducing the error with which managers identify good versus bad investments (project identification); and three, by reducing the information asymmetries among investors and the expropriation of investors’ wealth (adverse selection) (Bushman and Smith, 2001; Sloan, 2001). Bushman et al (2004) also document an inverse association between measures of the informativeness of accounting numbers and governance. In particular, they posit that firms that produce accounting information of limited transparency place a higher burden in governance structures to overcome this shortcoming.
Thus, it is clear that corporate governance and financial accounting are inexorably linked through a complementarity relationship. Complementarity, as pointed out by Ball, Jayaraman and Shivakumar (2010), implies that “financial reporting usefulness depends on its contribution to the total information environment, whereas substitutability implies usefulness depends on the new information it releases on a stand-alone basis.” Thus, both governance and accruals information are jointly informative; each may contain information not contained in the other about the future prospects of the firm. Importantly, this suggests the possibility of two previously unexamined relationships that will be developed into three main hypotheses.
Firstly, I posit that governance could be overrated without Low AA as an input. The results in GIM (2003) indicate that the hedge portfolio of buying firms with strong governance (Democracy), and selling firms with weak governance (Dictatorship), can generate significant long-term abnormal return of 8.5 percent per year over the sample period from September 1990 to December 1999. The hedge return are asymmetrically positioned, with 3.5 (5.0) percent from the long (short) position of the Democracy (Dictatorship) firms. In particular, I argue that it is possible that the good governance associated with future positive abnormal stock returns could be attenuated when the subset of Democracy firms with Low AA is removed. Thus, good governance per se does not lead to future positive abnormal return, contrary to the findings in GIM (2003). In other words, good governance on a stand-alone basis no longer pays off. Isolating the Democracy firms with Low AA should also enhance significantly the governance effects on future positive abnormal return. Moreover, the positive abnormal return for the Democracy-Low AA firms should be significantly larger than those of the unconditional Low AA (Democracy) firms, which indicate an incremental value in the governance (Low AA) signal, lending further weight to the intuition that corporate governance and abnormal accruals are inexorably linked through a complementarity relationship. In addition, mixed governance (termed Drifter) and Dictatorship firms with Low AA should have positive abnormal return. Thus, Hypothesis 1, stated in its alternative form, is as follow:
H1a: Good governance (Democracy) without being accompanied by Low AA is not associated with positive abnormal return.
H1b: Democracy accompanied by Low AA is associated with highly significant positive abnormal return.
H1c: Democracy accompanied by Low AA have larger positive abnormal return as compared to the unconditional Low AA (Democracy) firms, highlighting the incremental value in the good governance (Low AA) signal; corporate governance and abnormal accruals are inexorably linked through a complementarity relationship.
H1d: Mixed governance (Drifter) and poor governance (Dictatorship) accompanied by Low AA are associated with positive abnormal return.
Of great interest and debate in the literature is the question of whether investors are able to “see through” transitory distortions in accrual accounting numbers. The explanation by Sloan is that investors are thought to be overly-fixated on earnings (the Earnings-Fixation Hypothesis), misinterpreting the transitory nature of the accruals information, only to be systematically surprised when accruals turn out, in the future, to be less persistent than cashflows. Consequently, abnormal stock returns result as corrections to the initial overreaction in the year immediately following extreme accruals. Thus, Sloan views future reversals to be a result of aggressive or “bad” accounting that originally inflate accruals. Accordingly, a hedge portfolio that buys (sells) firms with low (high) accruals can generate abnormal return of 10.4 percent, with 4.9 (5.5) percent from the long (short) position in the subsequent year. Further evidence by Xie (2001), DeFond and Park (2001) and Chan, Chan, Jegadeesh, and Lakonishok (2006) indicate that this “accruals anomaly” is related to abnormal, or sometimes called discretionary, accruals . They argue that certain discretionary actions on the part of managers induce a transitory element to accruals, with stronger mean-reverting tendency of discretionary accruals, defined using the Dechow, Sloan and Sweeney (1996) modified Jones model, leading to an overpricing of aggregate accruals.
However, a limitation of Sloan’s study is that the returns predictability could be attributed to unidentified risk factors that is correlated with accruals or unknown research design flaws (Kothari, 2001). Healy (1996) pointed out that one major deficiency is the inability of these accruals model to “adequately incorporate the effect of changes in business fundamentals”. Healy added that since the residual accruals estimated by accruals model could arise due to changes in business fundamentals and because of ex post management forecast errors, and the models are accrual expectations models rather than models of discretionary accruals, he would change the label from “discretionary” to “abnormal” if he were to rewrite his influential paper (1985) about the opportunistic behavior of managers. Healy and Whalen (1999) also highlighted their inadequacy to “further identify and explain which types of accruals are used for earnings management and which are not”.
Therefore, and secondly, I argue that the conventional interpretation of EQ, measured by the magnitude of abnormal accruals, could vary across governance structures. The noise and uncertainty associated with the abnormal accruals signal - that is, managerial discretion could be interpreted as either opportunistic or conveying credible private signal about firm performance - is interactively resolved with information about the firm’s governance structure, and the unique pairing of the signals contains unique information about the future prospects of the firm. Abnormal accruals, when accompanied by good governance, become more informative and the interactive combined signal corroborates with the Performance Management Hypothesis. In particular, firms with high or extreme income-increasing AA, usually interpreted as engaging in earnings management, will not have negative future abnormal return if they happen to be also Democracy firms, contrary to the predictions in Sloan (1996). Firms with high or extreme income-increasing AA, when accompanied by Dictatorship and Drifter governance structures, have negative future stock returns, consistent with Sloan’s predictions. Thus, Hypothesis 2, stated in its alternative form, is as follow:
H2a: High AA accompanied by good governance (Democracy) are associated with positive future abnormal return.
H2b: Low AA accompanied by mixed governance (Drifter) or poor governance (Dictatorship) are associated with negative future abnormal return.
Thus, the predicted associations from the two hypotheses are summarized in the above diagram for ease of reference in subsequent discussion and analyses. The signs in the table denote the direction of the association with future abnormal return; while the number of signs indicates the magnitude and significance of the abnormal return, where two positive (negative) signs denote highly positive (negative) future returns. I make no predictions on the direction of the associations for the firms with mixed AA.
The evidence from H2 if rejected in its null form will be strengthened in an additional test if there is evidence as follow: when the portfolio of firms with revelation of high or extreme income-increasing accruals in period t experiences the biggest magnitude in accruals reversal in period t+1, those who are also Democracy firms will have positive future abnormal return, not negative return as was predicted under Sloan’s hypothesis. The trend of reported earnings and the subsequent accruals reversals at these firms are interpreted as credible private signals of firm performance by the managers, resulting in larger positive future stock returns, as it has been shown that earnings trend consistency is valued at a premium by the market (Barth, Elliott, and Finn, 1999), as is consistency in benchmark performance (Bartov et al, 2002; Kasznik and McNichols, 2002; Koonce and Lipe, 2010). Thus, Hypothesis 3, stated in its alternative form, is as follow:
H3: Good governance (Democracy) firms with revelation of high or extreme income-increasing abnormal accruals in period t that experiences the biggest magnitude in accruals reversal in period t+1 are associated with positive future abnormal return.
Recently, and increasingly, the results in GIM (2003) are being challenged as artifacts of either asset pricing model misspecification or unexpected industry performance, and the excess returns were not significantly different from zero after controlling for industry clustering effects (Johnson, Moorman, and Sorescu, 2009). Core, Guay, and Rusticus (2006) find that neither analysts nor investors were surprised by differences in operating performance across Democracy or Dictatorship firms, and resolve the puzzle of apparent nonzero long-term abnormal return in the absence of firm-specific surprises. Core et al (2006) also showed that the relative performance of good and bad governance portfolios reverses following the GIM sample period with the good governance portfolio underperforming the bad governance portfolio over the period 2000-2003. Bebchuk, Cohen and Wang (2010) showed that the abnormal return associated with the G-Index during the post-GIM period of 2000-2008 had disappeared. Bebchuk et al (2010) argued that this result could be due to market participants’ learning to appreciate the difference between firms scoring well and poorly on the governance indices after the publication of the results in GIM. Cremers and Nair (2005) examined how the simultaneous consideration of two different governance mechanisms – takeover vulnerability and shareholder activism – is crucial for the documented abnormal return in GIM (2003); they found that the portfolio that buys Democracy firms and shorts Dictatorship firms generates abnormal return only when public pension fund (blockholder) ownership is high as well. In addition, prominent commercial governance ratings are found to have limited or no success in predicting firm performance, restatements, security litigation and other outcomes of interest to shareholders (Daines, Gow, and Larcker, 2010). Until GIM (2003), literature on individual governance characteristics had not identified a conclusive systematic relation to firm performance, and these recent observations reflect the extreme difficulty in distilling all of the complex governance mechanisms into a single, integrated, yet informative overall score, with econometrics issues of governance as an endogenous firm choice, correlated omitted variables and measurement errors complicating the relationship (Larcker, Richardson, and Tuna, 2007; Larcker and Rusticus, 2010).
This paper is the first, to the best of my knowledge, to attempt to empirically resolve this long-standing tense debate regarding the relationship between governance and firm performance, and show that both the supporters and the sceptics of the results in GIM (2003) are not incorrect by pointing out that this “performance gap” in governance can be closed by extending the analysis beyond using corporate governance rating on a stand-alone basis, particularly by considering the interactive effects of abnormal accruals and governance which yield a more informative combined private signal about firm value.
The observant reader will notice that there is a striking similarity with both the governance and accruals trading strategy in GIM (2003) and Sloan (1996). Both of the documented abnormal returns are concentrated on the short side. Without an economically significant positive return to the long position in the Democracy and extreme income-decreasing accruals portfolio, it is possible that the hedge returns no longer exceeds transaction costs, especially given the high transaction costs, limits to arbitrage and short-selling constraints associated with taking a short position (Shleifer and Vishny, 1997; Jones and Lamont, 2002; Boehmer et al, 2009). University of Notre Dame professor of finance Tim Loughran commented in the CFA Digest that he is “always suspicious of anomalies that seem to be focused on the short side” (Trammell, 2010). Loughran related how he wanted to short Krispy Kreme, but was told by his broker that it is not possible because “every single share that’s available to be shorted has been shorted”. In addition, it appears that the predictive returns from employing the accruals strategy is dissipating, as what Ron Kahn, Barclays Global Investors (BGI) then global head of research, stated in Financial Times in 1/2009 that “buying companies with high quality earnings and shorting those most dependent on accruals proved a good strategy, until the market figured it out” (Skypala, 2009). Green, Hand, and Soliman (2009) extended the time period five years beyond the 2003 endpoint used by Lev and Nissim (2006) and Mashruwala et al (2006) and found that abnormal accruals is no longer an effective predictor of future stock returns because the anomalous returns are arbitraged away by hedge fund investors deploying greater capital, an estimated peak dollar investments of almost $60 billion in 2007, in exploiting this signal to the point that they are no longer positive. Thus, a firm with Low AA may even have poor future stock performance if too many investors crowd around a similar trading strategy of buying firms with Low AA.
Therefore, this paper also restores the viability of both investment strategies by documenting how the long position in Democracy firms with Low AA – the Super-Performers - generates abnormal annualized return of 10.5 percent over 1991-2008, well in excess of possible transaction costs.
3. Data, Variable Description, and Research Methodology
3.1 Measure of governance and abnormal stock returns
The data for this study is drawn from the eight volumes published by the Investor Responsibility Research Center (IRRC) that have a governance index score (G-Index) and financial and stock price data from CRSP/Compustat Merged database (CCM) and CRSP database respectively. The G-Index is based on 24 IRRC provisions which restrict shareholder rights, and a higher score is viewed as representing poorer governance. The score of the G-Index ranges from 1 to 24, and GIM (2003) classified companies with G-Index less than or equal to 5 as the ‘Democracy’ portfolio, while those with a score of 14 and above are classified as ‘Dictatorship’ portfolio. The volumes were published on the following dates: September 1990, July 1993, July 1995, February 1998, November 1999, February 2002, January 2004, and January 2006. The data in the 2008 RiskMetrics governance volume was not used because it is not comparable with data in the earlier IRRC volumes . Following GIM (2003) and subsequent literature, I exclude dual-class firms because of the unique governance structures and regulations prevailing for these sets of firms. Following this, the number of firms (at each publication date) is as follows: 1,303 (1990), 1,303 (1993), 1,333 (1995), 1,642 (1998), 1,492 (2000), 1,588 (2002), 1,675 (2004), 1,619 (2006). An annual time series of the G-Index is constructed using the forward-fill method of GIM (2003) by assuming that the governance provisions remain unchanged from the current date of on volume until the current date of the next volume. Given the relatively stability of G-Index over time, GIM (2003) argue that any measurement noise using the forward-fill method is likely to be relatively minor. Data in the last IRRC volume of 2006 are filled to the end of 2008. Thus, the sample period in this study is from September 1991 to December 2008. Each firm’s G-index is matched with its monthly returns (including dividends) from CRSP, and a value-weighted portfolio is constructed. Portfolios are rebalanced at the beginning of each month and governance data is updated whenever information in a new IRRC volume becomes available.
Abnormal stock returns is captured by the estimated intercept, “alpha”, using Fama-French (1993) three-factor model and includes the Carhart (1997) momentum factor UMD calculated from WRDS . For each calendar month, the value-weighted average return to portfolios of firms grouped into deciles of portfolios sorted by the G-Index is calculated, according to the most recent value of the G-Index. The excess monthly returns are regressed on the four factors as mentioned:
Rt = α + β1RMRFt + β2SMBt + β3HMLt + β4UMDt + εt (1)
where Rt is the return of the governance portfolio in excess of the risk-free rate (one-month Treasury bill) in month t, or (Ri – Rf)t; RMRFt is the month t value-weighted market return minus the risk-free rate, and the terms SMBt (small minus big), HMLt (high minus low), and UMDt are the month t returns on zero-investment factor-mimicking portfolios designed to capture size, book-to-market, and momentum effects, respectively. Thus, the estimated intercept α is the abnormal return in excess of what could have been achieved by passive investments in the factors .
Following GIM (2003), I replicate their main results in Table VI using their four-factor calendar time portfolio method using equity returns from September 1991 to December 1999 . My results are similar and are not presented. The results in GIM (2003) revealed that the positive monthly alpha for the Democracy portfolio, the group of firms with a G-Index of 5 or less, is a statistically significant 0.29 percent. The portfolios with G-Index of 6 and 7 also generate qualitatively similar positive monthly alpha of 0.22 and 0.24 percent respectively, albeit statistically insignificant. Given that the original Democracy portfolio comprise of only around 9 percent of the sample data on average, and that it is highly likely that there will be heightened attention on corporate governance in the post-GIM sample period, I extended the sample size of the Democracy portfolio by including firms with qualitatively similar positive monthly alphas and re-grouping the Democracy portfolio as firms with a G-Index score of 7 or less. Following this, Democracy firms now comprise 27.9 percent of the sample on average. Importantly, as one of my key tests is to examine whether isolating Democracy firms with Low Abnormal Accruals (AA) as an input will enhance significantly the governance effects on returns (H1b), such a re-classification is biased against my findings. In addition, I wish to show that Drifter and Dictatorship can have positive abnormal return as well (H1c), and such re-grouping will again be biased against my results. Likewise, the negative monthly alpha for the Dictatorship portfolio, the group of firms with a G-Index of 14 and above and comprising 5.5 percent of the sample on average in GIM (2003), is a statistically significant 0.42 percent; those with G-Index of 13 and 12 have qualitatively similar negative monthly alpha at 0.01 and 0.25 respectively. In the same fashion, I re-classified firms with a G-Index of 12 and above as Dictatorship, now comprising 20.0 percent of the sample on average. Firms with a G-Index between 8 and 11 comprise 52.1 percent of the sample on average, and they are termed Drifter. GIM (2003) and all the subsequent literature on governance made no mention about these Drifter firms even though they are the bulk of the sample size. The properties of the Drifter are deliberately examined to test whether Drifter with Low AA can also enjoy a valuation premium with positive future abnormal return just like the Democracy firms (H1d).
3.2 Measures of earnings quality
There is no one measure of earnings quality (EQ), a multi-faceted term, which is universally agreed upon (Dechow, Schrand and Ge, 2009). The EQ measures are selected based on the measures’ value relevance – the ability to explain variation in contemporaneous stock returns – because value relevance is generally viewed in the literature as a direct estimate of the measure’s usefulness in equity investors’ decision making (e.g. Collins et al, 1997; Francis and Schipper, 1999; Lev and Zarowin, 1999; Barton, Hansen and Pownall, 2010). Moreover, the FASB considers “relevance” as a primary quality that makes accounting information useful to investors (FASB, 1980; Barth, Beaver and Landsman, 2001; Holthausen and Watts, 2001). Below is a description of the two models of EQ that were considered.
3.2.1 Abnormal accruals in Dechow and Dichev (2002) model
The use of the Dechow and Dichev (2002) model has become the accepted methodology in accounting to capture discretion (e.g. Francis et al, 2005; Dechow, Ge, Schrand, 2010). Dechow and Dichev derived working capital accrual quality based on the following firm-level time-series regression :
∆WC = β0 + β1CFOt-1 + β2CFOt + β3CFOt+1 + εt (2)
Dechow and Dichev (2002) took the position that earnings mapping more closely to operating cash flows is of higher quality. The residuals from the regression reflect the accruals that are unrelated to cash flow realizations. The magnitude of these residuals is a firm-year measure of accruals quality, where higher value of the residuals denotes lower quality . The underlying assumption is that if a performance measure is closer to the firm’s cash flows, then accrual accounting – and therefore managers’ judgments and estimates – will have less of an effect on the reported performance measures. The measure attempts to isolate the managed or error component of accruals. Measures that are closer to operating cashflows have greater value relevance. The Dechow and Dichev (2002) model appears to provide better estimates of abnormal accruals than other models, and it has much higher explanatory power than the modified Jones model (and its various extensions) and much lower variability in the error term. Jones et al (2008) provide evidence indicating superiority of the Dechow and Dichev (2002) model over competing models. Specifically, they show that this model exhibits the strongest association with the existence and magnitude of fraud and non-fraud restatements, and therefore performs better than other models in estimating abnormal accruals.
The CFO (Compustat item OANCF) is derived from the Statement of Cash Flows reported under the Statement of Financial Accounting Standards No. 95 (SFAS No. 95, FASB 1987), given the results in Collins and Hribar (2002) showing that the balance-sheet approach to deriving CFO leads to noisy and biased estimates. The change in working capital from year t-1 to t (∆WC) is computed as ∆AR + ∆Inventory - ∆AP - ∆TP + ∆Other Assets (net), where AR is accounts receivables, AP is accounts payable, and TP is taxes payable. Specifically, ∆WC is calculated from Compustat items as ∆WC = - (RECCH + INVCH + APALCH + TXACH + AOLOCH). All variables are scaled by average total assets. Following Dechow and Dichev (2002), I replicate their main findings in Table 3 and Table 4 using data from their sample period of 1987-1999. My results are very similar and are not presented.
Ten decile portfolios sorted and ranked by the magnitude of the residuals in the regression model in (2) are formed three months after the end of each fiscal year to ensure that the financial statements are publicly available . The portfolio of firm-months with the lowest (highest) value in residuals is given an abnormal accruals (AA) score of 1 (10). Similar to the approach used in sorting the firms into the three categories of governance structures, the group of firms with a score of 3 and below is re-classified as “Low or Income-Decreasing AA”; those with a score between 4 and 7 are classified as “Mixed AA”; and finally, those with a score of 8 and above are classified as “High or Income-Increasing AA”.
3.2.2 Abnormal accruals in the modified Jones model by Dechow, Sloan and Sweeney (1996)
In the original Jones (1991) model, total accruals and working capital accruals are explained as a function of sales growth (Compustat item change in REVT) and plant, property & equipment (PPEGT) respectively, and all variables are scaled by lagged total assets. The modified Jones model by Dechow, Sloan and Sweeney (1995) is adjusted for growth in credit sales (Compustat item change in RECT), which are frequently manipulated:
TACCt = α + β1(∆REVTt - ∆RECTt)+ β2PPEGTt + + εt (3)
The power of the Jones’ model is increased by this modification, yielding a residual that is uncorrelated with expected (i.e. normal) revenue accruals and better reflects revenue manipulation . TACC is computed as change in current assets (Compustat item change in ACT), minus change in current liabilities (Compustat item change in LCT), minus change in cash (Compustat item change in CH), plus change in short-term debt (Compustat item change in DLC), minus depreciation (Compustat item DEPN) . The approach used in sorting and ranking the residuals in the modified Jones model in equation (3) and re-classifying the firm-months into the three categories of AA is similar to that as described for the Dechow and Dichev (2002) model in Section 3.2.1.
3.3 Measures of accruals reversal
Following Allen, Larson, and Sloan (2010), I define accruals reversal (ACCREVt+1) as the difference between accruals in the current period and accruals in the previous period, with the accruals being estimated as either ∆WC in equation (2) in the Dechow and Dichev (2002) model, or TACC in equation (3) in the modified Jones model. The implicit assumption in this definition is that accruals are expected to reverse within the next year as has been documented empirically in many studies (e.g. Sloan, 1996; Bradshaw et al, 2001) . For instance, a negative accruals reversal involves the revelation of high or extreme income-increasing accruals (e.g. boosting inventory accruals) in period t – conventionally interpreted as evidence of earnings management or poor EQ – and the reversal into negative accruals (e.g. inventory writedown) in period t+1. The magnitude of ACCREVt+1 is sorted and ranked to form ten decile portfolios three months after the end of each fiscal year, and then matched with the monthly CRSP returns in period t+1. Again, a similar approach as described in the earlier sections is used to re-classify the ten portfolios into three portfolio categories: big net negative accruals reversal (Negative Accruals Reversal), mixed accruals reversal (Mixed Accruals Reversal), and big net positive accruals reversal (Positive Accruals Reversal). I am particularly interested in testing the hypothesis, stated in its alternative form, of whether the abnormal return or monthly alpha in the association between both positive and negative accruals reversal and future stock returns is significantly positive (H3), contrary to the negative returns in Sloan’s view.
4. Empirical Results
4.1 Summary statistics
Before examining the returns on the stocks sorted two-dimensionally by governance and abnormal accruals (AA) to test out the three key hypotheses highlighted in the previous section, I first look at the usual firm characteristics for the unconditional portfolios sorted along the single dimension of either governance or AA. These firm characteristics include: Market cap (in millions), calculated monthly as shares outstanding times the month-end share price; Price, which is a common proxy in for transaction costs as it has been documented in prior literature that low-priced stocks have higher trading costs; Turnover is the monthly number of shares traded relative to the number of shares outstanding; BM or book-to-market is the book value equity per share relative to the month-end share price; PE or price-earnings ratio is end-of-fiscal-year share price relative to EPS; Div or dividend yield is dividend per share relative to share price; Sales Growth; ROA or return on assets is income before extraordinary items relative to average total assets; Leverage is total net debt relative to total assets; R&D, research and expenditure expense relative to sales; Capex1 is capital expenditure relative to sales; Capex2 is capital expenditure relative to average total assets; Deferred Revenue is deferred current revenue (Compustat item DRC) relative to average total assets; and Special Item is special items relative to average total assets.
4.1.1 Characteristics of abnormal accruals portfolio
From Panel A of Table 1, the median size for the firms in the High AA portfolio is bigger with a market cap at $963 million, as compared to $835 million for firms in the low accruals portfolio. Firms in the High AA portfolio have relatively higher share price, slightly higher trading intensity based on turnover, lower book-to-market ratio, quite similar PE ratio, lower dividend yield, higher sales growth, surprisingly relatively higher operating performance as measured by return on asset (ROA), relatively similar debt leverage ratio, lower R&D investments, higher capex spending, higher deferred revenue, and larger negative special items. There is a slightly higher operating performance in the previous year for High AA, while there is deterioration (improvement) in ROA in the following year for High AA (Low AA). There is no difference in the average governance quality between the two sets of firms as measured by the G-Index .
Most of my results are similar to prior literature findings, and also consistent with the popular “growth explanation” for the accruals anomaly with high accruals firm having higher sales growth and higher investments (capital expenditure). Fairfield et al (2003) and Zhang (2007) argue that the negative future returns associated with high accruals are due to diminishing returns on investments, since the measurement of accruals are scaled by average total assets, and therefore high accruals could be capturing high investments or growth. In their iconic study, Lakonishok, Shleifer and Vishny (1994) argue that investors extrapolate past strong growth information too far into the future, and as a result, stock prices tend to reverse for growth firms. Titman, Wei, and Xie (2004) suggests that firms with high capital expenditures tend to be overinvesting, and therefore, earn lower future stock returns. Cooper, Gulen, and Schill (2008) document a negative relation between asset growth and returns. Fama and French (1995, 1996) suggest that growth firms could be financially distressed and hence investors are compensated with lower expected returns. My results appear to suggest that firms with high abnormal accruals may not be financially distressed since they are relatively bigger in size and have better operating performance. A key difference with prior literature is that I am restricted to stocks with data on a G-Index score, which limits my sample size to around 1,500 firms on average per year over 1991-2008. Caylor (2010) find that managers use discretion in deferred revenue to avoid negative earnings surprises. Interestingly, the high accruals firm in my sample have higher deferred revenue (5.8 percent of average total assets), which could suggest that they are also opportunistically manipulating deferred revenue.
Dechow and Ge (2006) find that low accrual firms are more likely to have negative non-cash special items, such as an asset write-off. These low accrual firms with negative special items have higher ROA and higher positive future abnormal returns, and they interpret the results to mean that accounting accruals decisions by managers to take a one-time charge is a signal that it is taking actions to turn the firm around. Also, they infer that investors fail to understand that these negative special items are transitory and exhibit low earnings persistence, and thus, the accruals anomaly is more pronounced for these firms. I find that the Low AA firms in my sample have negative special items (1.1 percent of average total assets) and ROA improves in the following year, consistent with Dechow and Ge (2006).
4.1.2 Characteristics of governance quality portfolio
From Panel B of Table 1, the median size for the firms in the Democracy portfolio is surprisingly smaller with a market cap at $918 million, as compared to $1.6 billion in Dictatorship, as it is often thought that bigger firms have more resources to spend on installing corporate governance practices. Democracy firms have relatively lower share price, higher turnover, quite similar book-to-market ratio, higher PE ratio, lower dividend yield, higher sales growth, less leverage, higher R&D, higher capex, higher deferred revenue, and relatively similar slight negative special items. Surprisingly, there is no significant difference in the comparison of current and next-period operating performance (ROA) for both sets of firms.
4.2 Baseline results
Table 2 shows the monthly intercepts or alphas in the Fama-French-Carhart regressions for the portfolios double-sorted independently by governance quality and abnormal accruals (AA) measured using the Dechow and Dichev (2002) model . The intercepts, which indicate abnormal future returns, have been multiplied by 100 so that they can be interpreted as percentages.
In Panel A of Table 2 which describes the data for the overall sample period from September 1, 1991 to December 31, 2008, the monthly alpha for the unconditional Democracy portfolio is positive at 0.289 percent, albeit statistically insignificant. For the sub-period September 1, 1991 to December 31, 1999 in Panel B of Table 2, which is the original sample period in GIM (2003), the monthly alpha is positive at 0.212 percent, which is quite close in economic significance to the 0.29 percent for the original and smaller Democracy portfolio in GIM (2003), although it is statistically insignificant. Recall that as per the description in Section 3, I have extended the sample size of the Democracy portfolio which now comprises 27.9 percent of the sample on average, as compared to the original 9 percent in GIM (2003). The unconditional Low AA portfolio has significant positive abnormal future return at 6.4 percent per year (t-statistics of 2.60) over 1991-2008 and 6.6 percent (t-statistics of 2.16) in the sub-period 1991-1999, although the positive return is no longer significant in the sub-period 2000-2008, which is consistent with Sloan (1996) and also with the recent findings in Green et al (2008) that the returns to the abnormal accruals portfolio are dissipating due to hedge funds overcrowding the trades in exploiting this signal.
The portfolio of Democracy firms with Low AA, dubbed Super-Performers, generates a positive monthly alpha of 0.875 percent (t-statistics of 2.73), or abnormal return of 10.5 percent per year from 1991 to 2008. Thus, the null in H1b can be rejected. The 10.5 percent abnormal return for this Super-Performers or Democracy-Low AA portfolio is far larger than the return for the unconditional Democracy portfolio (3.5 percent). It can be inferred that the incremental value in the Low AA signal is 7.0 percent per year. Notice also how the 10.5 percent abnormal return for this Democracy-Low AA portfolio is higher than the return for the unconditional Low AA portfolio (6.6 percent); thus, the incremental value in the good governance signal is 3.9 percent. These results lend further weight to my conjecture that corporate governance and abnormal acccruals are inexorably linked through a complementarity relationship; the null in H1c can be rejected. The abnormal return of these Super-Performers are also economically larger (700 basis points per year) than the long position documented in GIM (2003), and is also 200 basis points more than the entire hedge returns in GIM (2003). Interestingly, a closer investigation indicate that some of these Super-Performers include well-known, institutional big-cap stocks, such as Coca-Cola Co, AT&T, Hewlett-Packard, Wyeth, Lowe’s, Home Depot, and EMC, formed in the portfolio at various months in the sample period.
In addition, I find evidence that removing these Super-Performers will reduce the remaining Democracy portfolio returns to no different from zero statistically over the period of 1991-2008, and over the sub-period of 1991-1999 that was examined in GIM (2003) (H1a). In other words, good governance per se no longer pays off, contrary to the findings in GIM (2003). Therefore, the null in H1a can be rejected.
Mixed governance firms, with a G-Index between 8 and 11, comprise 52.1 percent of the sample on average, and they are termed Drifter. GIM (2003) and all the subsequent literature on governance made no mention about these Drifter firms even though they are the bulk of the sample size. The unconditional monthly alpha for Drifter portfolio is negative on average in 1991-2008 and in the two sub-periods (1991-1999 and 2000-2008). Interestingly, I find that the portfolio of Drifter with Low AA has significantly positive monthly alpha of 0.520 percent (t-statistics of 2.22), or abnormal return of 6.2 percent per year over 1991-2008; the returns are even greater during the sub-period 1991-1999 at 9.2 percent per year (t-statistics of 2.82). Thus, it is not only good governance firms that enjoy positive future abnormal return; Drifter with Low AA can revel in this capital appreciation outperformance as well. The factor loading for SMB is significantly positive, indicating that the stocks in this particular Drifter-High EQ portfolio tend to be smaller stocks, although this no longer holds true in the sub-period 1991-99. During the sub-period of 2000-2008, the monthly alpha for the Drifter-High EQ portfolio dropped to an insignificant 0.325 percent. Surprisingly, even Dictatorship with Low AA can have positive abnormal return at 2.4 percent per year over 1991-2008, albeit statistically insignificant, as compared to 0.2 percent per year for the unconditional Dictatorship portfolio. The null in H1d can thus be rejected.
For the unconditional High AA portfolio, the abnormal future returns is negative 2.2 percent per year over 1991-2008, as expected under Sloan (1996), albeit statistically insignificant. Democracy with High AA have positive, albeit insignificant, annualized abnormal return of 3.2 percent, which lends some support for the null rejection in H2a. Unsurprisingly, High AA firms accompanied by Dictatorship and Drifter governance structures have negative abnormal annualized returns of 0.9 and 7.5 percent (t-statistics of -2.90) respectively, which are as predicted by Sloan (1996); thus, the null in H2b can be rejected, particularly for the Drifter-High AA portfolio. Interestingly, the excess performance for the Drifter-High AA portfolio is larger (by 200 basis points per year) than the returns from the short position (5.5 percent per year) documented in Sloan (1996). The factor loading SMB for the Drifter-High AA firms is significantly positive, indicating that the stocks in this portfolio tend to be smaller stocks.
The small negative insignificant returns for the short position of the Dictatorship-High AA portfolio may seem, at first blush, surprising since it is the worst of both worlds. However, this is consistent with the findings in Core et al (2006) who find that weak governance firms have poorer operating performance, but investors and analysts continue to forecast this difference and hence are not systematically surprised to the extent that leads to stock price declines. The results are also consistent with Bowen, Rajgopal and Venkatachalam (2008) who find that managers do not systematically exploit poor governance structures to engage in accounting discretionary at the shareholders’ expense since subsequent future operating performance is positive. A caveat is that stock returns as a yardstick of performance measurement is a “noisy” measure, since bad governance can impose substantial ongoing costs on shareholders with no return effect so long as shareholders are not surprised by the costs.
In the additional test for the Negative ACCREV portfolio of stocks with revelation of high or extreme income-increasing accruals in period t which experiences the greatest magnitude in accruals reversal in period t+1, the results in Table 3 indicate positive annualized abnormal future returns of 10.8 percent (t-statistics of 1.98) per year for those are also Democracy firms, contrary to the expectation of negative future returns in Sloan (1996) . Delving deeper into this Negative ACCREV-Democracy portfolio, I find that 43 percent of the sample are Democracy-High AA in the previous period. This means that not all the firms with extreme high abnormal accruals in period t reverse sharply in period t+1. For this specific group (N = 2785), the future positive abnormal returns is even larger at 20.3 percent per year over 1991-2008 (t-statistics of 3.18) ! Again, this is not the negative return that was expected under Sloan’s hypothesis. On one hand, negative accruals reversal may imply aggressive accounting, such as managers opportunistically boosting inventory accruals in period t and subsequently being forced to write down inventory in period t+1 when demand falls short. On the other hand, as the cash consequences that the accruals anticipate are realized when the accruals reverse, the trend of reported earnings and the subsequent accruals reversals at these negative accruals reversal firms who have at the same time good governance structures are interpreted as credible private signals of firm performance by the managers, resulting in larger positive future stock return. This can be explain by how earnings trend consistency is valued at a premium by the market (Barth, Elliott, and Finn, 1999), as is consistency in benchmark performance (Bartov et al, 2002; Kasznik and McNichols, 2002). Thus, the null in H3 can be rejected.
It may be argued that if there is incremental value in the good governance signal, then there should be positive abnormal future return for the Positive ACCREV-Democracy portfolio as well, or those firms who have low or extreme income-decreasing accruals in period t which experiences large accruals reversal to high accruals in period t+1. I find some evidence that this holds true, particularly in the sub-period 1991-1999 where the Positive ACCREV-Democracy portfolio generates positive abnormal future return of 9.7 percent per year, although the magnitude is greatly reduced to 2.4 percent for the overall sample period 1991-2008 and is also no longer significant. The factor loadings for SMB and HML are significantly positive and negative respectively, indicating that the stocks in this particular portfolio tend to be smaller and “growth” stocks.
Overall, the empirical results from testing the three hypotheses highlight the joint importance of governance and abnormal accruals in contributing to the total information environment to separate winners from losers.
Repeating the analysis using the modified Jones model by Dechow et al (1996) to estimate the abnormal accruals, all the results as shown in Table 4 and 5 are qualitatively similar, although the statistical significance is lost for most of the findings for the overall sample period from 1991-2008. A closer investigation highlights that the results hold true in the original sub-period 1991-1999 in GIM (2003), but the significance has mainly dissipated in the post-GIM sub-period 2000-2008. This is consistent with the findings in Bebchuk et al (2010) and Green et al (2008) that the governance effect on performance and the return to the abnormal accruals strategy had largely disappeared in the 2000s due to “learning” by the market participants or hedge funds deploying excess capital to exploit the signals. Green et al (2009) further argued that the abnormal accruals trading strategy documented by Sloan (1996) was known to a few in academe but to no practitioners in the pre-Sloan sub-period 4/89-12/95. This pre-Sloan period also coincided with my findings that the AA signal provides incremental value during the sub-period 1991-1999. However, the accruals anomaly took some time to be understood for investors to take definite action (Shleifer and Vishny, 1997; Lee, 2001; Mitchell, Pedersen, and Pulvino, 2007). In the post-Sloan-TAR period, Green et al (2008) pointed out that not only was the accruals anomaly widely known both inside and outside of academe, but during the period, key senior accounting academics such as Charles Lee and Richard Sloan significantly increased their ties to Barclays Global Investors.
There is also heightened attention by the SEC, the media, and the public in earnings quality issue in the 2000s, particularly after the various accounting scandals epitomized by the Enron case, and increased regulatory scrutiny such as the passage of the Sarbanes-Oxley Act, or Sarbox (2002), and Regulation Fair Disclosure, or RegFD (1999-2000), and higher incidence of litigation risks associated with abnormal accruals (DuCharme et al, 2004) during this period. These factors could probably account for “lower” opportunistic manipulation of accruals in which the “discretionary” portion could be estimated using the now widely-known modified Jones model (Cohen, Dey, and Lys, 2008; Bartov and Cohen, 2009), resulting in a weaker trading signal, and hence the decaying return and lack of statistical significance for my sub-period 2000-2008 from the modified Jones model.
4.3 Firm characteristics and firm operating performance in the two-dimensional portfolios
In this section, I explore the return on the two-dimensional portfolios in greater depth by examining their firm characteristics. In Table 6, I make comparisons between five pairs of portfolios: (1) Democracy-Low AA (Super-Performers) Vs. Democracy-High AA portfolios, so as to attempt to find out the source of the incremental value in the AA signal in the firm characteristics; (2) Democracy-Low AA (Super-Performers) Vs. Dictatorship-Low AA to assess the incremental value in the governance signal; (3) Drifter-Low AA Vs. Drifter-High AA, so as to assess what are so different in the firm-characteristics between these two sets of firms beyond the Fama-French-Carhart factors, given that the results that the hedge abnormal return can be economically substantial at 13.7 percent per year; (4) Democracy-High AA Vs. Dictatorship-High AA, since firms with high abnormal accruals – conventionally interpreted as poor earnings quality – are expected to be associated with negative future return, but Democracy-High AA firms can instead have positive return – could there be any systematic similarities or differences in firm-characteristics that explain this; and finally (5) Dictatorship-Low AA Vs. Dictatorship-High AA, since it is surely an oddity for firms with poor governance structures to be associated with positive return if they are also accompanied by Low AA, and investigating the firm-characteristics could perhaps prove fruitful in re-looking into possible instances of “good” managerial entrenchment.
First, in the comparison between firms in Democracy-Low AA (Super-Performers) and Democracy-High AA in Table 6, Super-Performers are relatively smaller in size with median (mean) market cap at $630 million ($3.7 billion) versus $903 million ($4.7 billion) for Democracy-High AA firms. Also, Super-Performers have relatively lower share price, lower turnover, higher book-to-market ratio, relatively similar PE ratio, higher dividend yield, lower sales growth, lower ROA, slightly more leverage, lower R&D and capex, higher deferred revenue, and larger negative special items. There is no difference in operating performance in the previous year, while there is an improvement (deterioration) in ROA in the following year for Super-Performers (Democracy-Low AA). Second, as compared to Dictatorship-Low AA, Super-Performers are similar in size, have lower share price, higher turnover, slightly higher book-to-market ratio, lower PE, lower dividend yield, quite similar sales growth, lower ROA, lower leverage, higher R&D and capex, and higher deferred revenue. There is a slightly lower operating performance in the previous year for Democracy-Low AA, while there is an improvement in ROA in the following year for both. Interestingly, higher capex investments in the hands of the managers at these Super-Performers do not lead to poor stock return as was suggested by Titman et al (2004).
The results appear to suggest that Super-Performers could be “turnaround-stocks” as they have larger negative special items (such as a one-time non-cash restructuring write-off) and better subsequent operating performance. Thus, their outsized performance could be due to investors failing to understand the transitory nature of negative non-cash special items, pronouncing the return from the low accruals anomaly, according to the arguments in Dechow and Ge (2006). In the discussion of the paper by Dechow and Ge, Fairfield (2006) noted that “the evidence raise questions about the source of the improved accounting performance ... return on assets for the low accrual/negative special items firms may increase for various reason - the lower asset base from the write-off, the absence of negative special items in the following year, or higher ‘core earnings’ in the following year. Because Dechow and Ge do not control for the effect of the denominator and do not separate future earnings into its core and special components, the evidence does not demonstrate conclusively that the firms recover in any meaningful sense … poorly performing firms and negative accrual firms are not identical sets, but the authors did not differentiate between the two.”
As mentioned earlier, Super-Performers include well-known, institutional big-cap stocks, such as Coca-Cola Co, formed in the portfolio at various months in 1991-2008. Using Coca-Cola as an example , I find that the excess returns are mainly from the 1990-1991, 1994-1997 and 2006 period. Roberto Goizueta took over the reins of the CEO in 1985 and Coca-Cola embarked upon one of the most famous marketing blunders in corporate America history by launching the sweeter “New Coke” to compete with Pepsi for the “younger” taste buds. “New Coke” was booed with negative publicity and prompted the reversal back to “Classic Coke”. Coca-Cola sold the non-core entertainment business Columbia Pictures, purchased by Goizueta in 1982, to Sony for $3 billion in 1989. After the restructurings, the company emerge stronger from its earlier blunders and re-established itself as the pacesetter in the non-alcoholic beverage industry during the 1990s .
In 1990, the company opened the “World of Coca Cola” museum in Atlanta to retell its heritage; excess returns were generated in 1990-1991. 1993 saw the introduction of the popular “Always Coca-Cola” advertising campaign, and the world met with the lovable Coca-Cola Polar Bear for the first time. Coca-Cola also became a major sponsor of the Olympics and enjoyed a high profile during the 1996 Olympic Games. By 1997, 1 billion Coca-Cola products were sold every day – and 1997 was also the year of death of its iconic CEO Goizueta; excess returns were generated in 1994-1997. One of Goizueta’s notable accomplishments was to help Coca-Cola realize the goal to develop a diet version of Coke in 1982; 2005 saw the déjà-vu launch of Coke Zero, the popular zero calorie cola - excess returns were generated in 2006.
And all these corporate actions took place in a Democracy governance structure at Coca-Cola, suggesting that corporate governance could be the important joint factor that Fairfield (2006) questioned about to determine whether the low accrual firms with negative special items “recover in any meaningful sense”. As pointed out in the empirical results in Section 4.2, the 10.5 percent abnormal return per year over 1991-2008 for Super-Performers (low accruals firms with good governance) is higher than the return for the unconditional low accruals portfolio (6.6 percent), indicating that the incremental value in the good governance signal is 3.9 percent, and that the complementarity in governance and accruals information is important in determining returns predictability and the persistence in longer-term firm performance.
Third, Drifter-Low AA are slightly bigger in size than Drifter-High AA, have quite similar share price, slightly higher turnover, slightly higher book-to-market, quite similar PE ratio, slightly higher dividend yield, lower sales growth, lower ROA, quite similar leverage, quite similar R&D, lower capex, higher deferred revenue, and larger negative special items. There is a slightly lower operating performance in the previous year for Drifter-Low AA, while there is an improvement (deterioration) in ROA in the following year for Drifter-Low AA (Drifter-High AA). The “restructuring effect” is probably at work again for the positive abnormal return at Drifter-Low AA who have large negative special items. Interestingly, it also further reinforces the importance of governance quality in determining the persistence in longer-term firm performance since Super-Performers (low accruals firms with good governance) generate 4.3 percent per year more in abnormal return over 1991-2008 than Drifter with similarly negative accruals and negative special items.
Fourth, Democracy-High AA are smaller in size than Dictatorship-High AA, have lower share price, higher turnover, quite similar book-to-market ratio, higher PE ratio, lower dividend yield, higher sales growth, higher ROA, lower leverage, higher R&D and capex, higher deferred revenue, and quite similar negative special items. There is a mixed operating performance in the previous year for Democracy-Low AA, while there is deterioration in ROA in the following year for both. The results appear to suggest that booking higher sales growth and larger corporate investments (capex and R&D) are regarded as a genuine attempt by the managers to increase shareholders’ wealth even if it increases abnormal accruals and impacts short-term operating performance (lower ROA in the following year) at the Democracy-High AA firms, and hence their future return is not negative (although not significantly positive) as predicted under Sloan.
Fifth, Dictatorship-Low AA are smaller in size than Dictatorship-High AA, have lower share price, slightly lower turnover, higher book-to-market ratio, higher PE ratio, higher dividend yield, lower sales growth, lower ROA, higher leverage, slightly higher R&D, slightly lower capex, higher deferred revenue, and larger negative special items. There is a slightly lower operating performance in the previous year for Dictatorship-Low AA, while there is an improvement (deterioration) in ROA in the following year for Dictatorship-Low AA (Dictatorship-High AA). This appears to suggest that the supposed “entrenched” managers at Dictatorship-Low AA are probably achievers who want a “quiet life” and they produce higher future operating performance and pay a higher dividend yield to shareholders. This is different from the results in Bertrand and Mullainathan (2003) that show profitability declined in the firms run by “quiet-life” entrenched managers. The reason is likely because the incremental value in the AA signal helps in separating the quiet-performing managers from the “quietly” destructive entrenched managers who produce discordantly poor future operating performance.
5. Robustness Test
Kraft, Leone, and Wasley (2006) document a “look-ahead bias” in many accruals studies. Because many studies using the Dechow and Dichev (2002) model were interested in examining the evolution of accruals as well as the stock returns to an accruals-based trading strategy, the sample selection required that the next year’s cash flow from operations be present. But whether or not the numbers are present in the next year is not known at the time of portfolio formation, so the documented return is not the result of an implementable trading strategy. Kraft et al (2006) show in a sample of NYSE/AMEX firms that the return to the low accrual portfolio is 4.2 percent with the bias present but only 1.8 percent without it.
I investigate further this “look-ahead bias” by removing the term CFOt+1 in equation (2) and running the modified regression model which comprise of only historical accounting data known at the portfolio formation date. In Table 7 and 8, I find that all of my results are strikingly very similar, although the magnitude of the abnormal return to the Super-Performers is reduced to 6.5 percent per year (t-statistics 1.92) for 1991-2008 as compared to 10.5 percent in the original model. The abnormal return to the unconditional Low AA portfolio is reduced slightly to 5.7 percent per year (t-statistics 2.24) from 6.4 percent. The Drifter-Low AA portfolio has a slight increase in abnormal return to 6.6 per cent per year (t-statistics 1.84) from 6.2 percent, although the significance is lowered. In addition, the abnormal return to the Drifter-High AA portfolio is negative at 3.0 percent per year, as compared to minus 7.5 percent in the original model, and is no longer significant. The positive abnormal return to the Negative ACCREV-Democracy portfolio is reduced slightly to 9.4 percent per year (t-statistics 2.09) for 1991-2008 as compared to 10.8 percent. In short, the trading strategy still remains viable economically and statistically.
Interestingly, the results also reinforced the importance of the prospective cash flow from operations information, since its inclusion into the regression model to estimate abnormal accruals greatly enhance the magnitude of the future abnormal return. Dechow, Richardson and Sloan (2008) conjectured it is the use of cash, rather than the raising or the distribution of financing, that leads to predictable returns. Information of next-period’s cash flow from operations can reveal much about the use of cash, and market participants can assess whether managers have been credible in what they have communicated in the previous period(s) on how they intend to utilize cash in investment projects, and my results in this robustness test support the argument in Dechow et al (2008).
5. Summary and Conclusion
The signals of corporate governance and abnormal accruals are akin to the bow and arrow in a complementarity relationship, resolving the uncertainty associated with what each signal can reveal on a stand-alone basis about firm performance and its future prospects, as well as aiding in the understanding of whether managers exercise accounting discretion in an opportunistic or efficient manner. The bow (governance signal) without the arrow (abnormal accruals signal) is not effective; the governance effect on returns is attenuated to no different from zero when the firms with both good governance and low abnormal accruals (AA) are removed. Similarly, the arrow without the bow cannot shoot far and sharply to yield outsized abnormal future return; Super-Performers, the firms with both good governance and Low AA, can generate abnormal return of 10.5 percent per year over 1991-2008, as compared to the 3.5 and 6.4 percent for the unconditional good governance and Low AA firms respectively, illuminating the incremental value in what each signal can bring to each other. Together, the unique pairing of the “arrow” and the “bow” contributes to the total information environment to separate winners from losers.
The orthodox view since Sloan (1996) that high accruals is associated with negative future stock return has resulted in high accruals to be widely interpreted as evidence of earnings management or poor earnings quality. The Icarus manager, exalted by his flight when flying the pair of flexible accruals wax wings based upon the revenue recognition and matching principles, was flying too high to the nearness of the blazing sun, which softened the wax that held the feathers together. Daedalus cried out to his son that the wings were built for a higher purpose than his self-satisfaction; Icarus ignored the teachings of his father and flew higher, thinking his wings made him the equal of the Gods. The pair of wings came off, and Icarus plunged into the sea; akin to extreme accruals reversal and the “consequent” negative future stock return. Thus, the Icarus-managers’ accounting accruals discretion need to be curbed, since investors cannot unravel the valuation effect of reported earnings in a timely manner under current reporting standards.
Such a dominant view has not been questioned before (Christie and Zimmerman, 1996; Louis and Robinson, 2005; Bowen et al, 2008), although uncommon. Most forgot that it was Icarus, Daedalus’ son, who sank, not Daedalus himself. Daedalus escaped the labyrinth of King Midas and was the only mortal to fly without divine assistance. Healy and Whalen (1999) believe in the importance in identifying and explaining “which types of accruals are used for earnings management and which are not”. My results raise doubts that investors respond in the same manner to abnormal accruals, since Democracy firms with high or extreme income-increasing AA have positive future return. This suggests two things: one, the level of abnormal accruals is a coarse measure of earnings manipulation for these set of firms, although it appears to remain a reasonable proxy of earnings management or earnings quality for firms with mixed or poor governance structures; and two, shareholders benefit from “earnings management” because the high accruals signals future performance (e.g. Subramanyam, 1996; Chaney et al, 1996). The evidence helps in the understanding of investor behavior and whether the policy recommendations in Richardson, Sloan, Soliman, and Tuna (2005, 2006) and FASB to curtail the use of “less reliable” components of accruals are appropriate, especially for Democracy firms. If the joint interactive signal of governance and abnormal accruals can be a more informative measure of firm performance, reforms to limit managerial flexibility may be counterproductive and an “Icarus paradox”.
This study is also the first, to the best of my knowledge, to investigate the properties of the mixed governance (Drifter) firms, the group of firms unexamined in prior literature even though it forms the bulk of the sample size. I document that Drifter can have abnormal future returns as well – if the AA signal is combined interactively with the Drifter signal: the excess return at Drifter-Low AA is 6.2 per year over 1991-2008 while that at Drifter-High AA is negative 7.5 percent per year. In addition, the results restore economic viability to the long position of both the governance and abnormal accruals trading strategy, which can be important given short-selling constraints in the short position. My paper also contribute to the resolution of the highly debated issue in the governance literature by showing how both the supporters and critics of the governance effects on returns in GIM (2003) are not incorrect when the governance signal is interactively combined with the abnormal accruals information to yield unique information about the future prospects of the firm.
The explicit use of accounting information in contracts between management and financiers represents probably the most visible use of accounting information in governance mechanisms (Sloan, 2001). The results in my paper suggest that the design of managerial compensation requires obtaining performance measures that do not rely solely on earnings. Financiers require the firm to have a governance structure that will elicit the managers’ private information credibly. It is rare to observe in practice the use of both earnings and governance measures in contracting. Thus, my results suggest that the inclusion of both measures could result in more efficient contracting.
Finally, this paper highlights the salient fact that it is difficult to apply any one single measure, such as governance or abnormal accruals, on a stand-alone basis to assess firm value and performance, as not only are they one of a multitude of pieces of information of possible interest about firms’ quality, but they also interact with one another to resolve informational uncertainty about what each signal can reveal on its own. An investor considers a wide array of contextual information to continually rebalance his or her portfolio (Amir and Lev, 1996; Shevlin, 1996; Beneish, Lee, and Tarpley, 2001; Sloan, 2001; Sorensen, Hua, and Qian, 2005). Interestingly, my paper underscores the value of skillful fundamental analysis in moving away from generic strategies by combining different contextual information - governance information in this study - and looking through this lens to reach fresh insights in equity valuation. This is especially pertinent in a trading environment where large quantitative-oriented hedge funds pursue similar strategy resulting in correlated performance and destructive destabilizing price impact in deleveraging situations (Khandani and Lo, 2008; Boyson, Stahel and Stulz, 2008; Stein, 2009). Corporate governance is not just about complying with rules or reporting requirements. Rather it is about internalizing the values, spirit, and purpose behind the rules and is also integral in a company’s strategy in creating (or destroying) shareholders’ value. Thus, a sober consideration of the joint importance of governance and abnormal accruals information to separate winners and losers is also in the spirit of Sloan’s sagacious advice in the CFA Digest 1/2010: “I believe that using good fundamental analysis to detect accounting distortions by understanding the accounting and the company’s strategy and how they fit together will always be an incredibly important source of value-added for the investment management community”.

Stock Return Synchronicity and Technical Trading Rules

2010-11-22T05:15:00.001-08:00

Will be in Johannesburg and Cape Town to present my research paper on China's stock market in the 2010 Global Development Finance Conference from 23-26 November.

Stock Return Synchronicity and Technical Trading Rules
ABSTRACT
We explore the potential source of returns from technical trading rules at the firm-level by examining the cross-sectional relationship between technical trading returns and stock return synchronicity. Inspired by Roll (1988) and Morck, Yeung and Yu (2000), we use R2 of a regression of individual stock returns on the market return as our measure of synchronicity. If a low R2 is largely attributable to noise trading, stocks will have lower synchronicity with market factors and lower R2. Low R2 stocks earn higher expected returns, according to De Long, Shleifer, Summers, and Waldmann (1989, 1990), or due to limits of arbitrage (Shleifer and Vishny, 1997), a predicted relationship which we termed as the Noise Hypothesis. Overwhelming support in prior literature is in favor of lower expected returns in low R2 stocks, or the Price-Informativeness Hypothesis according to Morck, Yeung and Zarowin (2003). China is our context for investigation; it is the second most synchronous market in the study by Morck et al (2000) which has grown to become the world’s third largest stock market by market capitalization. We find evidence of a negative relationship between returns from technical trading rules and R2 over 1991-2009, in favor of the Noise Hypothesis. Our results remain robust after controlling for firm-specific characteristics which include market-to-book, size, leverage, dividend payout ratio, turnover and firm age. Thus, an additional simple yet practical statistics - the R2 - can guide trading decisions using technical trading rules. Do technical trading rules work? Possibly only when the R2 is low, and for larger and younger stocks with lower turnover. However, sub-period analysis reveal that when there is an improvement in the information environment after the punctuation by an economically significant fundamental shock - the Non-Tradable Share (NTS) reform in China in April 2005 - technical analysis work better post-NTS reform during 2005-09 for stocks with higher R2, consistent with the Price-Informativeness Hypothesis, and generally for older and bigger stocks with lower turnover and higher market-to-book ratio. Thus, without the guide of R2, investors should take the market prognosis by all these “alchemists” with their “voodoo” charts with a heavy dose of salt. We also reconciled the lively debate and extremely mixed evidence on the interpretation of R2 and its relationship with the cross-sectional returns of stocks.

1. INTRODUCTION AND MOTIVATION
Few departures in position in finance are as vexing as that of establishing consistent and reliable returns predictability from past returns using technical trading rules and chart patterns across markets and over time. While technical analysis, ridiculed as “alchemy” by Burton Malkiel in his 1973 book “A Random Walk Down Wall Street”, challenges the formidable market efficiency orthodoxy (Fama, 1970), there is pervasive use by practitioners and the persistence of belief in technical analysis techniques (see survey studies in Park and Irwin, 2007, and Menkhoff and Taylor, 2007). However, the intellectual vacuum at the core of technical analysis – that efficient markets remove possible short-term patterns and autocorrelations in stock returns - has been increasingly filled up in recent times by growing receptiveness that markets may not be fully efficient because of noise trading (Kyle, 1985; Black, 1986), that herding behavior of short-horizon traders can result in informational inefficiency (Froot, Scharfstein and Stein, 1992) and self-fulfilling tendencies (Frankel and Froot, 1990), and that prices may be affected by behavioural biases (Barberis, Schleifer and Vishny, 1998; Daniel, Kent, Hirshleifer and Subrahmanyam, 1998; Hirshleifer, 2001; Shiller, 2003). Such peripheral views get reinforced the more difficult market conditions are, when techniques based on profits and valuations failed (Talley, 2002), especially during the recent financial crisis (Avgouleas, 2009), and with the growing influence of quantitative hedge funds that employ the automation of technical trading rules as one of their investment strategies (Lo and Hasanhodzic, 2009). Still, the profitability of using technical trading rules based on past prices remains an open empirical question, albeit an extensively examined one.
We tread a different path in our study by exploring the potential source of the returns of technical trading rules at the firm-level, an issue that has not been commonly explored in prior studies. We are motivated to examine this because of the parallel observation of a reported decline in technical trading profitability in U.S. over time (Sullivan, Timmermann and White, 1999; LeBaron, 2000; Kwon and Kish, 2002; Ready, 2002; Schulmeister, 2009), and a lower synchronicity of U.S. stock prices, or higher idiosyncratic volatility of individual firms, over time as the U.S. economy developed (Morck, Yeung and Yu, 2000, hereafter termed MYY).
The popular explanation for this profitability decline in deploying technical trading rules is that markets have become more efficient and hence such opportunities have disappeared. This is especially so with the advent of cheaper computing power to spark the proliferation of computer-driven trading, the growth of electronic communication networks (ECNs) that allow thousands of buy and sell orders to be matched at the speed of light without any human intervention ; the increasing popularity of “dark pool” platform where buyers and sellers can anonymously match large blocks of stock and keep details of the deals and prices concealed to prevent distorting prices in the broader market; and the lower transaction costs; all of which are helping to remove possible short-term patterns and autocorrelations in stock returns.
Similar to MYY, Campbell, Lettau, Malkiel and Xu (CLMX, 2001) also found a secular decline in stock return synchronicity in the United States from 1960 to 1997, but they do not link it to cross-sectional returns. This time-series observation suggests that there could be a cross-sectional relationship between technical trading profitability and stock return synchronicity at the firm-level. Thus, the source of the profitability (or losses) of technical trading rules could be due to varying degrees of firm-level synchronicity with the market, a relationship that has not been explored in prior literature.
We like to emphasize that our study is more concerned about investigating the source of the returns from the technical trading rules by testing its association with stock return synchronicity, rather than focusing on establishing the highly contentious point of whether the technical trading rules are indeed profitable and robust to problems such as data-snooping biases (Sullivan, Timmerman and White, 1999), since we acknowledge that these trading rules might perhaps not work for certain stocks at the firm-level, and we want to know what are the predictors that determine the trading profits or losses from applying these technical rules.
Inspired by Roll (1988), MYY is the first in a series of papers that uses the R2 of a regression of individual stock returns on the market return as a measure of synchronicity, or the extent to which the stock prices of individual firms within a country move together. R2 is also the ratio of idiosyncratic volatility to systematic volatility; idiosyncratic volatility is thus the inverse measure of synchronicity. In sum, lower R2, or higher idiosyncratic volatility of individual firms, indicates lower synchronicity of stock returns. Roll (1988) offers an interesting discussion of R2, observing that the low R2 statistics among U.S. stocks and for common asset pricing models is due to vigorous firm-specific return variation not associated with identifiable news releases and public information. He concludes that this implies “either private information or else occasional frenzy unrelated to concrete information (noise)”. The incorporation of either firm-specific information or noise both result in a lower R2, but these two effects lead to starkly different predictions of the relation between R2 and expected stock returns:
The Price-Informativeness Hypothesis: If a low R2 is largely resulted from the firm’s environment causing the stock prices to aggregate more firm-specific information, greater firm-specific uncertainty is resolved such that market factors should explain a smaller proportion of the variation in stock returns, increasing the realized historical idiosyncratic volatility, and investors holding these stocks should require lower expected returns.
The Noise Hypothesis: If a low R2 is largely attributable to the trading by noise traders, stocks will have lower synchronicity with market factors and lower R2 because the changes in stock prices cannot be fully justified by changes in fundamental risks reflected in the common factors, and investors should earn higher expected returns according to De Long, Shleifer, Summers, and Waldmann (1989, 1990).
Both finance and accounting research had tilted overwhelmingly in favor of the Price-Informativeness Hypothesis, in that R2 or stock return synchronicity is a measure for how much private information is impounded into stock prices. When informed trading activity is generated, it contributes to the lower R2 (or increase in idiosyncratic volatility). This is in the spirit of the Grossman and Stiglitz (1980) argument who predict that improving the cost-benefit trade-off on private information collection leads to more extensive informed trading and to more informative pricing. In a market with many risky stocks, the ones with cheaper information about their fundamental values are more attractive to traders. Accordingly, traders acquire more information about these stocks and their prices are more volatile and more informative than the prices of stocks with more costly information. Private information is turned into public information, thereby reducing the adverse selection problem of uninformed investors trading with informed investors.
At the country-level, MYY (2000) find that stock prices are more synchronous (i.e. have higher R2) in emerging markets which are low-income countries with weak protection of investors’ and property rights; weak institutions discourage the acquisition of information about individual stocks and such markets lack informed traders because risk arbitrageurs find it more costly to keep their profits in such economies. However, there are mixed results when the country-level findings are examined at the firm-level. On one hand, Durnev, Morck, Yeung and Zarowin (2003) find evidence that firm with lower R2 exhibit higher associations between current returns and future earnings, suggesting that lower R2 is indicative of better informationally-efficient prices. Piotroski and Roulstone (2004) find that both institutional and insider trading are positively associated with idiosyncratic volatility. In other words, stocks with higher institutional trading and insider trading have lower R2, since institutional trading accelerates the incorporation of firm-specific information into stock prices, and consequently, lowers R2.
On the other hand, in a widely-cited paper, Ang, Hodrick, Xing, and Zhang (2006) report that stocks with low R2 (or high idiosyncratic volatility) is associated with “abysmally low returns”. The average differential between quintile value-weighted portfolios of the lowest and highest idiosyncratic volatility is about -1.06 percent per month. Ang (2009) also confirm that the link also exists in 23 other developed markets. The Noise Hypothesis is originated by Shiller (1981) who finds that the level of stock price volatility is too high to be explained by the volatility in the underlying fundamentals, e.g. dividends. Other studies suggest that behavioural factors, bubbles, herding, and other non-fundamental factors affect stock return volatility (see Shleifer (2000) for a review), and ultimately the usefulness of the synchronicity measure as a gauge of firm-specific information. Behavioural models, like Barberis and Huang (2001) predict that lower R2 stocks earn higher expected returns. In environments with frictions and incomplete information (Merton, 1987) and limits to arbitrage (Shleifer and Vishny, 1997), R2 (or the idiosyncratic volatility of a stock) is linked to its expected return.
Thus, if there is a cross-sectional relationship between technical trading profitability and stock return synchronicity, the direction is unclear due to the two competing hypotheses.
Still, the U.S. ranks as having the lowest synchronicity amongst the 40 countries in MYY (2000) study and there might not be a great deal of cross-sectional variation in synchronicity at the firm-level. China is the second most synchronous market in 1995 in MYY (2000) study, where over 80 percent of stocks often move in the same direction in a given average week. There are also several important stylized facts about China that made it an economically important ground for investigation. China’s GDP per capita was $455 in 1995 in the MYY (2000) study and has since surged more than 14-fold to $6,546 in 2009. While it is still an “emerging market” and “low-income country”, Shanghai has the world’s third largest stock market by market capitalization at around $3 trillion in its $3.2 trillion economy, briefly overtaking Tokyo in July 2009. Shares worth $5.01 trillion changed hands on the Shanghai Stock Exchange in 2009, compared with $4.07 trillion on the Tokyo Stock Exchange, according to data compiled by Bloomberg. Only the NASDAQ stock market and the New York Stock Exchange had higher trading volumes than Shanghai. As an emerging market, China has a very high ratio of stocks changing hands. Wong (2006) reported that the turnover velocity of stocks, defined as the total transaction volume divided by the total number of tradable shares, was about 500 percent, suggesting the prevalence of noise trading in China. Moreover, some countries, including China, place asymmetric restrictions on the price formation process, such as short-selling constraints, which impede the impounding of bad news into prices in a timely manner and contribute to the high co-movement of stock prices (Miller, 1977; Bris, Goetzmann and Zhu, 2003). Jin and Myers (2006) find that such synchronous markets are more prone to crashes.
Using a comprehensive sample of China stocks since the inception of the Shanghai Exchange in January 1991 to December 2009, we show that the returns from technical trading rules has a negative association with stock return synchronicity, or the R2. Thus, we find evidence in favor of the Noise Hypothesis in that stocks with lower R2 earn higher profits from technical trading rules. Ranking the sample into 10 decile portfolios by R2, we find that the technical trading returns in N1 (lowest R2 portfolio) exceeds that in N10 (highest R2 portfolio) by an annualized 7-11 percent over the sample period, depending on the type of technical trading rule that is employed. Our results remain robust even after controlling for firm-specific characteristics which include market-to-book, size, leverage, dividend payout ratio, turnover and firm age.
Thus, an additional simple yet practical statistics - the R2 - can guide trading decisions using technical trading rules. Imagine that the Bloomberg terminal, Yahoo Finance and financial websites should have an additional statistics – the synchronicity measure – to allow investors and traders to assess how effective their technical analysis can be; for instance, if the informational environment is generally noisy, then the technical traders should focus their efforts on less synchronous or low R2 stocks to increase their probability of generating abnormal profits.
Do technical trading rules work? Possibly only when the R2 is low, and for larger and younger stocks with lower turnover. However, sub-period analysis reveal that when there is an improvement in the information environment after the punctuation by an economically significant fundamental shock - the Non-Tradable Share (NTS) reform in China in April 2005 - technical analysis work better post-NTS reform during 2005-09 for stocks with higher R2, consistent with the Price-Informativeness Hypothesis, and generally for older and bigger stocks with lower turnover and higher market-to-book ratio. Thus, without the guide of R2, investors should take the market prognosis by all these “alchemists” with their “voodoo” charts with a heavy dose of salt. We also reconciled the lively debate and extremely mixed evidence on the interpretation of R2 and its relationship with the cross-sectional returns of stocks.
The rest of the paper is organized as follows. Section 2 explores the literature review and hypotheses development. Section 3 describes the data, variable description and construction, and methodology. Section 4 presents the empirical results, while Section 5 examines the robustness of the results in sub-periods. Section 6 concludes.
2. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT
2.1 Technical Trading Rules
Two empirical papers were particularly important in supporting the predictive capabilities of technical trading rules. Brock, Lakonishok and LeBaron (BLL, 1992) found significant technical trading profits by utilizing 26 trading rules to a very long data series of the Dow Jones index daily prices from 1897 to 1986. Lo, Mamaysky and Wang (2000) used a non-parametric kernel regression pattern recognition method to automate the evaluation of technical analysis trading techniques over the period from 1962 to 1996, and found strong evidence that there is incremental informational and practical value in technical analysis, particularly in NASDAQ stocks.
BLL (1992) results remain robust even after correcting for the leptokurtic, conditionally heteroskedastic, autocorrelated, and time-varying distribution in stock returns using the model-based bootstrap technique to overcome the weaknesses of conventional t-tests. However, Sullivan, Timmerman and White (STW, 1999) pointed out in that data-snooping biases can be severe when evaluating technical rules, which can lead to the false conclusion that technical trading strategies can predict future price movements. In particular, STW (1999) repeated BLL (1992) study by utilizing White’s (2000) Reality Check bootstrap methodology to correct for data-snooping biases and find that the trading rules examined do not generate superior out-of-sample performance. BLL acknowledged that possible data snooping biases remain when they use a range of rules chosen ex post. They argue that such dangers are minimized by the deliberate choice of a simple class of rules that has been in common use for a long period of time. Interestingly, STW acknowledged that they found BLL in-sample results to be robust to data-snooping over the 100-year period in BLL (1992).
However, our study is more concerned about investigating the source of the returns from the technical trading rules by testing its association with stock return synchronicity, rather than focusing on establishing the highly contentious point of whether the technical trading rules are indeed profitable and robust to problems such as data-snooping biases (Sullivan, Timmerman and White, 1999), since we acknowledge that these trading rules might perhaps not work for certain stocks at the firm-level, and we want to know what are the predictors that determine the trading profits or losses from applying these technical rules.
There are surprisingly few papers that examine the value of technical analysis in China. Chen and Li (2006) found weak evidence for technical trading profits over the period from 1994 to 2002, but only for 39 companies which cover “23 percent of the daily turnover of the entire A-share market”. There are some supporting evidence that technical analysis add value in emerging markets (Bessembinder and Chan, 1995; Ito, 1999), but Ratner and Leal (1999) found the opposite results after correcting for data-snooping bias and adjusting for round-trip transaction costs, while Chen, Huang and Lai (2009) found there is a sharp decline in trading profits after implementing a one-day lag scheme to account for non-synchronous trading bias in eight Asian markets. These studies exclude China in their analysis.
Given the extraordinary growth in China to become the world’s third largest stock market in recent years which were not in the sample period of most prior studies, it should be interesting to fill the gap in the extant literature findings by examining the source of returns predictability from deploying technical trading rules in a highly synchronous but fast-changing market like China.
2.2 R2 or Stock Return Synchronicity
The dominant interpretation of R2, or stock return synchronicity, is an important issue because prior research suggests that more informative stock prices, measured by lower R2, lead to better resource allocation, and therefore functional efficiency with efficient stock prices directing capital to the highest-value users, which has implications for economic growth (Tobin, 1982; Wurgler, 2000; Durnev, Morck, and Yeung, 2004, Wang, Wu and Yang, 2009).
Since the influential studies by MYY (2000) and CLMX (2001) documenting the trend of lower R2 over time, many proposed explanations have been instrumental in supporting the Price Informativeness story, that is, low R2 is a reasonable measure for the quality of the information environment at either the country-level or the firm-level.
In particular, at the country-level, MYY find that stock prices are more synchronous (i.e. have higher R2) in emerging markets which are low-income countries with weak protection of investors’ and property rights; weak institutions discourage the acquisition of information about individual stocks and such markets lack informed traders because risk arbitrageurs find it more costly to keep their profits in such economies. At the firm-level, Durnev, Morck, Yeung and Zarowin (2003) find evidence that firm with lower R2 exhibit higher associations between current returns and future earnings, suggesting that lower R2 is indicative of better informationally-efficient prices. Piotroski and Roulstone (2004) find that stocks with higher institutional trading and insider trading have lower R2. There is also evidence that Increased institutional ownership (Bennett, Sias, and Starks, 2003; Xu and Malkiel, 2003) is associated with lower R2. The idea is that Institutional trading contributes to private information collection and accelerates the incorporation of firm-specific information into stock prices (Hartzell and Starks, 2003), and provides a better explanation for a lower R2. Hutton, Marcus and Tehranian (2010) find that R2 decreases with information transparency. Ferreira and Laux (2007) show that firms with better corporate governance (as measured by having fewer anti-takeover provisions) display higher trading activity, better information about future earnings in stock prices, and lower R2. Irvine and Pontiff (2009) found that lower R2 could be due to product markets becoming more competitive.
In a widely-cited paper, Ang, Hodrick, Xing, and Zhang (2006) report that stocks with low R2 (or high idiosyncratic volatility) is associated with “abysmally low returns”. The average differential between quintile value-weighted portfolios of the lowest and highest idiosyncratic volatility is about -1.06 percent per month. Ang (2009) also confirm that the link also exists in 23 other developed markets. Jiang, Xu and Yao (2009) find that firms with past low R2 (or high idiosyncratic volatility) tend to have more negative future unexpected earnings surprises, leading to their low future returns. There is overwhelming support for the Price Informativeness story of R2.
The Noise Hypothesis is originated by Shiller (1981) who finds that the level of stock price volatility is too high to be explained by the volatility in the underlying fundamentals, e.g. dividends. West (1988) provides a theoretical model in which low R2 is associated with less firm-specific information and more noise in returns. In West’s model, relatively more information results in prices being closer to fundamental values, and the release of new information results in smaller price movements and lower R2. West empirically tests his model and reports results indicating that lower R2 is positively associated with bubbles, fad, and other non-fundamental factors. Recent evidence by Brandt, Brav, Graham and Kumar (2010) show that the trend of lower R2 is a speculative episodic event driven by low-priced stocks dominated by retail traders and that there is a reversal to higher R2 (or lower idiosyncratic firm volatility) during the 2000s, using small trades data from ISSM/TAQ and brokerage data. Other direct or implicit opposing explanations of the Price Informativeness story view include firm fundamentals become more volatile, such as an increase in the variance of return on equity (Wei and Zhang 2006) or opaqueness in financial accounting information (Rajgopal and Venkatachalam 2006); newly listed firms becoming increasingly younger (Fink et al. 2009) and riskier (Brown and Kapadia 2007).
Rebutting the widely-cited claims by Ang et al (2006), Fu (2009) reports that expected idiosyncratic volatility, estimated using the EGARCH model, is positively correlated with stock returns. Duffee (1995) found a positive contemporaneous relation between realized monthly idiosyncratic volatility and stock returns. Bali and Cakici (2008) show that the results in Ang et al (2006) are sensitive to the methodology used to form volatility portfolios and to the data frequency used to estimate idiosyncratic volatility, and that the negative relationship between idiosyncratic volatility and expected returns disappears in the equal-weighted returns. Huang, Liu, Rhee and Zhang (2010) point out that the results in Ang et al (2006) may be driven by monthly return reversals.
Other studies supporting the Noise Hypothesis suggest that behavioural factors, bubbles, herding, and other non-fundamental factors affect stock return volatility (see Shleifer (2000) for a review), and ultimately the usefulness of the synchronicity measure as a gauge of firm-specific information. Behavioural models, like Barberis and Huang (2001) predict that lower R2 stocks earn higher expected returns. In environments with frictions and incomplete information (Merton, 1987) and limits to arbitrage (Shleifer and Vishny, 1997), R2 (or the idiosyncratic volatility of a stock) is linked to its expected return. Merton (1987) suggests that, in the presence of incomplete markets where investors have limited access to information, firm-specific risk cannot be fully diversified away, and thus firms with low R2 require higher average returns to compensate investors for holding imperfectly diversified portfolios. In the influential “limits of arbitrage” argument by Shleifer and Vishny (1997), arbitrageurs tend to avoid stocks with low R2 (or high idiosyncratic volatility) during the holding period, allowing these stocks to enjoy higher expected returns whose mispricing are not arbitraged away. These arbitrageurs care more about the short-run performance, because they use capital provided by investors, who tend to withdraw funds if the short-run performance is poor. Thus, they desire to keep the ratio of reward-to-risk over shorter horizons high and are less willing to take large positions in these stocks and thus the largest mispricing are found in these stocks which receive the least arbitrage resources.
In addition, Barberis, Shleifer and Wurgler (2005) also find significant changes in firms’ R2 values surrounding additions and deletions to the S&P 500 Index in the U.S., consistent with market frictions influencing synchronicity. Since additions and deletions to indices do not signal new information to the market regarding firms’ fundamentals, the changes in firm’s R2 values surrounding changes in the composition of indices is inconsistent with an information-based explanation of the R2 measure. Consistent with the noise-in-returns interpretation of the R2 measure, Kumar and Lee (2006) find that noise traders (uninformed retail investors) have a significant influence on stock price synchronicity. Thus, the findings of Barberis et al. (2005) and Kumar and Lee (2006) indicate that market frictions, i.e., factors unrelated to information, have a significant influence on stock price synchronicity. Other research supporting the Noise Hypothesis include Ali, Hwang and Trombley (2003), Mashruwala, Rajgopal, and Shevlin (2006) and Zhang (2006).
2.3 Hypotheses
We posit that the source of the profitability (or losses) of technical trading rules could be due to varying degrees of firm-level synchronicity with the market, a relationship that has not been explored in prior literature. Yet, in the cross-sectional relationship between technical trading profitability and stock return synchronicity, the direction is unclear due to the two competing hypotheses, namely Price Informativeness Hypothesis and Noise Hypothesis. Given that China appears to be a “noisy” market, we posit that there is a positive relationship in the regression of technical trading returns on ψi, which is the inverse measure of R2 or lack of stock return synchronicity (we will explain the rationale for transforming the variable in Section 3.2), that is, a higher ψi or lack of stock return synchronicity (or lower R2) is associated with higher technical trading returns. In other words, the coefficient on the synchronicity measure ψi is positively significant.
Our paper is similar in spirit to Teoh, Yang and Zhang (TYZ, 2009) and Chang and Luo (2010) who find bigger anomalies among lower R2 stocks. The presence of anomalies indicates that stock prices are inefficient with respect to information about future cashflows that are contained in the predictive variables explored by TYZ (2009) . Their findings suggest that stocks whose returns have low R2 may incorporate less information about future fundamentals, and are more difficult for investors to analyze accurately. Using a much larger sample size and different methodology compared to Durnev et al (2003), TYZ (2009) also find that firms with lower R2 have smaller future earnings response coefficients (ERCs), indicating that their current stock price incorporates a smaller amount of future earnings news, and thus more uncertainty about future earnings news remains unresolved, which is inconsistent with Durnev et al (2003). In addition, low R2 firms have worse information environment as measured by earnings quality, earnings persistence, and earnings predictability, and have higher probability of distress. These results imply that low R2 stocks incorporate less information about future cashflows and thus inconsistent with the Price-Informativeness Hypothesis and more consistent with the Noise Hypothesis.
Figure 1: The declining synchronicity of China stock prices, or the declining fraction of China stock return variation explained by the market as measured by R2, the statistic from running a market model regression using weekly returns including dividend income from 1991 to 2009, using our sample size of 740 companies which represents around 90% of the population of stocks on Shanghai Stock Exchange in terms of market capitalization. Returns and indexes data are from Datastream. Note that the R2 in MYY (2000) for China in 1995 was 45.3% reported in their Panel C of Table 2 which is consistent with MYY.
Figure 1 graphs the average R2 across stocks, based on weekly returns from 1991 to 2009. We observe an overall declining trend in R2. This brought us to the attention on whether there are any time-series dynamics that could possibly affect the cross-sectional relationship between stock return synchronicity and technical trading returns. We examine this issue further in Section 4.
We like to emphasize that we do not explore the time-series dynamics on why R2 is declining over time; rather, we are more interested in what this time-series trend for our main predictor in the synchronicity measure implies for the direction of the cross-sectional relationship between stock return synchronicity and technical trading returns. Specifically, we want to find out whether or not there is a structural break in the beta coefficient for the synchronicity measure ψi. If so, it will be unclear whether the relationship of higher returns from lower R2 stocks still holds.
But what sub-period(s) should we investigate to assess whether our results are robust? To avoid data-snooping biases (Lo and MacKinlay, 1990), we ask if there are any economically significant fundamental shocks to the information environment faced by stocks in China over the period. Indeed, there is the important Non-Tradable Share (NTS) reform that was announced in April 2005. Following the NTS reform in 2005, the market capitalization of Shanghai Stock Exchange grew tremendously from around $380 billion to around $3 trillion at the end of 2009. Average R2 from Jan 1991 to April 2005 in the pre-NTS reform period was 37 percent as compared to 21 percent in the post-NTS reform period from May 2005 to December 2009.
We hypothesize that the informational environment in China should improve in the post-NTS reform period during May 2005-09 to the extent that R2 is now a measure that is more consistent with the Price-Informativeness Hypothesis. In other words, the NTS reform will lead to greater transparency for stocks and the cost-benefit trade-off on private information collection is improved, leading to more extensive informed trading and more informative pricing, as in the spirit of Grossman and Stiglitz (1980). Traders acquire more information about stocks and their prices are more volatile (equivalently, lower R2) and more informative than the prices of stocks with more costly information. Thus the positive coefficient on the synchronicity measure ψi for the overall period from 1991-2009 should flip to the negative sign during the post-NTS sub-period. As a result, we hypothesize that low R2 stocks will now have lower returns from the technical trading rules (not higher as were under the Noise Hypothesis) after the NTS reform where there is an economically significant fundamental shock to the information environment.
3. DATA, VARIABLE DESCRIPTION AND CONSTRUCTION, AND RESEARCH METHODOLOGY
We draw the data for our study from the Datastream database. Our initial sample includes all 847 firms traded on the Shanghai Composite Index since the inception of the Shanghai Stock Exchange from 2 Jan 1991 to 31 December 2009. After removing firms with more than 100 days of zero returns in any year in the construction of our returns from technical trading rules, requiring firms to have a minimum of 40 weeks of non-zero returns to estimate our synchronicity measure ψi, and that the sample to contain data for the control variables which include Market-to-Book, Size, Leverage, Dividend Payout ratio, Turnover, and Firm Age, we are left with a final sample of 740 firms that represent, on average, 90 percent of the initial population of stocks in terms of market capitalization.
3.1 Technical Trading Rules
Following BLL (1992), we evaluate three types of rules: Variable Length Moving Average (VMA) rules, Fixed Length Moving Average (FMA) rules, and Trading Range Break (TRB) rules (resistance and support levels). BLL (1992) provide additional description and motivation for these trading rules, as well as some historical perspective on their usage:
Variable Length Moving Average (VMA) and Fixed Moving Average (FMA): Moving average trading models take advantage of positive serial correlation in equity returns. A trading signal usually follows a large movement in stock price under the assumption that the autocorrelation bias in the time series trend will continue in the same direction. The VMA rules analyzed are as follows: 1±50, 1±150, 1±200, where the 1 represents the number of days in the short moving average, and the 50, 150 and 200 represent the number of days in the long moving average. Buy (sell) signals are emitted when the short-term average exceeds (is less than) the long-term average by at least a pre-specified percentage band (0 percent or 1 percent). This test is repeated daily with the changing moving averages throughout the sample. The buy position is a long position in the stock and is maintained until a sell signal is indicated. With the sell signal, the investor is out of the market. A rule is effective if the average buy minus sell (buy-sell) signal is positive, significant, and greater than a buy and hold alternative after trading costs. BLL (1992) evaluate each rule with a trading band of zero and one percent of returns. A zero band classifies each return to emit either a buy or sell signal, while a band of one would emit a buy or sell signal only when the short moving average crosses the trading band. With a band of zero, this method classifies all days into either buys or sells. Buy (sell) signals are emitted when the short moving average cuts the long moving average from below (above) and moves beyond it by the pre-specified band. Once a signal is emitted, VMA rules call for the position to be maintained until the short and long moving averages cross again, while FMA rules hold the position for a fixed number of days. We evaluate FMA strategies with fixed holding periods of ten days.
Trading Range Break (TRB): TRB rules involve comparing the current price to the recent minimum and maximum. TRB rules emit buy signals when the current price exceeds the recent maximum by at least a pre-specified band, and emit sell signals when the current price falls below the recent minimum by at least the pre-specified band. The rationale for this rule is that when the current price reaches the previous peak, a great deal of selling pressure arises because many people would like to sell at the peak. However, if the price exceeds the previous peak, it is indicated that the upward trend has been initiated. Like BLL (1992), we evaluate separate TRB rules where recent minimums and maximums are defined as the extreme observations recorded over the prior 50, 150, and 200 days, respectively. We use bands of 0 and 1 percent, making for a total of six TRB combinations, and then evaluate each TRB rule using fixed investment horizons of 10 days.
3.2 Synchronicity Measure ψi
MYY (2000) is the first in a series of papers that uses the R2 of a regression of individual stock returns on the market return as a measure of synchronicity, or the extent to which the stock prices of individual firms within a country move together. R2 is also the ratio of idiosyncratic volatility to systematic volatility; idiosyncratic volatility is thus the inverse measure of synchronicity. Thus, lower R2, or higher idiosyncratic volatility of individual firms, indicates lower synchronicity of stock returns. Following MYY (2000), we estimate firm-specific return variation using a two-factor international model which includes both the local and U.S. market index returns:
rit = αi + β1rmt + β2rust + eit (1)
using weekly return data; where rit is the return of stock i in period t; rmt is the value-weighted local market return; and rUSt is the value-weighted U.S. market return.
Like MYY (2000) and other international studies, we use weekly returns to deal with infrequent trading in international markets. Following Dasgupta et al (2010), we compute the stock’s lack of synchronicity as the ratio of idiosyncratic volatility to total volatility σ2ie=σ2i that is precisely 1-R2i of Eq. (1). Given the bounded nature of R2; we conduct our tests using a logistic transformation of 1-R2i:
ψi = log(1-R2i) (2)
Thus, our predictor variable ψi measures idiosyncratic volatility relative to market-wide variation, or the lack of synchronicity with the market. One reason for scaling idiosyncratic volatility by the total variation in returns is that firms in some industries are more subject to economy-wide shocks than others, and firm-specific events may be correspondingly more intense. Additionally, this scaling and transformation allow for comparability to other studies. We do not add control variables to our price regression in (1) because MYY (2000) view the R2 as a summary measure of the amount of information reflected in returns.
3.3 Relationship between Stock Return Synchronicity and Returns from Technical Trading Rules
We examine the relationship between technical trading returns and stock return synchronicity R2 by estimating the following basic model:
TTRi = α + β ψi + γ Firm Controlsi + εi (3)
where TTRi is Technical Trading Returns calculated using the methodology by BLL (1992) discussed in section 2.1; the synchronicity measure ψi is estimated from a market model that was discussed in section 2.2; Firm Controls include those commonly used in the literature, namely, Size (defined as the logarithmic of market value); Leverage (net debt over book equity); Dividend Payout ratio (dividend over net profits); Turnover (annual volume over number of shares outstanding); Firm Age (the number of years the company first appears on the Shanghai Exchange). We control for turnover as volume may provide relevant information if prices do not react immediately to new information (Blume, Easley and O’Hara, 1994).
The Price-Informativeness Hypothesis supports the view that expected returns from the predictor variable would be low; thus, the beta coefficient on the synchronicity measure ψi will be negative, that is, a higher ψi (lower R2) is associated with lower returns from the technical trading rules. On the other hand, a positive beta coefficient on ψi is consistent with the Noise Hypothesis, that is, a lower R2 is associated with higher returns.
4. EMPIRICAL RESULTS
4.1 Summary Statistics of Sample Characteristics and Returns from Technical Trading Rules
The summary statistics of R2, other sample characteristics and the average return from the three technical trading rules are reported in Panel A of Table 1. The average R2 is 25 percent, which is a significant decline from the 45 percent reported in MYY (2000). Panel B of Table 1 reports the cross-sectional average of the correlation among the sample characteristics; most of the sample characteristics do not appear to be highly correlated with our main synchronicity predictor ψi.
The average annualized mean buy returns from the three technical trading rules are reported in Panel C of Table 1. Because China does not allow for short-selling of stocks, we report only the mean buy returns generated from the buy signal in the technical trading rules. They range from 22-42 percent (22-24 percent for VMA, 17-24 percent for FMA, and 22-47 percent for TRB), which is significantly higher than the unconditional annualized average return of 8 percent, and also higher than the 12 percent reported by BLL (1992) for U.S. Dow Jones index.
4.2 Properties of R2 Deciles and Univariate Analysis
From Table 2, we find that low R2 stocks are generally smaller, younger, have a lower dividend payout ratio, and a higher leverage ratio. According to Baker and Wurgler (2006), such stocks are more difficult to value and their prices tend to be affected by investor sentiment, and they are more difficult to arbitrage, which could potentially result in these stocks having higher expected returns to compensate investors as argued earlier in the “limits of arbitrage” insight proposed by Shleifer and Vishny (1997) and consistent with the Noise Hypothesis. Interestingly, there is not any significant difference between the lowest decile R2 stocks and the highest ones in the market-to-book ratio. Also, high R2 stocks have a higher turnover ratio.
In addition, returns from technical trading rules have a negative association with stock return synchronicity, or the R2. Thus, we find evidence in favor of the Noise Hypothesis in that stocks with lower R2 earn higher profits from technical trading rules. Sorting the sample by R2 into deciles of 10 portfolios, we find that the technical trading returns in N1 (lowest R2 portfolio) exceeds that in N10 (highest R2 portfolio) by an annualized 10-37 percent over the sample period, depending on the type of technical trading rule that is employed. In particular, the spread differential between the highest and lowest R2 portfolios is the highest for the TRB technical trading rule.
In the next section, we carry out a multivariate regression analysis of equation (3) outlined in Section 2.3 to control for the firm-level characteristics (market-to-book, size, leverage, dividend payout ratio, turnover, and firm age) in order to ensure that our findings of the negative relationship between technical trading returns and stock return synchronicity are robust.
4.3 Multivariate Regression
The multivariate analysis of the regression model from Section 2.3 to investigate the relationship between technical trading returns and synchronicity is presented in Table 3. The coefficient on the synchronicity measure ψi remains positive and significant after controlling for a battery of firm-level characteristics that include Market-to-Book, Size, Turnover, Leverage, Dividend Payout and Firm Age across all three technical trading rules. Thus, the findings are consistent with the Noise Hypothesis in that stocks with higher ψi (lower R2) have higher technical trading returns.
In addition, we find that the coefficients on the fundamental-based factors i.e. Market-to-Book, Leverage and Dividend Payout, are insignificant across all three technical trading rules. This is an appealing and intuitive result in that we should not expect any relationship between these fundamental factors and technical trading returns since technical trading rules rely on non-fundamental trading signals.
Finally, we find that Firm Age and Turnover are significantly negatively related to technical trading returns, whereas Firm Size is significantly positively associated with technical trading returns, across all three technical trading rules. Thus, larger and younger stocks with lower turnover have higher technical trading returns. If turnover is a proxy for liquidity as suggested by existing literature, the result is consistent since investors may demand a liquidity premium for low liquidity stocks which are more costly to trade. Dasgupta et al (2010) find that younger firms tend to have significantly lower R2 than do older firms, since the new information content (surprise) is larger for younger firms (Dubinsky and Johaness, 2006) and that would drive higher firm-specific return variation. Thus, their results suggest that younger firms have higher returns according to the Noise Hypothesis. However, the findings that larger stocks have higher technical trading returns is a counter-intuitive and important result because of the well-known “size effect” documented by Black (1976) and Banz (1981) in that smaller firms have higher risk-adjusted returns, on average, than larger firms. Marshall, Qian and Young (2009) also found that technical analysis is more profitable for smaller stocks, albeit in U.S. over 1990-2004. We leave this interesting puzzle for future research.
5. SUB-PERIOD ANALYSIS AND THE NON-TRADABLE SHARE (NTS) REFORM IN 2005
Following the Non-Tradable Share (NTS) reform that was announced in April 2005, the market capitalization of Shanghai Stock Exchange grew tremendously from around $380 billion to around $3 trillion at the end of 2009. Average R2 from Jan 1991 to April 2005 in the pre-NTS reform period was 37 percent as compared to 21 percent in the post-NTS reform period from May 2005 to December 2009.
We hypothesize that the informational environment in China should improve in the post-NTS reform period during May 2005-09 to the extent that R2 is now a measure that is more consistent with the Price-Informativeness Hypothesis. In other words, the NTS reform will lead to greater transparency for stocks and the cost-benefit trade-off on private information collection is improved, leading to more extensive informed trading and more informative pricing, as in the spirit of Grossman and Stiglitz (1980). Traders acquire more information about stocks and their prices are more volatile (equivalently, lower R2) and more informative than the prices of stocks with more costly information. Thus the positive coefficient on the synchronicity measure ψi for the overall period from 1991-2009 should flip to the negative sign during the post-NTS sub-period. As a result, we hypothesize that low R2 stocks will now have lower returns from the technical trading rules (not higher as were under the Noise Hypothesis) after the NTS reform where there is an economically significant fundamental shock to the information environment.
Section 5.1 covers some institutional background information on the NTS reform. Section 5.2 outlines the Chow Test to detect the presence of a structural break in beta coefficient for the synchronicity measure ψi. Section 5.3 details the empirical results of the relationship between technical trading returns and synchronicity in the two sub-periods, that is, pre-and post-NTS reform (1992-04/2005 and 5/2005-2009), and a discussion on the implications of the findings.
5.1 Institutional Background on the Non-Tradable Share (NTS) Reform
The Shanghai and Shenzhen Stock Exchanges were established in December 1990 and July 1991 respectively. Non-tradable shares (NTS) prior to the 2005 reform composed of legal-person shares and state shares are held by SOEs or government agencies. Legal-person shares were transferable between domestic institutions upon the approval of CSRC. Tradable shares composed of A-shares (denominated in local currency) and B-shares (denominated in foreign currencies and reserved for foreign investors, and H-shares . The non-tradable portion was as high as 72 percent in 1993, and well over 60 percent prior to the NTS reform in 2005. According to the data from Chinese Security Regulatory Committee (CSRC), institutional investors held 28.89 percent of the value of tradable shares at the end of 2007, an increase by almost 25 percent compared to 2001. Before the NTS reform in 2005, the ownership structure in Chinese firms was concentrated, representing a partial transition from an economy in which most enterprises were owned by the state. At least 80 percent of the listed firms were created from the existing state-owned enterprises (SOEs) through carve-outs, in which the original business group remains as the parent firm, as well as the controlling shareholder. The largest shareholder controls more than 40 percent of the total shares in around 80 percent of listed firms, while the second largest shareholder typically owns less than 10 percent.
The conflicting incentives of controlling and minority shareholders caused by this split-share ownership structure can lead to significant inefficiencies inside the firm (Shleifer and Vishny, 1986, 1993; Rajan and Zingales, 2003). It has been argued that prior to the NTS reform, managers focused too much on book value, since any trades of state shares or legal shares approved by the CSRC took place at book value (Allen et al, 2007). Aharony, Lee and Wong (2000) documented that Chinese SOEs engage in financial packaging for public listing. Allen et al (2005) showed that China’s formal sector (consisting of state-controlled firms) underperforms the “informal sector” of non-state-owned firms. Ball, Kothari and Robin (2000) provide evidence that accounting income in China lacks timely incorporation of economic loss because of political influence on financial reporting practices. Piotroski, Wong and Zhang (2009) find that state-controlled firms suppress negative financial information around visible political events. Since the blockholders could not sell their shares, they were inclined to expropriate wealth from minority shareholders (LaPorta et al, 2002; Wei, Xie and Zhang, 2005; Cao, Dybvig and Qiu, 2007; Cheung et al, 2009; Chen, Jian and Xu, 2009). There is also evidence of significant cash transfer or tunnelling of resources via related lending from listed firms back to controlling owners after related-party transactions (Jian and Wong, 2008). State shareholders are also less inclined to discipline their CEOs (Chang and Wong, 2009).
On 31 January 2004, the state council called for comments on how to promote the share-trading reforms. This showed the Chinese government’s determination to change the structure of the stock market . On 29 April 2005, under the permission of state council, the CSRC issued “Notice on the Pilot Reform of the Share-Trading Business of Listed Companies”. Under the new plan, the remaining state shares among listed firms are converted to “G” shares and are tradable . Four listed firms were in the pilot scheme that started the NTS reform process . On 4 September 2005, CSRC issued Administrative Measures on Non-tradable Share Reform in Listed Companies and the reform had gone into real implementation from the pilot stage. By November 2006, 1,200 firms accounting for 96 percent of listed companies had completed the restructuring. By the end of 2007, there were only a few companies that have not reached an agreement with their shareholders on the terms of the reform.
During the reform, many new regulatory policies were launched, such as new accounting standards which aimed to improve transparency and to protect the interest of minority shareholders .
5.2 Structural Break Analysis
In the last section, we find that model (3) has the highest adjusted R2 for all three technical trading rules. We select model (3) to carry out our Chow Test to examine whether the coefficient on synchronicity is different in the two sub-periods, that is, pre-and post-NTS reform (1992-04/2005 and 5/2005-2009). We implement the three different trading rules (VMA (150,1,0), FMA (150,1,0,10), TRB (150,0,10)) in the two sub-periods to obtain the returns for our sample of stocks. The synchronicity measure ψi and the firm control factors for each sub-period are calculated using the same approach as outlined in the previous sections. Thus, we have:
TTR1i = α1 + β1 ψ1i + γ1 Firm Control1i + ε1 where i, i = 1, 2, . . . , n1
TTR2i = α2 + β2 ψ2i + γ2 Firm Control2i + ε2 where i, i = 1, 2, . . . , n2
and the corresponding null hypotheses:
H10 : α1 = α2, β1 = β2, γ1 = γ2.
H20 : β1 = β2.
The probability values for these tests are given in Table 4 and we reject the null hypotheses that the coefficient on the synchronicity measure ψi is equal. Thus, there exists a structural break pre- and post-NTS reform (i.e. before and after 5/2005).
5.3 Empirical Results of the Relationship between Technical Trading Returns and Synchronicity Pre- and Post NTS Reform
The average annualized mean buy returns from the three technical trading rules in the two sub-periods are reported in Table 5. The technical trading returns are negative during the pre-NTS reform sub-period, ranging from -4 to -33 percent depending on the technical rules applied, compared to the unconditional annualized average return of -15 percent. Post-NTS reform, the technical trading returns are hugely positive, ranging from 35 to 65 percent depending on the technical rules applied, which is better than the unconditional annualized average return of 25 percent.
Table 6 show the important result that the sign of the coefficient in the synchronicity measure ψi for the VMA and FMA technical rule flips from positive during the pre-NTS reform period and to negative during the post-NTS reform period as hypothesized. While the sign for the TRB rule remains positive, it has now become insignificant. In other words, lower R2 stocks will now have lower returns from the technical trading rules (not higher as were under the Noise Hypothesis) after the NTS reform. When there is an economically significant fundamental shock to the information environment as was the case for the NTS reform, R2 is now a proxy measure for informative prices and a measure that is more consistent with the Price-Informativeness Hypothesis.
The implications for these findings are important since it reconciles the lively debate and extremely mixed evidence on the interpretation of the synchronicity measure. Does low R2 stand for informed trading leading to more informative prices under the Price-Informativeness Hypothesis, or does it imply noisy trading, limits of arbitrage or/and incomplete market under the Noise Hypothesis? As emphasized, these two competing hypotheses have starkly different relationship with expected returns, that is, both informed and noisy trading lead to low R2, but the former is related to lower expected returns, while the latter indicate higher expected returns.
Thus, technical trading rules work better for low R2 stocks when the information environment does not experience any economically significant fundamental shock, such as the case for China during the sub-period from 1991 till April 2005 before the NTS reform, which is consistent with the Noise Hypothesis. However, an economically significant fundamental shock to the information environment will lead to the synchronicity measure to become a proxy for informative pricing, as was the case for China post-NTS reform from May 2005 till December 2009, resulting in lower technical trading returns to low R2 stocks, consistent with the Price-Informativeness Hypothesis.
After an economically significant fundamental shock to the information environment, higher technical trading returns come from stocks with higher R2 for the VMA and FMA technical rules, and generally for older (not younger) and bigger stocks with lower turnover. In addition, we observe that the coefficient on the fundamental factor Market-to-Book is now significantly positive. If MTB is a proxy for “growth” stocks (Lakonishok, Shleifer, and Vishny, 1994), the result indicates that these companies have higher technical trading returns. When MTB is a proxy for distress (Fama and French, 1993, 1995) and profitability (Daniel and Titman, 2006; Ecker, Francis, Olsson and Schipper, 2009), the result suggests that less distressed and less profitable stocks have higher technical trading returns.
To sum up, the relationship between stock return synchronicity and technical trading returns is negative over the period 1991-2009, that is, low R2 stocks have higher technical trading returns, consistent with the Noise Hypothesis. Post-NTS reform, during the period from May 2005-2009, stock return synchronicity and technical trading returns are positively related, that is, low R2 stocks have lower technical trading returns, consistent with the Price-Informativeness Hypothesis. We do not find this result to be conflicting. After all, we have only around four years of informed trading post-NTS reform during May 2005 to December 2009 as compared to around fourteen years of noise trading pre-NTS reform during January 1991 to April 2005, and the overall sample period from 1991-2009 is therefore dominated by noise trading, and hence the overall significantly negative relationship between stock return synchronicity and technical trading returns can be justified. As the information environment in China improves going forward in the next few decades, we can expect that the interpretation of R2 to be more consistent with the Price-Informativeness Hypothesis.
Interestingly, the results suggest that fundamental analysis could play a bigger role in the gathering of relevant firm-specific information for decision-making in investing in developing transitional economies determined in establishing the institutional structures and complementary changes in country infrastructure to create incentives for higher quality informational environment and good governance to protect investors’ rights.
A higher quality informational environment is important because the risk generated by noise trading can reduce the capital stock and consumption of the economy (De Long et al, 1989), and also forces managers to focus on the short term, and to bias the choice of investments against long-term projects. Shleifer and Summers (1990) argued that even if investors earn higher average returns from noise trading, it is because they bear more risk than they think. And even if they get rich over time, it is only because they underestimate the risk and get lucky.
There are policy implications in noise trading. Shleifer and Summers (1990) gave the analogy that making it costly for noise traders to bet on the stock market to protect them from their own utility losses is in principle identical to the case for prohibiting casinos, horse races, and state lotteries. In addition, noise trading benefit arbitrageurs who take advantage of noise traders. For instance, when noise traders are optimistic about particular securities, it pays arbitrageurs to create more of them. These securities might be mutual funds, new share issues, penny oil stocks, or junk bonds: anything that is overpriced at the moment. Just as entrepreneurs spend resources to build casinos to take advantage of gamblers, arbitrageurs build investment banks and brokerage firms to predict and feed noise trader demand. This suggests that regulatory actions could be needed when noise trading is prevalent to regulate the activities of these arbitrageurs taking advantage of the noise traders, as evident from the recent 2008 Financial Crisis with noise traders chasing subprime mortgage assets created by the financial institutions.
Thus, our results appear to suggest that the relationship between technical trading returns and R2 can also help regulators to assess whether the informational environment is “noisy” or “informative”, and make their policy recommendations and regulatory actions accordingly.
6. SUMMARY AND CONCLUSION
We acknowledge that technical trading rules might perhaps not work for certain stocks at the firm-level, and we want to know about the source behind the trading profits or losses from applying these technical rules. We believe that we are the first to empirically establish the link between technical trading returns and stock return synchronicity. An additional and a very simple yet practical statistics - the R2 - can guide trading decisions using technical trading rules . Imagine that the Bloomberg terminal, Yahoo Finance and financial websites should have an additional statistics – the synchronicity measure – to allow investors and traders to assess how effective their technical analysis can be; for instance, if the informational environment is generally noisy, then the technical traders should focus their efforts on less synchronous or low R2 stocks to increase their probability of generating abnormal profits.
Do technical trading rules work? Possibly only when the R2 is low, and for larger and younger stocks with lower turnover, consistent with the Noise Hypothesis. However, sub-period analysis reveal that when there is an improvement in the information environment after the punctuation by an economically significant fundamental shock - the NTS reform in China announced in April 2005 - higher technical trading returns post NTS-reform in 2005-2009 come from stocks with higher R2 for the VMA and FMA technical rules, consistent with the Price-Informativeness Hypothesis, and generally for older (not younger) and bigger stocks with lower turnover and higher market-to-book (MTB). Thus, without the guide of R2, investors should take the market prognosis by all these “alchemists” with their “voodoo” charts with a heavy dose of salt . We thus reconcile the lively debate and extremely mixed evidence on the interpretation of R2 and its relationship with the cross-sectional returns of stocks.
An economically significant fundamental shock to the information environment also lead to the significance of the Market-to-Book (MTB) ratio, suggesting that growth, distress and profitability (fundamental factors which MTB ratio proxies for) are important determinants to technical trading returns. Thus, fundamental analysis could play a bigger role in the gathering of relevant firm-specific information for decision-making in investing in developing transitional economies determined in establishing the institutional structures and complementary changes in country infrastructure to create incentives for higher quality informational environment and good governance to protect investors’ rights.
Our results also appear to suggest that the relationship between technical trading returns and R2 can also help regulators to assess whether the informational environment is “noisy” or “informative”, and make their policy recommendations and regulatory actions accordingly. For instance, when the informational environment is noisy, regulatory actions could be needed to regulate the activities of arbitrageurs taking advantage of the noise traders to protect them from their own utility losses, as evident from the recent 2008 Financial Crisis with noise traders chasing subprime mortgage assets created by the financial institutions.
A cross-country study adapting our research methodology will likely be helpful to assess the relative usefulness and interpretation of R2.
Using a Bayesian framework, Treynor and Ferguson (1985) suggest that past prices, when combined with other valuable information, can be helpful in achieving unusual profit. He concludes that: “It is the non-price information that creates the opportunity. The past prices serve only to permit its efficient exploitation.” A natural important extension would be to examine the use of fundamental analysis in conjunction with technical analysis, which we leave for future research.

Dollar Bears Go Into Hibernation as QE2 Attacks Prove Unfounded

2010-11-22T05:09:00.005-08:00

Dollar Bears Go Into Hibernation as QE2 Attacks Prove Unfounded
By Catarina Saraiva - Nov 22, 2010 12:52 PM GMT+0800
At a time when foreign officials and U.S. lawmakers are criticizing the Federal Reserve’s plan to buy Treasury bonds, the currency market is voting in favor of Ben S. Bernanke’s quantitative easing.
The Dollar Index measuring the currency’s performance against those of six major trading partners has climbed as much as 5.1 percent from its low this year on Nov. 4. Futures traders have slashed bets for a decline in the dollar against the euro, yen, Australian dollar and Swiss franc, data from the Commodities Futures Trading Association in Washington show.
Leaders from Chinese Premier Wen Jiabao to John Boehner, the nominee to be the next speaker of the House of Representatives, have said Fed Chairman Bernanke’s plan to print money and buy $600 billion of U.S. government debt will cause instability and faster inflation. The $4 trillion-a-day currency market is signaling the Fed’s strategy is unlikely to debase the dollar as long as the economy continues to strengthen.
“The dollar has found a bottom,” said Lane Newman, director of foreign exchange in New York at ING Groep NV, the largest Dutch financial-services company.
Strategist forecasts for the dollar to weaken have all but ceased. Since mid-October, the average of 38 estimates in a Bloomberg survey has been for the currency to trade at about $1.36 to the euro by mid-2011. It ended last week at $1.3673.
‘Clueless’ Policy
German Finance Minister Wolfgang Schaeuble said Nov. 5 the Fed’s policy was “clueless” and unlikely to revive growth. Brazilian Finance Minister Guido Mantega, who used the phrase “currency war” six days after the Fed suggested at its Sept. 21 meeting it was willing to ease monetary policy, said Nov. 4 the U.S. is throwing “money from a helicopter” and may cause asset bubbles to form.
Bernanke defended the decision in a speech last week in Frankfurt, saying it’s the best way to underpin the dollar and support the global recovery. Economists at London-based Barclays Capital said in a Nov. 19 report that U.S. growth will accelerate this quarter from 2.4 percent in the three months ended Sept. 30, while the 16-nation euro zone goes through “turmoil” amid talks to bail out Ireland.
Ireland applied for a bailout to help fund itself and save its banks, becoming the second euro member to seek a rescue from the European Union and the International Monetary Fund. Irish Finance Minister Brian Lenihan said the loan will be less than 100 billion euros ($138 billion), refusing to give any further details at a press conference in Dublin yesterday.
Investor concern that Ireland may default drove up yields on its 10-year bonds last week to 6.46 percentage points more than those on German bunds of similar maturity, a record.
Turning Bullish
“It’s become almost fashionable to criticize the Fed,” though Europe’s fiscal crisis has “changed the picture quite a bit,” said Vassili Serebriakov, a currency strategist at Wells Fargo & Co. in New York.
Wells Fargo, the third-most accurate currency forecaster of 44 firms tracked by Bloomberg for the six quarters ending Sept. 30, estimates the dollar will end the year at $1.38 to Europe’s common currency, and gain to $1.34 in 2011. Last month, the firm was calling for an exchange rate of $1.43.
IntercontinentalExchange Inc.’s Dollar Index fell 0.5 percent to 78.109 as of 1:50 p.m. in Tokyo today, dropping for a fourth day. That’s still below 82.918 level on Aug. 27, when Bernanke said the central bank “will do all that it can” to keep the recovery on track. That sparked speculation that the Fed would conduct a second round of so-called quantitative easing and keep interest rates at record lows through 2011.
Open Letter
“The dollar cannot mount a sustainable rally in the face of quantitative easing,” said Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York. “The Fed is capping U.S. interest rates and by doing that, it’s making the dollar an unattractive currency compared to other countries with higher interest rates.”
A group including former Republican government officials and economists wrote an open letter to Bernanke, published Nov. 15, saying the asset purchases “risk currency debasement and inflation” and won’t curb a U.S. jobless rate that has held above 9 percent since May 2009.
The best way to underpin the dollar and the global recovery “is through policies that lead to a resumption of robust growth in a context of price stability in the United States,” Bernanke said in a speech in Frankfurt on Nov. 19. Countries that undervalue currencies may inhibit growth around the world and risk financial instability at home, he said.
Foreign Demand
Treasury Department data last week showed global investors bought a net $81 billion of U.S. stocks, bonds and other financial assets in September, above this year’s average of $71 billion, after Bernanke laid out the bond purchase plan the previous month to central bankers in Jackson Hole, Wyoming.
During the first round of quantitative easing the Fed bought $1.725 trillion of government and mortgage bonds between November 2008 and March 2010. In the past three years the Dollar Index has ranged from a low of 70.698 in March 2008 to as much as 89.624 in March 2009. This year’s high was 88.708 in June.
Investors may prefer the dollar as the Fed’s effort to avoid deflation by injecting more cash into the financial system shows signs of succeeding. A general decline in consumer prices tends to hurt a currency because international investors have less incentive to buy assets in that nation.
Yields on 30-year Treasury bonds, which are most sensitive to changing expectations for faster inflation, rose last week to 4.42 percent, the highest since May.
Pimco’s Take
“The long end of the market is telling you to give Mr. Bernanke and his colleagues the benefit of the doubt that this thing can be successful,” said Paul McCulley, a managing director at Newport Beach, California-based Pacific Investment Management Co., which runs the world’s biggest bond fund. McCulley made the comments last week in an interview on Bloomberg Radio’s “The Hays Advantage” with Kathleen Hays.
Futures traders have slashed bets the dollar will weaken against the euro. The number of contracts hedge funds and other large speculators hold at the Chicago Mercantile Exchange betting on a gain in Europe’s currency tumbled to 8,606 as of Nov. 16 from the high this year of 48,243 on Oct. 8, according to Commodity Futures Trading Commission data.
Traders “overshot” on the dollar’s weakness and “we’re now seeing a reversal of that,” said Jeffrey Young, head of North America foreign exchange research at Barclays in New York. “It makes sense that the dollar is going to have to rise” as bond yields in the U.S. increase, he said.
Broad Rally
Since the Dollar Index’s low this year on Nov. 4, America’s legal tender has risen against 15 of its 16 most-widely traded counterparts tracked by Bloomberg. It gained the most against Sweden’s krona, rising 4.3 percent, followed by 3.6 percent versus Norway’s krone and 3.4 percent compared with the franc.
UBS AG, the second-largest currency trader behind Deutsche Bank AG, raised its one-month forecast last week for the dollar on signs of recovery in the U.S. economy and Europe’s lingering fiscal crisis.
The Zurich-based firm sees the greenback strengthening to $1.30 per euro in a month, compared with its previous estimate of $1.40, according to a research note dated Nov. 15. The U.S. currency may climb to 85 yen in one month, from a previous target of 80 yen, it said. The dollar traded at 83.39 yen today in Tokyo from 83.55 yen in New York on Nov. 19.
“Europe’s fiscal troubles are set to continue and the U.S. economy is starting to revive after summer weakness,” analysts led by Mansoor Mohi-uddin, the Singapore-based chief currency strategist at UBS, wrote in the note. “We expect investors to look more favorably on the dollar now.”

Michael Dell Shows Ben Bernanke Is Impotent: William Pesek

2010-11-22T05:09:00.003-08:00

Michael Dell Shows Ben Bernanke Is Impotent: William Pesek
By William Pesek - Nov 22, 2010 9:59 AM GMT+0800
Bloomberg Opinion
Suspicions that the Federal Reserve’s moves won’t save the U.S. are often based on events in Tokyo. Round Rock, Texas, may be a better place to look.
That’s where the computer empire Michael Dell created in 1984 is based. As Fed Chairman Ben Bernanke pumps a new burst of stimulus into the economy, he hopes to spur businesses to hire, spend and help avoid a second recession.
It’s no longer so simple. In September, Dell Inc. sold $1.5 billion in 3-, 5- and 30-year notes. In regulatory filings, Dell said the proceeds were for “capital expenditures, advancements to or investments in our subsidiaries, and acquisitions of companies and assets.” Nine days later, Dell said it will spend more than $100 billion in China during the next decade.
Dell says the money it raised won’t be used outside the U.S. Yet it’s hard not to connect the dots and wonder what the Fed thinks it will accomplish by flooding America with cash when much of it will leak overseas. This is stimulating developing nations in Asia and elsewhere more than the U.S.
There are two reasons why the Fed’s largess is bad for Asia. The first has gotten lots of press: The torrent of hot money is adding to overheating risks. The second deserves more attention: Asian governments gain room to foster the false perception that their region is immune to the West’s malaise.
Global Fed
The internationalization of the Fed has been unfolding for two decades. When Mexico crashed in the mid-1990s, traders from Tokyo to New York looked to the Fed to rescue markets. When Asia blew up in 1997 and Russia defaulted in 1998, markets again turned to Washington. The Fed calmed investors and U.S growth surged.
That was then. An unexpected quirk of globalization is that the mighty Fed has been reduced to tossing monetary experiments at the wall to see what sticks. One round of quantitative easing here to boost growth, another there. And so on, and so on.
Things have gone so full circle that former Fed Chairman Alan Greenspan, a man as responsible as any for the credit crisis, is now taking potshots at the Bernanke Fed. The brouhaha over U.S. interest rates has even made a Fed watcher out of former Alaska Governor Sarah Palin.
All this is having a schizophrenic effect on Asia. On the one hand, it’s giving investors that 1996 feeling. More money is rushing into markets than can be productively used. In 1997, remember, things ended badly.
Inflation Alert
Premier Wen Jiabao last week said China is drafting measures to counter excessive price increases with inflation at the highest in more than two years. McDonald’s Corp. tells the story. The world’s largest restaurant chain is increasing prices for its burgers, drinks and snacks in China to offset costs. On Friday, China’s central bank said it will raise the reserve ratio requirement for banks by 50 basis points starting Nov. 29.
On the other hand, Asians were the winners from the global credit meltdown partly because of all the cash that arrived in search of better returns. While Asia’s leaders abhor the resulting rise in exchange rates, they understand that capital inflows have benefits. Asia hasn’t had to open the fiscal floodgates the way that the U.S., Japan and Europe have.
The risk is that Asian leaders let this good fortune go to their heads. All isn’t well in the global financial system as Ireland goes the way of Greece. As Europe’s debt crisis broadens and threatens bigger targets like Spain, the global credit crunch might kick up again. And who knows, maybe Ireland will soon be hitting up cash-rich China for a bailout.
Fed’s Bubbles
Asia has proven it can live without the U.S. consumer, at least for a while. Yet the quality of growth matters as much as the quantity. Is it based on true, sustainable demand or the Fed’s bubbles? There’s reason to think it’s the latter rather than the former driving Asian markets. It means Asia’s current pace isn’t sustainable as long as the $14 trillion U.S. economy and troubled euro zone are limping.
Quantitative easing hasn’t worked for Japan. If it’s going to work in the U.S., capital controls may be inevitable. The Fed must stop the seepage of liquidity overseas. It makes no sense for the Fed to take such monumental risks with its balance sheet if America isn’t reaping the benefits. Wanton U.S. policies also are dangerous in the long run if they make developing nations more vulnerable to boom-and-bust cycles.
That gets us back to Round Rock, Texas. By investing so much in China, Dell is anticipating the trajectory of global growth. Standard Chartered Plc thinks China’s economy will overtake the U.S. by 2020. If so -- and it’s a big if -- Dell is just operating in the best interest of shareholders.
Bernanke shouldn’t be accelerating the process, though, and that’s the upshot of his actions. It’s one thing to take the Fed into unchartered territory. It’s quite another to force-feed the benefits and risks of U.S. policies to other countries.

Private Equity Finds Liquidity, Finally

2010-11-22T05:09:00.001-08:00

Private Equity Finds Liquidity, Finally
Financial sponsors are extracting dividends from their portfolio companies while credit is still cheap.
Vincent Ryan, CFO.com | US
November 19, 2010
The recap is back — the dividend recapitalization, that is. Private-equity firms are taking advantage of wide-open credit markets and low interest rates to get liquidity on their investments and releverage their portfolio firms.
Bond sales to fund dividends accelerated in the third quarter to $12.6 billion, about 45% of the volume for the first three quarters of the year. Another $5.7 billion of such issuances took place in the first three weeks of October. About 81% of dividend financing in 2010 has been for private-equity-owned firms, as opposed to public companies, and the average dividend has been 107% of the initial equity contribution by the financial sponsors, says Terence Tchen, a managing director at Houlihan Lokey.
"[Financial sponsors] are getting all the money they invested and an extra 7%, and the ownership doesn't change," says Tchen.
"From the standpoint of a lot of [general partners], the best option right now is a dividend recap," says Alan Wink, director of the private-equity group at accounting firm EisnerAmper LLP. "Would it be their first choice? No. But it's probably their best choice."
The tax advantages of a dividend recap has boosted recap deals over the last few months. The thinking has been that if Congress fails to extend the Bush tax cuts — in particular the 15% qualified dividend rate — or changes the rules on carried interest, PE funds would have a limited time to distribute dividends before taxes increase. "PE funds measure returns on an aftertax basis, so they care about taxes from a performance return standpoint," says Tchen. But with the midterm elections handing control of the House to Republicans, the expiration of the tax cuts appears less likely.
Cheap debt financing has also played a role. There have been 10 straight weeks of inflows to high-yield bond funds. "Some lenders are even willing to do covenant-lite deals," says Karen Miles, a managing director of financial advisory services at Houlihan Lokey.
Concurrently, the choices financial sponsors have for totally exiting investments are limited. Few financial sponsors want to take the leap of an initial public offering, for one; IPO performance is still erratic. "There's always the risk of whether or not the IPO window will be open," says Tchen. Also, secondary leveraged buyout activity (financial sponsor selling to financial sponsor), while somewhat brisk earlier in the year, has slowed. Such deals totaled just $10 billion over the last six months, according to an analysis of Capital IQ data by CFO.
What kind of companies could be pondering leveraged recaps? Companies and financial sponsors that don't think now is the right time to sell, or want to sell but didn't get started early enough to complete a deal in 2010. "This is a way to pull some money off the table and not relinquish control," says Miles. Of course, the companies also have to have the balance sheet for a larger debt burden and the cash flows to make interest payments.
If the tax advantage is taken off the table, many financial sponsors could choose to wait, especially if they expect a stronger U.S. economy in 2011. The financial sponsor may want to have the company hit improved earnings and cash-flow projections before exiting the investment wholly or in part. "It's a lot easier to sell a company that has a 20% rise in trailing EBITDA versus one that is just promising those results," says Tchen.
The trend to dividend recaps is not without controversy. Not all private-equity firms use dividend recaps or think they are a smart use of capital. When a PE firm gives the money back to investors, it's signaling that it can't invest the money wisely as the investor, says Robert Landis a partner in origination at The Riverside Company. He says Riverside would only do a dividend recap as a last resort, and only if the portfolio company is significantly deleveraged.
Creditors, investors, and credit rating agencies also generally dislike leveraged recapitalizations. Dividend recaps make the CFO's job tougher. "All of a sudden [the finance chief] has to worry about making larger interest and principal payments, and might think twice about investing in new plant and equipment," Wink says. "The company can become less competitive."
However, historically, dividend recaps do not appear to blow up companies. In a study of deals spanning eight years in the late 1990s and early 2000s, Standard & Poor's found that companies that underwent leveraged recapitalizations had a 6% default rate, compared with 11% for all companies bought in LBOs. One reason was that only companies with strong cash flows can complete these deals, and companies that were recapped had lower leverage multiples.
The leverage being put on recapped companies this time around is also conservative. Year to date, the average debt-to-EBITDA of recapped companies has gone from 2.5 times to 4.1 times post-transaction. In the third quarter, average leverage rose to 4.6 times, but the numbers fall below the average of the LBO wave earlier this decade, says Tchen of Houlihan Lokey.
"Capital has been growing in these companies as they accumulate cash," says Tchen. "They have strong-enough cash flows and can handle the debt."

Greed Beats Fear in U.S. Stock-Bond Correlation Tumbling to Three-Year Low

2010-11-22T05:08:00.005-08:00

Greed Beats Fear in U.S. Stock-Bond Correlation Tumbling to Three-Year Low
By Whitney Kisling - Nov 22, 2010 8:01 AM GMT+0800
For the first time since the financial crisis started, U.S. shares are moving independently of the bond market, a sign that profits and valuations are guiding investors more than concern about the economy.
The 30-day correlation coefficient measuring how often the Standard & Poor’s 500 Index moves in tandem with 10-year Treasury yields fell to minus 0.42 from a record 0.89 in June, data compiled by Bloomberg show. Readings of 1 indicate prices are moving together, while zero shows no link and minus 1 means they are going in opposite directions. Stocks and debt are ending a lockstep relationship that began in July 2007 and lasted through the worst recession since the 1930s.
Pioneer Investments, Security Global Investors and Citigroup Inc. say the broken connection is bullish as the greatest number of S&P 500 companies in a decade post earnings growth. During the bull market from 2002 to 2007 when the S&P 500’s price and profits doubled, the correlation averaged 0.15, data compiled by Bloomberg show.
“I prefer days when companies are rewarded or punished based on their performance,” said John Carey, a Boston-based money manager at Pioneer, which oversees about $250 billion. Before, “people were worried that some large events over which they had no control would influence the direction of the market and investment results,” he said.
Bernanke’s Pledge
The S&P 500 rose less than 0.1 percent to 1,199.73 last week as China took steps to curb inflation. The index has advanced 13 percent since Federal Reserve Chairman Ben S. Bernanke hinted on Aug. 27 in Jackson Hole, Wyoming, that he would use a strategy known as quantitative easing to boost the economy. The relationship between the 500 stocks and the benchmark index fell to 0.55 on Nov. 11, the lowest since May 3, according to Birinyi Associates Inc. data on 50-day correlation.
The relationship using 30 days of data between the S&P 500 and 10-year Treasury yields was last negative in July 2007. It jumped to 0.79 on Aug. 14, 2007, five days after Paris-based BNP Paribas SA halted withdrawals from three investment funds because it couldn’t value their holdings as U.S. subprime mortgage losses roiled credit markets. The stocks-bonds relationship never turned negative in 2008.
The S&P 500 plunged 4.7 percent and yields on 10-year Treasuries tumbled 33 basis points, or 0.33 percentage point, on Sept. 15, 2008, after New York-based Lehman Brothers Holdings Inc. filed for bankruptcy. The correlation jumped to 0.83 on Oct. 6, 2008, as the financial crisis intensified, reaching the highest level since a month after the Iraq War began in 2003, data compiled by Bloomberg data show.
Profits, Takeovers
Bernanke’s Aug. 27 comments helped end the lockstep moves. Weaker connections among assets mean profits, takeovers and valuation will drive returns, Security Global’s Mark Bronzo said. The S&P 500 climbed to a two-year high on Nov. 5 and the rate on 10-year Treasuries dropped to the lowest level since 2009 on Oct. 8.
While Howard Ward of Mario Gabelli’s Gamco Investors Inc. says stocks are likely to rally, loosening correlations aren’t fueling his optimism.
“The correlation is moving lower because of what’s now a real perceived difference in the return potential for stocks versus bonds,” said Ward, whose firm oversees $26 billion in Rye, New York. “I understand people are very anxious about stocks because of volatility, because of economic uncertainties and because they didn’t do well for the last 10 years, but buying bonds today is like buying stocks in 1999,” before the S&P 500 plunged 49 percent, he said.
First Decade Loss
Treasuries returned 81 percent between 1999 and 2009 while the S&P 500 dropped 9.1 percent, including dividends, for its first loss over the course of a decade, according to data compiled by Bank of America Corp.’s Merrill Lynch and Bloomberg.
As correlations break down, quarterly financial results are swaying share prices more than at any time since 2007. S&P 500 companies that beat the average analyst profit forecast gained 0.1 percent since reporting results, while those that missed declined 3.3 percent, according to data compiled through Nov. 16 by Westport, Connecticut-based Birinyi. That’s the first time in three years companies beating estimates rallied and those that missed fell on average.
“There are those individual names that will produce stronger earnings and profit margins, and will be rewarded for that,” said Bronzo, a money manager in Irvington, New York, whose firm oversees $22 billion. “We’re returning to a more normal economic environment as we’re moving past the financial crisis. So where the market traded all as a group, there’ll be more of a distinction between sectors and names.”
Beating Forecasts
Third-quarter earnings surpassed analyst projections by 6.6 percent for the 457 companies that have reported since Oct. 7, Bloomberg data show. It was the sixth straight period in which more than 70 percent of companies beat forecasts, the longest stretch since at least 1993, according to Bloomberg.
Analysts forecast 87 percent of S&P 500 companies will post higher earnings next year. That would be the most since at least 2000, estimates from more than 10,000 analysts compiled by Bloomberg show.
“There’s a better chance for active managers to outperform,” said Eric Teal, chief investment officer at First Citizens BancShares Inc. in Raleigh, North Carolina, which manages $5 billion. “Over the past few years, many of the macro forces have driven the stock market returns and now more fundamentals are starting to drive the market.”
Stocks, Junk Bonds
Stocks that trade at below-average price-earnings ratios and that trailed benchmark indexes in 2010 -- such as Hewlett- Packard Co. and Merck & Co. -- should benefit as equity returns diverge, Carey said. MFS Investment Management’s James Swanson recommends technology companies because they have money to return to shareholders.
Hewlett-Packard has almost $15 billion in cash, the 12th- highest amount in the S&P 500. While at least 28 of 38 analysts covering the Palo Alto, California-based company recommend investing in the world’s largest computer maker, the stock has fallen 18 percent this year, pushing the valuation down to 8.3 times 2011 estimated profit.
Merck, the world’s second-largest drugmaker, has a price- earnings ratio of 9.2 times next year’s forecasts, Bloomberg data show. The Whitehouse Station, New Jersey-based company is down 3.3 percent this year, compared with the S&P 500’s 7.6 percent gain, even as per-share earnings excluding some items are projected to expand 13 percent next year, the best annual growth since 2007, according to the analyst average.
‘My Goodness’
“My goodness, these are very good prices for these stocks,” Carey said of health-care companies. The 51 pharmaceutical producers, device makers and health insurers in the S&P 500 trade for 12 times annual earnings, compared with a 10-year average of 19.2, data compiled by Bloomberg show.
While the benchmark index for American shares has rallied 77 percent since reaching a 12-year low on March 9, 2009, prices relative to earnings remain below historical levels. More than 88 percent of S&P 500 stocks are cheaper than their average since 2005, based on next year’s forecasts, compared with the decade’s 66 percent mean, data compiled by Bloomberg show.
Takeovers picked up this year, with $651 billion worth of U.S. deals announced since January, compared with $635.8 billion for all of last year, according to data compiled by Bloomberg.
Stronger correlations made it more difficult for mutual funds to distinguish themselves. The standard deviation, or variation in returns, for funds invested in the biggest U.S. companies declined to 4.1 percent in the second quarter, data compiled by Lipper and Bloomberg show. That was the lowest since at least 2000. The figure climbed to 9.8 percent last quarter as correlations weakened.
Similar Performance
Returns among money managers mirrored one another regardless of strategy. An index of hedge funds focused on bonds of distressed companies has returned 8.5 percent this year, according to data compiled by Bloomberg and Chicago-based Hedge Fund Research Inc. Over the same period, a gauge of Latin America funds returned 7.1 percent. The correlation between the two has climbed to about 0.28 point more than the 12-year average, Bloomberg data show.
“More focused investing may be in the process of developing,” Tobias Levkovich, Citigroup’s chief U.S. equity strategist in New York, wrote in a report this month. “As returns begin to diverge, investors arguably can be well-served by buying those stocks they deem attractive without worrying about macro conditions that can swing entire groups.”

The 'Build America' Debt Bomb

2010-11-22T05:08:00.003-08:00

The 'Build America' Debt Bomb
By Steven Malanga
951 words
22 November 2010
The Wall Street Journal
In a Rasmussen poll taken before the midterm election, half of the respondents said that members of Congress who supported the 2009 federal stimulus didn't deserve to be re-elected. Many weren't. Yet the lame-duck Congress might extend one of the key elements of that stimulus: "Build America Bonds" (BABs). States and municipalities have used these bonds to rack up some $160 billion in new debt over the last 19 months.
Build America Bonds were created to re-energize the municipal bond market, which contracted sharply in late 2008. Investors had become wary that the credit crunch would spread to municipals, as insurers who back state and local bonds got hurt in other markets and stopped insuring public debt. Facing declining tax revenue and growing deficits, some local governments suddenly couldn't borrow.
The Obama administration responded with a new kind of taxable bond that offered a 35% federal subsidy on the interest rate. Washington designed the subsidy to appeal to investors such as pension funds and overseas buyers who don't buy traditional municipal bonds because they can't take advantage of their tax-free status. The federal subsidy allowed states and cities to offer these investors an attractive return. The catch: Congress authorized the program only through 2010, to allay concerns that BABs would become a permanent bailout.
States and cities jumped deeply into this new market. California alone has issued some $21 billion in BABs, mostly as a substitute for its general obligation debt to support everything from school construction to sewer projects. New Jersey has used up to $500 million to recapitalize its depleted transportation trust fund. Columbus, Ohio, issued $131 million in BABs to start construction of a downtown convention hotel. And in Dallas, Texas, when no private operator would finance a new convention hotel, the city went ahead with a government-subsidized hotel, courtesy of $388 million in BABs.
Now dozens of governments and other municipal issuers (like New York's Metropolitan Transportation Authority and the University of California) have hired lobbyists to push Congress to extend BABs beyond this year. And in its 2011 budget, the Obama administration proposed making Build America Bonds permanent, with an interest-rate subsidy of 28%.
But the BAB program hasn't been the unqualified success its advocates claim. While the original municipal bond crisis in late 2008 was attributed to the meltdown of other credit markets, it has since become clear that investors retreated from municipal debt as much because of the poor fiscal practices of many local governments. BABs have only contributed to the problem, increasing state and local debt even when the market has signaled that it considered some municipal borrowers overextended.
One sure signal has been the sharp rise in the cost for investors to insure against default. In June, the price of a contract protecting an investor from a default by Illinois on its bonds rose to a record high of $309,100 on $10 million of debt over five years, according to CMA Datavision. The national average for states is $190,000 per $10 million in debt. At that point, Illinois surpassed California as the worst credit risk among U.S. states.
A more telling signal was that, based on the cost of insurance contracts, CMA Datavision listed both states in June among the 10 biggest government default risks in the world. Illinois was at greater risk of default than Iraq. Yet thanks to the BAB subsidy, Illinois was still able to borrow some $300 million in bonds by offering a 7.1% interest rate.
Meanwhile, investors are realizing that states and localities face long-term costs in addition to their muni debt, especially retirement obligations. Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester assess the 50 states' unfunded pension bill at $3 trillion, and they say that the municipal tab for pensions could reach $500 billion. That is on top of some $2.8 trillion in outstanding state and local borrowing, according to the Federal Reserve.
The governments that have made the most use of BABs have been those with the greatest fiscal problems. The biggest issuer of BABs, California, has relied on an unprecedented number of gimmicks to balance its books in the last two years -- such as temporarily increasing tax withholding rates and issuing IOUs to vendors.
New Jersey used a big chunk of its BAB funding to relieve the burden from past budget tricks. Over the years its legislature has diverted gas-tax money from its transportation trust fund, which is supposedly dedicated to public works, to paper over previous general account budget deficits. Now the state is borrowing with BABs to restock the trust fund, though servicing the interest on those bonds will haunt future budgets.
The Obama administration believes the BABs' direct federal subsidy is a more efficient way to raise money than traditional tax-free municipals. But when money that would otherwise go to private business flows into subsidized government activities, resources are misallocated.
This is no idle speculation: The financial press is full of stories of investment managers recommending BABs over corporate bonds with similar ratings, thanks to the advantage of federal subsidy. There is also a future bailout risk, given that the federal government might not allow a state or local government to default on a Build America Bond. None of this is what voters signed up for on Nov. 2.
---
Mr. Malanga is a senior fellow at the Manhattan Institute and the author of the recently published "Shakedown: The Continuing Conspiracy Against the American Taxpayer" (Ivan R. Dee).

Pharmaceutical Industry Is Facing Biological Warfare

2010-11-22T05:08:00.001-08:00

Pharmaceutical Industry Is Facing Biological Warfare
By Hester Plumridge
469 words
22 November 2010
The Wall Street Journal
It is a new battle for the drugs industry, and it will be hard-fought. U.S. and European regulators are debating guidelines for approving "biosimilars," which would allow copies of cancer and multiple-sclerosis treatments to be developed for the first time. That is a big threat for biotech firms and pharmaceutical companies like Roche. It is also a huge opportunity for generics players.
Biological treatments are proteins manufactured in living cells, rather than chemical-based drugs. Biotech firms including Amgen and Biogen, and pharmaceutical companieslike Pfizer, Novo Nordisk and Roche are key players in a market worth some $100 billion in annual sales.
Biologics are complex to manufacture. They command high prices. And although companies face a wave of patent expirations from 2014, there are no mechanisms for approving generic copies for the majority of these products.That means biotech specialists tend to trade at a premium to peers with products more at risk from generic competition.The premium isnow under threat.
Guidelines for approving a raft of biosimilars, or copies of biological drugs, are expected in Europe later this month. The threat has been known for years, but the market may be underestimating theimpact. Credit Suisse has forecast a 5%-10% annual decline in sales of biological treatments once patents expire, but that looks conservative.
Patent expirations on conventional drugs have caused sales to fall at rates of up to80% per year. True, biosimilars have higher barriers to entry. While generic drugs can typically be developed for under $5 million, biosimilars can take twice the time and cost as much as $200 million each. Regulators may require extensive clinical trials to approve them. Doctors may be reluctant to prescribe "copycat" treatments.Patent holders will alsofight to protect sales, refining their drugs or making them easier to administer.
But pharmaceutical firms accept that biosimilars will eventually be approved, not least because governments need to facilitate the development of cheaper drugs. Biosimilar sales could rise from $250 million last year to $20 billion by 2020, estimates generics manufacturer Sandoz, a division of Novartis. The world's largest generics firm, Teva Pharmaceuticals, is already testing its version of Roche's cancer and arthritis drug Rituxan. Pfizer, too, is beefing up its generics business.
Roche's historic 20%-30% premium to peers has all but disappeared as the risks to its drug portfolio have become clearer. And generics firms look like the winners. Teva now trades at 11.5 times this year's earnings, a fraction above the global pharmaceutical sector. That is still behind biotech specialists like Novo Nordisk. But as opportunities for biosimilars develop, the balance could tip further in generic manufacturers' favor.

Accounting Method Sucks Up Oil

2010-11-22T05:07:00.003-08:00

Accounting Method Sucks Up Oil
By Dan Strumpf
683 words
22 November 2010
The Wall Street Journal
NEW YORK -- An accounting practice is making the millions of barrels of excess crude that have flooded the oil market disappear -- for a few weeks, anyway.
To avoid a tax charge tied to rising oil prices, refiners and other companies that store crude are scrambling to make sure they end the year with the same inventories that they had at the start. Stockpiles on the Gulf Coast plunged nearly 7 million barrels in the week ended Nov. 12, the region's biggest drop in over two years, according to the Energy Information Administration. Another 25 million barrels need to go for this December's inventories to match last year's. But if past years are any indication, inventories are likely to rise just as quickly with the start of the new year.
The oil market has been waiting months for just such a drop in supplies along the nation's main refining corridor. Prices are poised to soar on any indication that rising demand from the recovering economy is bringing a two-year-old oil glut to an end.
But the recent draws aren't that sign, and it's being reflected in the price of oil. Crude prices are off 7.2% since ending at a two-year high on Nov. 11, trading late Friday at $81.51 a barrel. Futures nearly fell below $80 a barrel for the first time in a month on Wednesday -- after the government inventory report -- as U.S. demand looked weak.
"It's not any huge surge in demand that's causing the drawdown," said a spokesman for a large refiner that is reducing inventories for tax reasons.
Companies usually reduce stocks by importing less oil, then drawing on inventories to refine into fuel. Last week, oil imports hit an 11-month low, the EIA said.
The refiner, like much of the oil industry, uses a form of accounting called "last in, first out," or LIFO, to value their inventories. The practice allows a company to claim each barrel of oil they sell was the most recent one purchased. That creates an incentive to lower end-of-year inventories when prices climb because the more expensive oil is the "first out," allowing the remaining oil to be taxed at a lower rate.
Oil inventories are typically valued each year using prices at the start of the year, said Les Schneider, partner at the Washington, D.C., law firm Ivins, Phillips & Barker and an expert on inventory taxation.
If a refiner builds up one million barrels of oil inventories over the course of 2009, it could value that crude at the January 2009 price of roughly $40 a barrel. But if the refiner ends 2010 with 1.5 million barrels in storage, the additional 500,000 barrels would be valued at around $80 a barrel, the January 2010 price.
In addition, oil companies face taxes in Gulf Coast states based on the level of inventory they have in storage, providing another incentive to draw down year-end inventories.
Crude stockpiles fell sharply in November and December in three of the past four years, only to quickly rebound. Inventories are down nearly 3% nationwide in the past two weeks of government data, though they remain well above the historical average.
"Year after year, we see crude inventories in the Gulf Coast region decline in December. . .and it doesn't mean a darn thing in terms of whether the global oil market is tight or not," said Tim Evans, an oil analyst at Citi Futures Perspective.
The Obama administration has periodically tried to end LIFO accounting, and earlier this month, the co-chairs of a presidential commission charged with finding ways to reduce the deficit proposed doing away with the practice.
Companies that use LIFO, however, have opposed its repeal, saying it protects them against rising prices. The American Petroleum Institute, the main oil-industry lobbying group, has argued that repealing LIFO would result in a "significant upfront tax increase."

Quiet VIX Hides Anxiety in ETFs

2010-11-22T05:07:00.001-08:00

Quiet VIX Hides Anxiety in ETFs
By Brendan Conway
494 words
22 November 2010
The Wall Street Journal
NEW YORK -- Wall Street's favorite "fear index" is looking calm lately. But the same is less true for many sector-specific indicators, including for hot stocks such as energy and materials.
The CBOE Market Volatility Index, or VIX, touch its lowest intraday level since April on Friday, one session after staging its biggest one-day decline since June. The index, which tracks the prices of protective Standard & Poor's 500 options, tends to spike when investors are anxious and fall when they aren't. The placid VIX closed down 0.71, or 3.8%, to 18.04.
But investors can also track exchange-traded funds' options for similar worry signals, since they are popular tools to hedge stock holdings in specific sectors. Eyeing their "implied volatility" can give insight into the thinking of investors with outsize exposure to a sector.
The outlook for several of the most commonly traded sector ETFs actually showed more anxiety over the last month, a time when the VIX hovered in a low range. The reading for popular ETFs on emerging-market stocks, materials, technology and financials each rose by double digits, according to a ConvergEx Group study.
There was a sharp rise in worried emerging-markets trading last week. With rate-tightening concerns in China, bearish put volume on iShares MSCI Emerging Markets Index Fund leapt to its highest level in months. A put conveys the right to sell shares at a fixed price and can be used to guard against or speculative on the chance that a stock or index moves lower.
Overall, the rise in Consumer Staples Select Sector SPDR Fund's figure has been highest, up more than 24%. Energy Select Sector SPDR Fund also showed more anxiety, up more than 20%. The study used data from IVolatility.com.
"Folks who are closer to the individual sector seem to see risk where people who trade the market as a whole don't quite yet," said ConvergEx Group Chief Market Strategist Nicholas Colas.
There is a more benign interpretation. Portfolio insurance is relatively inexpensive after the big rally in stocks. Investors aren't fearful of a plunge so much as they are willing to give up a few percentage points to lock in gains, Mr. Colas said.
But even that rosier scenario would seem to suggest a degree of worry. If investors are willing to pay more for protective options, that suggests less than supreme confidence in the resilience of the stock market, and in the Federal Reserve's backstop.
To some, that the VIX hovers below its historical average looks itself like an anomaly. The U.S. economy is still shaky enough to need quantitative easing. Europe's sovereign-debt woes persist. Potential economic trouble in China threatens.
"To me," Mr. Colas said, "VIX below 20 in the environment we're in shows complacency."

Criticism Hinders Fed's Plan --- Doubts About Quantitative Easing Have Spurred Treasury Yields Higher

2010-11-22T05:06:00.005-08:00

Criticism Hinders Fed's Plan --- Doubts About Quantitative Easing Have Spurred Treasury Yields Higher
By Sudeep Reddy
861 words
22 November 2010
The Wall Street Journal
Criticism of the Federal Reserve's latest bond-buying program, both from insiders and from U.S. politicians, is muting the plan's potential benefits for the economy.
Amid widely publicized skepticism about the efficacy and wisdom of the bond buying, investors and traders are questioning whether the Fed would be able to expand its bond purchases beyond $600 billion -- even if inflation continues falling and unemployment remains high.
Those doubts have contributed to an increase in yields on U.S. Treasury bonds since the Fed announced the program on Nov. 3, they say.
The criticism "has raised questions about the Fed's ability and resolve to control the yield curve," said Mohamed El-Erian, chief executive and co-chief investment officer of Pimco, the bond-fund giant. "The criticism has unsettled markets naturally inclined to worry about the politicization of the Fed and its loss of autonomy."
The success of the latest round of quantitative easing, or QE2, hinges on shaping public and market expectations. The more the public and investors believe the Fed is likely to keep buying bonds to depress long-term interest rates until the economy comes back, the more likely the markets are to keep long-term rates from rising.
Communicating a willingness to do more bond buying if needed despite dissent from inside the Fed and political pressure, primarily from Republican politicians and their advisers, is proving a challenge for Fed Chairman Ben Bernanke and a policy-setting committee with a diverse set of views.
"The behavior of longer-term Treasury rates is a measure of the credibility problem that the Fed is facing now," said Alfred Broaddus, former president of the Federal Reserve Bank of Richmond, who deems QE2 a "reasonable step" to guard against deflation.
As a result, he said, Mr. Bernanke may need to speak more about his strategy and emphasize, as he did in the spring, that the Fed has both the tools and the willingness to withdraw stimulus to prevent too much inflation, Mr. Broaddus said. "To me, this largely is a communications issue."
In the weeks after the Fed announcement, several top Republicans -- including incoming House Speaker John Boehner of Ohio and potential presidential candidate Sarah Palin -- have expressed concern that the Fed's latest policy will result in too much inflation down the road. Some conservative economists, joined by political strategists who are coordinating with potential 2012 Republican candidates, have called on Mr. Bernanke to halt the bond-buying program. Few analysts see that outcome as likely, but the pressure on the Fed has been clear.
Inside the Fed, a handful of regional bank presidents have been vocal about their opposition to the bond-buying program, while others have voiced doubts about it. Just days after the Nov. 3 decision, Fed Governor Kevin Warsh, usually an ally of Mr. Bernanke and one of those who voted in favor of QE2, publicly expressed skepticism about the policy's ability to boost the economy, saying it should be reconsidered if the U.S. dollar continued to fall or if commodity prices rose too much.
The bond buying -- which the Fed plans to pursue at $75 billion a month through the middle of next year -- was designed to lower yields on Treasury securities as the Fed soaked up the supply of debt and thereby raised bond prices. Yields on the 10-year Treasury note, a benchmark for corporate and mortgage borrowing, fell in the weeks after Mr. Bernanke hinted at the move in late August.
In early October, the 10-year note was trading at 2.38%. Last week, it closed as high as 2.91%, settling at 2.871% on Friday.
"The criticism and resulting market reaction makes QE2 less effective," said Axel Merk, a Fed critic who runs mutual funds focused on currencies. "If the Fed wants to achieve the same goal, they have to print even more money. Of course, they can pursue the policy, but it'll be more expensive for everyone involved."
The public blowback has been only one factor pushing yields higher. David Ader, head of government-bond strategy at CRT Capital LLC, said many investors were simply closing positions established in the run-up to the QE2 announcement. "I think the bulk of the move is a position unwind exacerbated by the timing of the year" that led others to exit as well, he said.
Many traders expect rates to fall again in the coming months as Fed buying continues, unless the economy shows unanticipated signs of growth or inflation.
While the political backlash may have contributed to recent uncertainty about policy, Mr. Ader said the Fed also is showing signs of speaking more forcefully, as Mr. Bernanke did on Friday in response to foreign complaints about Fed policy.
"I think we've seen over the course of the last couple of weeks the attack, and now we've seen the defense," Mr. Ader said. "It seems to me they're [Fed officials] gaining a little bit of gumption."

Clive Palmer gives his Queensland Nickel employees Mercedes Benz cars and trips to Fiji for Christmas, following a major boost in company profits

2010-11-22T05:06:00.003-08:00

Queensland Nickel Employees Get Mercedes & Vacations for Christmas
Clive Palmer gives his employees Mercedes Benz cars and trips to Fiji for Christmas, following a major boost in company profits
BY: m.mcnamara | Sun Nov 21, 2010
Christmas has come early this year for the 800 employees of Queensland Nickel, when their boss Clive Palmer gifted them with $10 million worth of Christmas bonuses.
Thanks to a 30 percent production increase in 2010, Palmer gave 55 of his top performers brand new Mercedes B Class Hatch cars. Another 750 employees were rewarded with trips for two to five-star resorts in Fiji, while 60 employees, who have all started less than six months ago, were gifted with trips to Port Douglas.
Queensland Nickel was losing $10 million a month before Palmer took over in 2009, but production has been boosted by 30 percent, resulting in “hundreds of millions of dollars” for the company. Rising nickel prices have also helped the rebound.
According to the Sydney Morning Herald, Palmer said, “The employees in Queensland Nickel have worked tirelessly since July 2009, to make this business a success and now I want to reward them.”
He added, “There's nothing worse than being a small cog in a big machine where no one really appreciates you,” he said. “We want to make the workforce realise that they are all important to us.”
Palmer credits ingenuity of staff to the positive shift in Queensland Nickel’s fortunes. "When we took over the plant we recognised that we didn't know how to run the plant as well as the workforce," he said. “Our strategy was to get the workforce onside and realise that we are all in this together. We let them go to do what they thought was best.”

Scandal Bruises A Star Manager

2010-11-22T05:05:00.009-08:00

Scandal Bruises A Star Manager
By Steve Eder
1242 words
22 November 2010
The Wall Street Journal
Joseph F. "Chip" Skowron III was in a hurry to try his hand in finance, such a hurry that he quit a prestigious Harvard University orthopedic-surgery residency to begin a career trading health-care stocks.
Mr. Skowron's decision in 2001 disappointed a Harvard adviser who tried to persuade him to finish his medical training, but it paid off handsomely. That same year, Mr. Skowron became a health-care analyst for the hedge fund SAC Capital Advisors LP before quickly moving on to another well-known hedge fund, Millennium Partners LLC. By 2003, he had joined FrontPoint Partners LLC, a hedge fund where he soon would co-manage more than $1 billion in health-care investments.
With the big jobs came a 10,190-square-foot home in Greenwich, Conn., whose value was assessed in 2010 at slightly less than $6 million.
Mr. Skowron traveled in elite political and social circles, as a major donor to John McCain's 2008 presidential campaign, according to campaign finance records, and a member of the exclusive Monticello Motor Club, an automotive resort and track outside of New York City. The club's sign-up fees start at $25,000 and among the members are racer Jeff Gordon and comedian Jerry Seinfeld, the president of the club said.
Along the way, the 41-year-old husband and father amassed a collection of luxury cars that has included a blue Ferrari 458 and a black Porsche Cayenne, according to state records.
On Nov. 2, life in the fast lane came to a halt. The U.S. Attorney's office in Manhattan and the Securities and Exchange Commission unveiled an insider-trading case, charging French doctor Yves M. Benhamou with sharing confidential drug-trial data with a hedge fund.
The court documents said tips Dr. Benhamou provided about a company called Human Genome Sciences Inc. enabled one fund to avoid $30 million in losses in late 2007 and early 2008. FrontPoint Partners, which wasn't named in the complaint, confirmed it was the fund referenced in the documents.
Mr. Skowron has been put on leave pending the investigation's outcome, FrontPoint said previously. The firm declined to comment for this article. Mr. Skowron wasn't named in the complaint and hasn't been charged. He referred questions to his lawyer, James Benjamin, of Akin Gump Strauss Hauer & Feld LLP.
"Dr. Skowron is proud of his work as a physician, investor and philanthropist," Mr. Benjamin said in a statement. "He denies receiving confidential information about the Achieve trial. It is unfortunate that the government has taken the drastic step of arresting and imprisoning Dr. Benhamou, an eminent physician, on the basis of circumstantial allegations that we believe are untrue."
Dr. Benhamou's lawyer declined to comment.
The court documents alleged that Dr. Benhamou was paid by a firm that connected experts with investors to confer with the hedge fund.
According to people familiar with the matter, the charges against Dr. Benhamou don't have a direct connection to a vast insider-trading probe reported by The Wall Street Journal on Saturday, in which authorities are investigating, among other things, whether analysts and consultants for these types of firms have passed along nonpublic information.
Mr. Skowron's suspension was a blow to a man described by one former colleague as among "the brightest of the bright." And over nearly a decade of investing in the health-care world, he earned a reputation as a successful stock-picker and a shrewd, demanding investor.
Like many hedge funds, FrontPoint trades quickly in and out of shares, sometimes using a network of doctors and other health-care advisers who could provide market analysis or color on trends.
The use of outside advisers was one of the methods that caught the eye of Mr. Skowron's supervisors, who cautioned him about trading securities that were discussed with the advisers, people familiar with the matter previously told the Journal.
Last year, Mr. Skowron became less involved in day-to-day oversight of investments in FrontPoint's big health-care funds to focus on marketing the funds to investors, people familiar with the matter said.
Mr. Skowron then went on to manage a smaller fund to invest in health-care companies in emerging-market countries.
During his leave, Mr. Skowron has spent time with his family and close friends, and he plans to continue doing volunteer work, according to a person familiar with him.
Even as Mr. Skowron pursued his career in finance, he kept a hand in medicine, volunteering for AmeriCares, a disaster relief and aid organization that has flown him to places such as Kosovo, Cuba and India.
Last year, Mr. Skowron told the hedge-fund publication AR Magazine that he carried a 2000 photo of himself with a six-year-old boy in a Kosovo operating room.
He told the magazine that local doctors wanted him to amputate one of the boy's legs because he had a tumor below his knee. Mr. Skowron instead chose to excise the tumor, which turned out to be benign.
"I remember crying tears of joy," Mr. Skowron told the publication, adding that he received a second photo six months later of the boy walking without crutches. "He was smiling and happy. That was all the thanks I needed."
Since Mr. Skowron's FrontPoint suspension, he has taken leave as an AmeriCares national director.
AmeriCares Chief Executive Curtis Welling declined to comment.
Mr. Skowron earned a medical degree in 1998 from Yale University after completing his undergraduate work at Vanderbilt University. He also earned a doctorate in cell biology from Yale.
After finishing his medical studies at Yale, Mr. Skowron began Harvard's combined orthopedic residency program, which picks 10 doctors for five years of surgery training, according to Jim Herndon, who directed the program. In 2001, three years into his studies, Mr. Skowron decided to leave.
That year, Mr. Skowron joined SAC Capital, where he spent less than a year before moving on to Millennium in 2002.
"He thought he could use some of medical knowledge and insight into new products and new companies in a way that would be beneficial," said Robert Hurford, an orthopedic surgeon in Jacksonville, Fla., and former residency colleague at Harvard.
In 2003, FrontPoint, which was founded by former executives of Tiger Management and Soros Fund Management, added an investment team to focus on health-care-related stocks.
Mr. Skowron and two former SAC colleagues were hired to run it.
As Mr. Skowron moved into finance, he allowed his Massachusetts medical license to expire. He recently applied for a new license in Connecticut and the application is pending, records show.
Mr. Skowron's decision to leave his residency early disappointed Dr. Herndon, who said he saw Mr. Skowron as a budding academic who had published papers in organic chemistry, cell biology and genetics. One paper was titled, "Cloning and characterization of mouse brush border myosin-I in adult and embryonic intestine."
Dr. Herndon was among those who tried to persuade Mr. Skowron to at least finish his residency.
"I tried to make the case that if he really wanted to go into investments, that was okay," Dr. Herndon said. "But, in case it didn't work out, you wanted to have the full training,"

Ending Banks' `Disco Inferno' Will Involve Errors, Haldane Says

2010-11-22T05:05:00.007-08:00

Ending Banks' `Disco Inferno' Will Involve Errors, Haldane Says
By Jennifer Ryan - Nov 22, 2010 8:00 AM GMT+0800
Bank of England official Andrew Haldane said that officials will need to show humility and may make mistakes as they adopt new regulatory tools to prevent future financial crises.
“The state of macro-prudential policy today has many similarities with the state of monetary policy just after the second world war,” Haldane said in a Nov. 20 speech in New York co-written by David Aikman and Benjamin Nelson. “Data is incomplete, theory patchy, policy experience negligible. Monetary policy then was conducted by trial and error. The same will be true of macro-prudential policy now.”
Haldane argued for the need for so-called macro-prudential tools to prevent crises caused by the collective behavior of banks. Former Citigroup Inc. Chief Executive Officer Charles O. “Chuck” Prince, expressed the dynamic in 2007 by saying his institution would keep lending so long as it had access to liquidity, because “as long as the music is playing, you’ve got to get up and dance.”
“Chuck Prince’s disco inferno causes murder on the dance floor,” said Haldane, who is the Bank of England’s executive director for financial stability. “The case for policy action may have grown over recent decades as competition in banking, and associated externalities, have intensified.”
Authorities need new tools to tackle this collective action problem because existing mechanisms aren’t sufficient, Haldane said.
The authors’ study of previous booms and busts shows they’re not influenced by particular monetary policy regimes, and they’re independent of the business cycle. This suggests monetary policy, which does aim at the business cycle, may not be suited to tame swings in credit that may destabilize the financial system, Haldane said.
New Tools
Micro-prudential tools that target individual banks may also be ineffective, the paper said. A policy that only addresses one firm at a time will leave room for others to boost risk taking.
Instead, officials should consider macro-prudential tools, such as capital and liquidity requirements that operate across a financial system, Haldane said. These measures may also include pay rules that link individual salaries to the long-term performance of firms.
These policies should also take care to address expectations of market participants, the paper said.
Haldane said that officials will need to exercise “simplicity and humility” in their approach to macro- prudential oversight.
“Without absolute clarity about the objectives of any macro-prudential policy framework and the policy rule necessary to deliver these objectives, expectations will not adjust and policy will be impotent,” the paper said. “Any lack of transparency of failure of communication is likely to inhibit seriously the effectiveness of macro-prudential policy.”

GOME chairman admits: we lied

2010-11-22T05:05:00.005-08:00

GOME chairman admits: we lied
22nd November 2010
The story so far
Back in September, we wrote about the battle for control of GOME Electrical Appliances Holding Limited (GOME, 0493). Shareholders voted the way we recommended, and the result was that:
• Wong Kwong Yu (Mr Wong, a.k.a. Huang Guangyu, f.k.a. Wong Chun Kit) was unsuccessful (48:52) in replacing the Chairman Chen Xiao (Mr Chen) and an executive director with his lawyer Mr Zou Xiao Chun (Mr Zou) and his sister Ms Huang Yan Hong (Ms Huang);
• GOME was successful (55:45) in re-electing the directors nominated by Bain; and
• Mr Wong was successful (55:45) in revoking the general mandate to issue shares without first offering them to existing shareholders
Prior to the meeting, Bain converted its bonds into shares and now holds 9.98% of GOME (not 11.06% - it used the wrong denominator in its filing).
With a vote that close, clearly the matter was not over, and there was a peace to be found. Otherwise, Mr Wong could have continued requisitioning SGMs in the hope of getting lucky. Plus, it makes sense for GOME to sit down with Mr Wong's representatives and negotiate an injection of the remaining stores operated by Mr Wong's private business into GOME, at a price which other shareholders, including Bain, can support. That part has not yet happened, but on 10-Nov-2010, GOME announced a truce in which Mr Zou will be appointed as an ED and Ms Huang as a NED. First they have to enlarge the maximum number of directors from 11 to 13, but that should be a formality at the SGM on 17-Dec-2010.
Mr Chen's confession
Now, word reaches us from Beijing of an altogether more serious matter, in the form of a research report by Matthew Forney's Fathom China Ltd, for GaveKal Dragonomics. As we said in our article of 7-Sep-2010:
On 10-Dec-2008... GOME reported that "the business, operations and relationship with its suppliers has remained normal". That's interesting, because the GOME management now claims in the SGM circular that there was a "sudden withdrawal of credit facilities" and an "acceleration of payment demands by suppliers" which "occurred following the arrest and conviction of Mr. Wong"... Similarly, in two letters to shareholders published in newspapers on 26-Aug-2010 and 30-Aug-2010, letters which GOME has failed to file with HKEx, it states that following Mr Wong's arrest, "relations with banks and suppliers were strained almost to breaking."
In the Fathom China profile on GOME, the researcher asked the Chairman, Mr Chen, about these conflicting statements. The report quotes him as saying:
"In fact, the impact was big. I think anybody in that situation would have said the same thing. If we’d said what was really happening, it would have caused a bigger panic… But we weren’t directing those comments to our shareholders. They were directed more to our partners, like brands and suppliers. There was absolutely a problem, but if you go out and say there’s a problem, then everybody would be worried."
There you go. Mr Chen admits that GOME lied when it told investors, in an announcement filed with the regulators, that the business, operations and relationship with its suppliers had remained normal. Mr Chen was CEO and acting Chairman at the time of the announcement, and says that he knew it was a lie. It is absolutely unacceptable for listed companies to lie in public statements, and it is an offence under Section 298 of the Securities and Futures Ordinance, punishable on indictment by a fine of up to $10m and 10 years in jail. A subsequent claim that investors were not supposed to read those statements is no defence. Webb-site calls on the SFC to investigate.
While on the subject of false and misleading statements about a company's condition, isn't it about time we saw some charges in the CITIC Pacific case?

'Risk On,' 'Risk Off' No More --- As Countries' Recoveries Diverge, Currencies May Move Less in Tandem

2010-11-22T05:05:00.003-08:00

'Risk On,' 'Risk Off' No More --- As Countries' Recoveries Diverge, Currencies May Move Less in Tandem
By Bradley Davis
766 words
22 November 2010
The Wall Street Journal
It might be time for some currencies to go their own way.
The risk-on, risk-off paradigm in which currencies with similar yields tend to advance or retreat en masse shows signs of weakening as the global recovery lurches forward at divergent speeds.
The break in typical risk-on, risk-off trading could become more common as China and the economies closely tied to it continue to march ahead, while the U.S. is weighed down by questions over its own growth and the Federal Reserve's dollar-diluting easing program.
Meanwhile, the specter of a default within the euro-zone periphery keeps the euro vulnerable to swings up and down based on headlines coming out of the fiscally troubled region.
"The euro-zone sovereign-debt problem is going to be around for years," said Robert Lynch, currency strategist at HSBC in New York, and the effects of the Fed's asset-purchase program still are yet to be fully played out.
Looking at the euro-dollar pair, then, might not be the best way to take the temperature of general market sentiment, or the willingness to take risk.
"The very different backdrop in Europe and the U.S.," compared with the full-speed-ahead growth in emerging markets, means that the even though the euro might average around $1.35 over the next few months, "you could have significant swings around that depending on when the market's attention is focused on deficiencies in the euro zone, or [when it's on] the difficult backdrop in the United States."
Friday's currency-price action had the euro, which typically moves in concert with the higher-yielding currencies considered riskier, bucking that trend. The common currency posted a modest gain against the dollar, benefiting from Ireland's move closer to accepting a fiscal lifeline.
Late Friday, the euro was at $1.3685 from $1.3628 late Thursday. The dollar was at 83.48 yen from 83.51 yen.
Other higher-yielding currencies, such as the Australian dollar and Brazilian real, kept on marching in near lock-step, weakening against the U.S. dollar as the specter of China putting a brake on growth triggered investor fears.
"The market gets anxious these moves will have an outsize, negative effect on Chinese growth and therefore have negative ripple effects" on growth as a whole, Mr. Lynch said. But, "the reality is that those concerns tend to be short-lived."
By afternoon Friday, the Australian dollar had retraced some of its knee-jerk losses on the China news, trading down about 0.4% on the day against the greenback.
Monetary policy that is loose -- or getting even looser, in the case of the U.S. -- competes with policy that is tightening, such as the change in China's bank-reserve requirement. Tightening that could slow growth can cast a temporary pall over currencies closely tied to the pace of growth, such as the Australian dollar, said Daragh Maher, deputy head of global foreign-exchange strategy at Credit Agricole CIB in London.
But "what we're seeing from China in terms of policy response" to concerns over inflation and too-fast growth "is something that moves it onto a trajectory they feel is more sustainable," Mr. Maher said. "That's got to be a good thing for emerging-market growth."
"It's still surprising how much energy is spent on worrying about whether the U.S. is going to grow 1.8% or 2.5%, when really what we should be worried about is [whether China grows] at 10% or 6%," Mr. Maher said. "They are clearly the engine of growth."
While the euro may decouple from its traditional role as a risk-on currency -- sometimes following its own path based on investor sentiment toward the debt crisis -- currencies most closely tied to global growth are likely to continue to follow the path of China: up.
In other currency moves on Friday, euro was at 114.24 yen from 113.80 yen. The U.K. pound was at $1.5989 from $1.6042. The dollar was at 0.9921 Swiss franc from 0.9967 franc.
The ICE Dollar Index, which tracks the greenback against a trade-weighted basket of currencies, was at 78.402 from 78.635.
For the year-to-date, the dollar is up 4.6% on the euro but down 10.3% on the yen.

Mutual Funds' Tale of 2 Classes

2010-11-22T05:05:00.001-08:00

Mutual Funds' Tale of 2 Classes
By Ian Salisbury
512 words
22 November 2010
The Wall Street Journal
It is generally accepted that the mutual-fund investor has been pulling his money out of the U.S. stock market since, and because of, the 2008 financial crisis. The truth is, it is more complicated than that.
Investors have indeed yanked hundreds of billions of dollars out of so-called retail classes of domestic stock funds, such as those they traditionally buy directly from fund companies or through a financial adviser working on commission.
But at the same time, they have actually poured money into so-called institutional shares. As the label suggests, these are used by pensions, endowments and other institutions -- but they also are frequently used by 401(k) plans and fee-based financial advisers.
"There are a lot of factors at work," says Morningstar analyst Syl Flood, adding that different funds' tendency to allow investors to use different share classes for different purposes makes reading even seemingly clear-cut trends devilishly tricky.
One possible interpretation is that financial advisers aren't holding the line when worried investors declare they have had enough of stock losses. In that scenario, advisers appear to have allowed clients to jump out of the market, a move many investing experts believe should be avoided.
A contrasting take, however, is that the financial crisis has accelerated a decadelong shift in which advisers are abandoning commission-based business models in favor of fee-based ones, and that more often they are also seeking the cheapest fee-oriented share classes.
The trend may even suggest investors are putting greater faith in financial advisers than before, since fee-based accounts can mean advisers have more input into clients' investment decisions.
The dynamics aren't mutually exclusive, and there is outside evidence to support both. Morgan Stanley Smith Barney, for instance, says it is in the process of moving investor dollars into institutional share classes from retail classes in its fee-based advisory accounts, although specific numbers are proprietary. Meanwhile, data from research firm Cerulli Associates show growing popularity over the past several years for types of brokerage accounts that let investors boost cash holdings above typical levels.
Overall, investors have pulled about $90 billion from domestic stock mutual funds since the start of 2009 when the market was near its nadir, according to Morningstar.
But, in fact, the total shows two different stories. Investors have pulled more than $162 billion from funds' retail share classes, including about $129 billion from Class A, B, and C shares, the classic "load" shares that investors traditionally buy when they work with a commission-based financial adviser.
They have also pulled about $55 billion from retail no-load share classes, the kind they buy when they purchase shares in some fee-based brokerage accounts or directly from fund companies.
At the same time, inflows into institutional share classes, which are frequently held in 401(k) plans or by investors in fee-based brokerage accounts overseen by financial advisers, amounted to $72 billion.

Seoul Plays M&A Matchmaker

2010-11-22T05:04:00.003-08:00

Seoul Plays M&A Matchmaker
By Peter Stein
428 words
22 November 2010
The Wall Street Journal
Is the South Korean government playing matchmaker to determine the outcome of one of the biggest deals ever in the country's banking sector?
For years, legal troubles and political controversy plagued efforts by Lone Star Funds, a U.S. private-equity firm, to sell off the 51% stake in Korea Exchange Bank it purchased in 2003. Until last week, Australia & New Zealand Banking Group Ltd. was the acknowledged front-runner in the third, presumably final attempt to close the deal.
Now, Hana Financial Group Inc. of Seoul has surprised the market with a preliminary agreement to take KEB off Lone Star's hands. It is expected to offer at least 10% more than the stake's current market value, or probably somewhere north of $4 billion.
For many in South Korea, the question is: what is really going on? That is because many assume the government is orchestrating the banking sector's revamp, a multiyear process of consolidation that is coming to a denouement with two sales: KEB, and the other for a 57% government-held stake in Woori Finance Holdings Co. still to be put on the auction block.
On the surface, Hana successfully pulled off (as a Dow Jones colleague put it to me) a brilliant head-fake. Until now, the industry assumed Hana would pursue Woori, South Korea's biggest lender by assets and itself a combination of other, smaller lenders rolled up over the years.
By turning its sights instead on KEB, Hana looks guilty of torpedoing the Woori stake sale. That has prompted speculation that Hana wouldn't act without an implicit nod of approval from the government.
"Some people suspect that the government intervened in this in some way," asserted Kim Bo-hun, a representative of KEB's labor union.
"Hana Bank isn't capable of properly managing KEB's corporate financing and overseas business," Mr. Kim said. "If Hana takes over, it will lead to the demise of both banks."
That is likely overstating the case. Acquiring KEB, which is strong in foreign exchange and trade finance, might be the right move for Hana, focused on retail and commercial banking. A Nomura research report last week said such a deal made more sense than merging with Woori, whose business overlaps more with Hana's. Nomura suggested, however, that Hana would probably need to bring in investors to shore up its bid.

Commodities Whipsaw Investors

2010-11-22T05:04:00.001-08:00

Commodities Whipsaw Investors
By Carolyn Cui
966 words
22 November 2010
The Wall Street Journal
If this month has felt like a wild ride for stock investors, it has been positively hair-raising for those in the commodities market.
Price swings for raw materials reached the highest levels in more than a year as investors initially celebrated the prospect of U.S. monetary easing and then panicked at the possibility China would be too severe in its attempts to cool its economy.
Prices of everything from gold to copper and cotton leapt to new highs, only to be slapped down just as quickly. Trading volume in many commodities roared to records, including for silver, cotton and corn.
Since the beginning of October, the Dow Jones-UBS Commodity Index's 30-day realized volatility has doubled to 25%, the highest since September 2009.
The moves were particularly striking because stock-market volatility has been relatively benign, even with triple-digit moves in the past few sessions. The same measure of 30-day volatility in the Standard & Poor's 500-stock index is near six-month lows.
For commodities, the overarching reason for the volatility is the outsize reaction to new signs that China has stepped up its moves to tighten credit and contain inflation. But the huge amount of money flooding into commodities markets appears to be helping exaggerate those moves.
With that money has come a new breed of investors more focused on trading in and out of commodities to profit from price moves rather than the standard producers and consumers relying on the market to manage their risks.
Since August, money managers, such as hedge funds, have raised their bullish bets on oil, copper, soybeans and many other markets. These funds' total net-long positions all peaked in the week ended Nov. 9, before being cut in the past week, according to the Commodity Futures Trading Commission.
All this suggests volatility will at least be around, if not increase, in the short term, even if many people believe commodities overall have a lot further to rally.
"When you have this large [speculative] exposure built up, you do run a risk," said Tim Evans, a commodity analyst at Citi Futures Perspective, a commodity-research arm of Citigroup. Because "you've used up your potential to draw in more new money -- that's the time when you are vulnerable to a reversal."
That may have started.
Since Nov. 9, the Dow Jones-UBS Commodity Index has declined 7%, amid waves of selling triggered by China's moves to tackle inflation.
Of all the commodities that were whipped around, those directly affected by demand from China suffered most. Zinc sank 16%, cotton shed 15%, and crude oil fell 7%.
Investors "are getting more and more nervous as we get close to year end," said Andy Smith, senior commodity strategist at Bache Commodities. They are "not sure whether they should take the money off the table and run for the year or stay in the game."
Commodity consumers around the world are making real-time assessments about whether they should jump in and buy now or wait for better prices.
Many are balancing not just fundamental supply-and-demand data but also macro forces such as monetary policy in China and the U.S.
The debate over how fast China's economy may expand and whether other emerging markets will step down hard on their economies also is driving some of the price swings.
The current volatility is a "fundamental manifestation of uncertainty about the pace of rising demand," said Colin P. Fenton, head of global commodities research and strategy at J.P. Morgan Chase.
Consumer prices in China rose 4.4% in October from a year earlier, a 25-month high, setting off a slew of anti-inflation moves, including an increase in bank reserve requirements and talk of possible price controls.
China has been the main source of demand growth for many commodities.
This year, the country's oil consumption is expected to increase 820,000 barrels a day, or 35% of the world's total oil consumption growth, according to the International Energy Agency.
The country has an even bigger influence in other markets, accounting for 70%, 57% and 46% of this year's global consumption rise for cotton, copper and soybeans, respectively.
"If you think China will grow less as a result of these policies, the next logical conclusion will be commodity demand from that country will also moderate given its importance" in terms of generating demand growth, said Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas.
Some expect China's measures will only temporarily damp price increases for raw materials and won't hurt the nation's real appetite for commodities. Even if China's economy expands at a slightly slower rate, it will be a huge force in the commodities market.
"The steps that they're taking so far will have only a marginal impact," said Dwight Anderson, managing partner at Ospraie Management LLC, a hedge fund specializing in commodities.
Soon, the markets will come to "conclude that the global economic recovery is intact and there will be sustained growth, especially in the emerging markets, for commodity imports," Mr. Fenton said.
Other analysts even see a silver lining to China's cooling moves.
China is taking pre-emptive measures to tackle inflation. In 1994, when inflation ran up to 27.7%, the country's central bank didn't increase interest rates but waited until a year later when the economy lost steam.
"If we are concerned about rising prices, we are probably setting ourselves up for a stronger and healthier way of growth," said Francisco Blanch, head of Global Commodity Research at Bank of AmericaMerrill Lynch.

In China's Orbit. After 500 years of Western predominance, Niall Ferguson argues, the world is tilting back to the East.

2010-11-21T18:44:00.006-08:00

NOVEMBER 18, 2010
In China's Orbit
After 500 years of Western predominance, Niall Ferguson argues, the world is tilting back to the East.
By NIALL FERGUSON
"We are the masters now." I wonder if President Barack Obama saw those words in the thought bubble over the head of his Chinese counterpart, Hu Jintao, at the G20 summit in Seoul last week. If the president was hoping for change he could believe in—in China's currency policy, that is—all he got was small change. Maybe Treasury Secretary Timothy Geithner also heard "We are the masters now" as the Chinese shot down his proposal for capping imbalances in global current accounts. Federal Reserve Chairman Ben Bernanke got the same treatment when he announced a new round of "quantitative easing" to try to jump start the U.S. economy, a move described by one leading Chinese commentator as "uncontrolled" and "irresponsible."

"We are the masters now." That was certainly the refrain that I kept hearing in my head when I was in China two weeks ago. It wasn't so much the glitzy, Olympic-quality party I attended in the Tai Miao Temple, next to the Forbidden City, that made this impression. The displays of bell ringing, martial arts and all-girl drumming are the kind of thing that Western visitors expect. It was the understated but unmistakable self-confidence of the economists I met that told me something had changed in relations between China and the West.
One of them, Cheng Siwei, explained over dinner China's plan to become a leader in green energy technology. Between swigs of rice wine, Xia Bin, an adviser to the People's Bank of China, outlined the need for a thorough privatization program, "including even the Great Hall of the People." And in faultless English, David Li of Tsinghua University confessed his dissatisfaction with the quality of Chinese Ph.D.s.
You could not ask for smarter people with whom to discuss the two most interesting questions in economic history today: Why did the West come to dominate not only China but the rest of the world in the five centuries after the Forbidden City was built? And is that period of Western dominance now finally coming to an end?
In a brilliant paper that has yet to be published in English, Mr. Li and his co-author Guan Hanhui demolish the fashionable view that China was economically neck-and-neck with the West until as recently as 1800. Per capita gross domestic product, they show, stagnated in the Ming era (1402-1626) and was significantly lower than that of pre-industrial Britain. China still had an overwhelmingly agricultural economy, with low-productivity cultivation accounting for 90% of GDP. And for a century after 1520, the Chinese national savings rate was actually negative. There was no capital accumulation in late Ming China; rather the opposite.
The story of what Kenneth Pomeranz, a history professor at the University of California, Irvine, has called "the Great Divergence" between East and West began much earlier. Even the late economist Angus Maddison may have been over-optimistic when he argued that in 1700 the average inhabitant of China was probably slightly better off than the average inhabitant of the future United States. Mr. Maddison was closer to the mark when he estimated that, in 1600, per capita GDP in Britain was already 60% higher than in China.
For the next several hundred years, China continued to stagnate and, in the 20th century, even to retreat, while the English-speaking world, closely followed by northwestern Europe, surged ahead. By 1820 U.S. per capita GDP was twice that of China; by 1870 it was nearly five times greater; by 1913 the ratio was nearly 10 to one.
Read More
• Power Shifts: Megacities Then and Now
Despite the painful interruption of the Great Depression, the U.S. suffered nothing so devastating as China's wretched mid-20th century ordeal of revolution, civil war, Japanese invasion, more revolution, man-made famine and yet more ("cultural") revolution. In 1968 the average American was 33 times richer than the average Chinese, using figures calculated on the basis of purchasing power parity (allowing for the different costs of living in the two countries). Calculated in current dollar terms, the differential at its peak was more like 70 to 1.
This was the ultimate global imbalance, the result of centuries of economic and political divergence. How did it come about? And is it over?
As I've researched my forthcoming book over the past two years, I've concluded that the West developed six "killer applications" that "the Rest" lacked. These were:
• Competition: Europe was politically fragmented, and within each monarchy or republic there were multiple competing corporate entities.
• The Scientific Revolution: All the major 17th-century breakthroughs in mathematics, astronomy, physics, chemistry and biology happened in Western Europe.
• The rule of law and representative government: This optimal system of social and political order emerged in the English-speaking world, based on property rights and the representation of property owners in elected legislatures.
• Modern medicine: All the major 19th- and 20th-century advances in health care, including the control of tropical diseases, were made by Western Europeans and North Americans.
• The consumer society: The Industrial Revolution took place where there was both a supply of productivity-enhancing technologies and a demand for more, better and cheaper goods, beginning with cotton garments.
• The work ethic: Westerners were the first people in the world to combine more extensive and intensive labor with higher savings rates, permitting sustained capital accumulation.
Those six killer apps were the key to Western ascendancy. The story of our time, which can be traced back to the reign of the Meiji Emperor in Japan (1867-1912), is that the Rest finally began to download them. It was far from a smooth process. The Japanese had no idea which elements of Western culture were the crucial ones, so they ended up copying everything, from Western clothes and hairstyles to the practice of colonizing foreign peoples. Unfortunately, they took up empire-building at precisely the moment when the costs of imperialism began to exceed the benefits. Other Asian powers—notably India—wasted decades on the erroneous premise that the socialist institutions pioneered in the Soviet Union were superior to the market-based institutions of the West.

Beginning in the 1950s, however, a growing band of East Asian countries followed Japan in mimicking the West's industrial model, beginning with textiles and steel and moving up the value chain from there. The downloading of Western applications was now more selective. Competition and representative government did not figure much in Asian development, which instead focused on science, medicine, the consumer society and the work ethic (less Protestant than Max Weber had thought). Today Singapore is ranked third in the World Economic Forum's assessment of competitiveness. Hong Kong is 11th, followed by Taiwan (13th), South Korea (22nd) and China (27th). This is roughly the order, historically, in which these countries Westernized their economies.
Today per capita GDP in China is 19% that of the U.S., compared with 4% when economic reform began just over 30 years ago. Hong Kong, Japan and Singapore were already there as early as 1950; Taiwan got there in 1970, and South Korea got there in 1975. According to the Conference Board, Singapore's per capita GDP is now 21% higher than that of the U.S., Hong Kong's is about the same, Japan's and Taiwan's are about 25% lower, and South Korea's 36% lower. Only a foolhardy man would bet against China's following the same trajectory in the decades ahead.
China's has been the biggest and fastest of all the industrialization revolutions. In the space of 26 years, China's GDP grew by a factor of 10. It took the U.K. 70 years after 1830 to grow by a factor of four. According to the International Monetary Fund, China's share of global GDP (measured in current prices) will pass the 10% mark in 2013. Goldman Sachs continues to forecast that China will overtake the U.S. in terms of GDP in 2027, just as it recently overtook Japan.
But in some ways the Asian century has already arrived. China is on the brink of surpassing the American share of global manufacturing, having overtaken Germany and Japan in the past 10 years. China's biggest city, Shanghai, already sits atop the ranks of the world's megacities, with Mumbai right behind; no American city comes close.
Nothing is more certain to accelerate the shift of global economic power from West to East than the looming U.S. fiscal crisis. With a debt-to-revenue ratio of 312%, Greece is in dire straits already. But the debt-to-revenue ratio of the U.S. is 358%, according to Morgan Stanley. The Congressional Budget Office estimates that interest payments on the federal debt will rise from 9% of federal tax revenues to 20% in 2020, 36% in 2030 and 58% in 2040. Only America's "exorbitant privilege" of being able to print the world's premier reserve currency gives it breathing space. Yet this very privilege is under mounting attack from the Chinese government.
For many commentators, the resumption of quantitative easing by the Federal Reserve has appeared to spark a currency war between the U.S. and China. If the "Chinese don't take actions" to end the manipulation of their currency, President Obama declared in New York in September, "we have other means of protecting U.S. interests." The Chinese premier Wen Jiabao was quick to respond: "Do not work to pressure us on the renminbi rate…. Many of our exporting companies would have to close down, migrant workers would have to return to their villages. If China saw social and economic turbulence, then it would be a disaster for the world."
Such exchanges are a form of pi ying xi, China's traditional shadow puppet theater. In reality, today's currency war is between "Chimerica"—as I've called the united economies of China and America—and the rest of the world. If the U.S. prints money while China effectively still pegs its currency to the dollar, both parties benefit. The losers are countries like Indonesia and Brazil, whose real trade-weighted exchange rates have appreciated since January 2008 by 18% and 17%, respectively.
But who now gains more from this partnership? With China's output currently 20% above its pre-crisis level and that of the U.S. still 2% below, the answer seems clear. American policy-makers may utter the mantra that "they need us as much as we need them" and refer ominously to Lawrence Summers's famous phrase about "mutually assured financial destruction." But the Chinese already have a plan to reduce their dependence on dollar reserve accumulation and subsidized exports. It is a strategy not so much for world domination on the model of Western imperialism as for reestablishing China as the Middle Kingdom—the dominant tributary state in the Asia-Pacific region.
If I had to summarize China's new grand strategy, I would do it, Chinese-style, as the Four "Mores": Consume more, import more, invest abroad more and innovate more. In each case, a change of economic strategy pays a handsome geopolitical dividend.
By consuming more, China can reduce its trade surplus and, in the process, endear itself to its major trading partners, especially the other emerging markets. China recently overtook the U.S. as the world's biggest automobile market (14 million sales a year, compared to 11 million), and its demand is projected to rise tenfold in the years ahead.
By 2035, according to the International Energy Agency, China will be using a fifth of all global energy, a 75% increase since 2008. It accounted for about 46% of global coal consumption in 2009, the World Coal Institute estimates, and consumes a similar share of the world's aluminum, copper, nickel and zinc production. Last year China used twice as much crude steel as the European Union, United States and Japan combined.
Such figures translate into major gains for the exporters of these and other commodities. China is already Australia's biggest export market, accounting for 22% of Australian exports in 2009. It buys 12% of Brazil's exports and 10% of South Africa's. It has also become a big purchaser of high-end manufactured goods from Japan and Germany. Once China was mainly an exporter of low-price manufactures. Now that it accounts for fully a fifth of global growth, it has become the most dynamic new market for other people's stuff. And that wins friends.
The Chinese are justifiably nervous, however, about the vagaries of world commodity prices. How could they feel otherwise after the huge price swings of the past few years? So it makes sense for them to invest abroad more. In January 2010 alone, the Chinese made direct investments worth a total of $2.4 billion in 420 overseas enterprises in 75 countries and regions. The overwhelming majority of these were in Asia and Africa. The biggest sectors were mining, transportation and petrochemicals. Across Africa, the Chinese mode of operation is now well established. Typical deals exchange highway and other infrastructure investments for long leases of mines or agricultural land, with no questions asked about human rights abuses or political corruption.
Growing overseas investment in natural resources not only makes sense as a diversification strategy to reduce China's exposure to the risk of dollar depreciation. It also allows China to increase its financial power, not least through its vast and influential sovereign wealth fund. And it justifies ambitious plans for naval expansion. In the words of Rear Admiral Zhang Huachen, deputy commander of the East Sea Fleet: "With the expansion of the country's economic interests, the navy wants to better protect the country's transportation routes and the safety of our major sea-lanes." The South China Sea has already been declared a "core national interest," and deep-water ports are projected in Pakistan, Burma and Sri Lanka.
Finally, and contrary to the view that China is condemned to remain an assembly line for products "designed in California," the country is innovating more, aiming to become, for example, the world's leading manufacturer of wind turbines and photovoltaic panels. In 2007 China overtook Germany in terms of new patent applications. This is part of a wider story of Eastern ascendancy. In 2008, for the first time, the number of patent applications from China, India, Japan and South Korea exceeded those from the West.
The dilemma posed to the "departing" power by the "arriving" power is always agonizing. The cost of resisting Germany's rise was heavy indeed for Britain; it was much easier to slide quietly into the role of junior partner to the U.S. Should America seek to contain China or to accommodate it? Opinion polls suggest that ordinary Americans are no more certain how to respond than the president. In a recent survey by the Pew Research Center, 49% of respondents said they did not expect China to "overtake the U.S. as the world's main superpower," but 46% took the opposite view.
Coming to terms with a new global order was hard enough after the collapse of the Soviet Union, which went to the heads of many Western commentators. (Who now remembers talk of American hyperpuissance without a wince?) But the Cold War lasted little more than four decades, and the Soviet Union never came close to overtaking the U.S. economically. What we are living through now is the end of 500 years of Western predominance. This time the Eastern challenger is for real, both economically and geopolitically.
The gentlemen in Beijing may not be the masters just yet. But one thing is certain: They are no longer the apprentices.
—Niall Ferguson is a professor of history at Harvard University and a professor of business administration at the Harvard Business School. His next book, "Civilization: The West and the Rest," will be published in March.

'When you wake, you will excel in school'

2010-11-21T18:44:00.004-08:00

'When you wake, you will excel in school'
Liew Hanqing
878 words
22 November 2010
Straits Times
More kids undergoing hypnotherapy to help boost grades, confidence
WHILE many students flock to tuition centres to give their grades a boost, some have found a different after-school destination: the hypnotherapist's office.
Hypnotherapy sessions, where subjects are brought into an almost trance- like state by a qualified therapist, are growing in popularity as a means to help students cope better with their schoolwork, the practitioners say.
It is unclear how many active certified hypnotherapists there are in Singapore, but an online register lists 24 names.
An online search throws up dozens more sites run by Singapore-based hypnotherapists.
The Straits Times spoke to 10 of them, who said they each see between five and 20 clients a week, about a fifth of whom are students. Some are as young as five, while a good number are in their teens.
While hypnotherapy is still a niche market, they say they have started to see more students over the past five years or so.
Hypnotherapist Alden Tan, who used to serve mainly adult clients, said about 15 per cent of his clients now are students. He thinks this is because people now have a greater awareness of hypnotherapy.
'There have been more media reports about hypnotherapy of late, and people may have seen it featured on TV,' he said.
Common issues these students face, he added, include difficulty concentrating in class, addiction to video games and a lack of confidence in specific subjects.
Hypnotherapist Anita Kashyap, who has treated children with exam anxiety and other school-related issues, said hypnotherapy works by motivating students through their subconscious mind.
She said: 'A child could be doing badly in maths because people around are reinforcing the belief that he/she is poor in the subject. Hypnotherapy can help them believe they can excel.'
Ms Kashyap added that hypnotherapy techniques for children include a mixture of storytelling and visualisation. In some cases, the hypnotherapist tells a story in which the client is the protagonist, she said.
'Such stories help the child visualise being able to do something specific,' she said.
Mr Tan added that relaxation techniques are often used on students to get them into a hypnotic state.
He said: 'They are usually lying on a couch with soothing music playing in the background. We then give them a series of instructions to put them at ease.'
Some children go into a hypnotic state 'in minutes' while others could stay fidgety for up to half an hour, Mr Tan said.
He stressed, however, that a big part of hypnotherapy involves establishing rapport with the client. 'It is very important to first gain their trust,' he said.
Academic issues aside, some parents seek hypnotherapy for their children to help them perform better in their co-curricular activities, hypnotherapist Boon Low told The Straits Times.
'If there is an important competition coming up, it's not uncommon for parents to bring their children for hypnotherapy,' he said.
While in a hypnotic state, students are far more receptive to positive suggestions that can help enhance their performance, he added. 'This can help elevate their self-confidence.'
The positive results of hypnotherapy have made believers out of parents such as Madam Anna Wee, 45, the chief executive officer of an SME.
A year ago, she signed her 15-year-old daughter up for hypnotherapy sessions to treat her insomnia, which had been affecting her focus at school.
The sessions were so effective that Madam Wee signed her daughter up for another session before her exams this year.
She said: 'My daughter is a typical student who doesn't spend enough time on her studies; I felt hypnotherapy would help her get more emotionally prepared for the exams.'
Another parent, Mr Ian Tay, 43, added that hypnotherapy sessions have helped his nine-year-old son overcome a fear of mathematics.
He said: 'After a few sessions, my son became more positive about the subject; he was more confident and his maths results gradually improved.'
But it is not cheap - hypnotherapy sessions, which usually last an hour or two, can cost anything from $150 to $200 each time.
Some clients' issues can be resolved in just one session, while others require several, depending on their condition.
Consultant psychiatrist Brian Yeo said that while he believes hypnotherapy to be generally harmless, parents must exercise caution when selecting a hypnotherapist for their children.
He said: 'It is important to ensure that the hypnotherapist is qualified and ethical, because hypnotherapists have the power to elicit information that the subject may not ordinarily want to reveal.'
He added, however, that it is possible for those who have undergone hypnotherapy to feel more empowered, and more able to cope with various kinds of stress.
'But those considering hypnotherapy should remember that anything that has the power to do good also has the power to do the not-so-good,' he said, adding that simple counselling could be a good alternative.
hanqing@sph.com.sg
WORD OF CAUTION
'It is important to ensure that the hypnotherapist is qualified and ethical, because hypnotherapists have the power to elicit information that the subject may not ordinarily want to reveal.'
Consultant psychiatrist Brian Yeo

Key lesson from US mortgage crisis: It pays to look beyond dividends for preference shares

2010-11-21T18:44:00.002-08:00

Preferable to exercise caution
Goh Eng Yeow, Senior Correspondent
1124 words
22 November 2010
Straits Times
Key lesson from US mortgage crisis: It pays to look beyond dividends for preference shares
TWO years ago, small investors felt hard done by when DBS Bank left them out in the cold in issuing a batch of preference shares, a bond-like investment.
So when it unveiled a similar issuance two weeks ago, this time catering to modest investment budgets, these small investors lost no time in jumping in.
The big attraction is the bank's proven track record which offers comfort to them that their hard-earned cash is going into a stable investment.
Another major draw is the attractive annual dividend payout of 4.7 per cent which beats hands down the meagre 0.125 per cent interest offered on bank savings accounts.
Until recently, preference shares were usually offered only to sophisticated investors such as insurance firms and wealthy individuals, as they are sold in tranches of $250,000 each. This puts them out of the reach of most retail investors.
But when DBS raised $1.7 billion from a preference share issue sold to institutional investors last month, it said that it might make a retail tranche available.
It was true to its word and, to make trading easier for retail investors, the lot size for the preference shares was reduced to just $10,000.
Considering the earlier misgivings that the bank had over the suitability of the product for small investors, it must have been rather surprised at the overwhelming response it received from them.
DBS had initially unveiled a $500 million retail offering. But it had to boost the offer to $800 million, after drawing more than $1.4 billion in subscriptions through ATMs and the bank's Internet banking platform, and another $400 million from institutional investors and DBS staff.
This more than made up for any disappointment which mom-and-pop investors might have felt two years ago when they were excluded from the bountiful feast which DBS had served up to sophisticated investors with an earlier $1.5 billion preference share offering.
Despite the big vote of confidence, however, some discerning investors are asking how the bank can pay out an attractive 4.7 per cent dividend on its preference shares when it is getting a far lower 1.8 per cent net interest margin on its loans.
Answering the question will require an understanding of how a bank manages its finances and some of the parameters used by analysts to measure its performance.
As everyone knows, a bank's business is to collect deposits and lend them at a higher interest rate to anyone needing funds for a whole host of activities from buying a home to operating a business.
But to ensure that depositors get their money back if a loan turns sour, regulators give banks a set of guidelines on the amount of capital that they are required to maintain as a buffer to back up their lending activities. In banking, this is known as the capital adequacy ratio.
To give an example, let's say a bank enjoys a net interest margin of 1 per cent. If it lends out $1 billion in loans, it will make a net profit of $10 million.
Put simply, if it is required to keep a capital adequacy ratio of 10 per cent, this means it will be required to set aside $100 million as capital to indemnify depositors in case some of the loans turn bad.
It can do this by either raising the entire sum from shareholders, or though a mixture of fund-raising from shareholders and selling preference shares.
But how it gets the capital will affect an important parameter tracking its performance - its return on equity.
With a net profit of $10 million, a bank will have a return on equity of 10 per cent if it raises the entire $100 million from shareholders.
But if it sells $50 million worth of preference shares and offers investors a 5 per cent payout, its profit will fall to $7.5 million, while its return on equity will rise to a whopping 15 per cent.
This explains why, even in a low interest rate environment, a bank can offer an attractive payout for preference shares. For some banks, it is also a more enticing option to raise capital, as it can give a boost to its return on equity.
For holders of preference shares, the high dividend payout helps to partly compensate them for missing out on any appreciation which a bank's shareholder will get on his investment, if the bank's share price rises.
But the downside is that as preference shares are regarded as a bank's core capital, he may not get any payment if the bank posts a loss and is unable to make any dividend payout.
For local lenders, the chances of such a mishap are remote. OCBC Bank stated in its preference shares document to retail investors two years ago that it had paid dividend on its shares every year since the end of World War II.
Still, it is important not to take such apparent rock-solid stability for granted, given the lessons of the global financial crisis two years ago.
Not many Singaporeans would have heard of Fannie Mae and Freddie Mac, two giant real estate lenders in the United States which billionaire Warren Buffett recently called the twin pillars of the country's mortgage system.
As both of them were backed by the US government, it was difficult to believe they could fail. But fail they did - in September 2008 - when they were forced into 'conservatorship' after losing billions of dollars on the rotting US mortgage market.
After they went belly up, the unthinkable happened: the billions of dollars in preference shares issued by them turned into worthless paper overnight.
It is a grim reminder of the risks facing holders of preference shares, no matter how remote the chances that these risks might become reality.
So far, the only institutions to issue preference shares in Singapore in the past two years are our local lenders which are well known for their prudent and conservative business practices.
But there is a likelihood that some companies may issue preference shares as an alternative means of raising capital. This being the case, it may be important for investors to look beyond the dividend on offer and study their business carefully, before jumping in

Many high-end condominium units are sitting unsold even after completion, as the luxury home market remains quieter than in previous years.

2010-11-21T18:44:00.000-08:00

not yet sold out
Esther Teo
701 words
22 November 2010
Straits Times
Still no buyers for 1,000 posh homes
MANY high-end condominium units are sitting unsold even after completion, as the luxury home market remains quieter than in previous years.
Twelve developments have been completed this year, each with more than 10 units still unsold as of last month, according to new data released by property consultancy CB Richard Ellis (CBRE).
Of these, 10 are in prime areas, with a total of 384 unsold units, CBRE said.
For instance, Wing Tai's Belle Vue Residences in Oxley Walk, which obtained its temporary occupation permit (TOP) in the second quarter, has not found buyers for 61 of its 176 units as of last month.
Paterson Suites, which had its TOP in the third quarter, has 79 units out of 102 yet to be taken up.
Another eight projects are expected to receive TOP soon, each with at least 10 unsold units, added CBRE.
Seven of these are also in prime locations: Districts 9, 10 and 11 - which cover Orchard, Holland, Newton and Bukit Timah - and the Sentosa and Tanjong Pagar areas.
In all, buyers are still needed for more than 1,000 posh homes in projects already completed or expected to be ready by early next year.
Most of these projects were first launched in the property boom of 2007, including Riveria Gardens in River Valley and Marina Collection in Sentosa Cove.
Not all these completed units are available for sale, however.
Experts say that some developers have yet to launch their remaining units as prices are still below their previous peak.
Developers are biding their time, waiting for the luxury market to catch up with or even surpass the historical highs, they say.
CBRE Research executive director Li Hiaw Ho said that developers either slowed down or stopped sales completely when the financial crisis hit Singapore.
When the residential market recovered last year, developers were hopeful that high-end prices would recover and that foreign interest would return.
However, while high-end prices have seen a recovery this year, they are still below the previous peak.
Foreigners are also less active compared to 2007 because the United States and European economies are still weak, he added.
Colliers International's director of research and advisory Tay Huey Ying said that luxury home prices are now just 5.4 per cent shy of their peak in 2007. While volumes are still thin, prices are gradually creeping up, she added.
'Some developers might feel that it is not the right time to launch as demand is still not strong enough to push luxury home prices past their previous peak.'
In boom years, some developers might have bought residential land at 'aggressive prices' and are now waiting for home prices to catch up, Ms Tay added.
Cushman and Wakefield's managing director Donald Han said some of these projects might have seen a significant number of units sold at relatively high prices pre-crisis when they were first launched.
Developers thus had an obligation to these initial buyers not to offload the remaining units at a lower price.
Seeming over-eager to sell could also cause the market to lose confidence in the developer's holding power, he said.
'Once a development has sold about 50 to 60 per cent, it would most likely have broken even and there would be less pressure to dump units,' he said.
'Developers can also choose to keep units to rent out temporarily,' Mr Han added.
Experts added that unlike 99-year leasehold mass market condos that might depreciate after completion, many of the high-end projects had freehold tenure.
Some luxury home buyers are also keen to 'feel and touch' their homes and the quality of the finishes before making such pricey purchases.
This might give completed projects at least some kind of an edge over new launches, they said.
Ms Wendy Tang, Knight Frank director of residential services, added that with prime residential sites hard to come by, developers might also see no urgent need to dispose of high-end projects quickly as it might be difficult to replenish land banks with such exclusive sites.

... tète-à-tète in the tent: strategies devise in a tent get victory 1000 li away ... 运筹帷幄之中 决胜千里之外