Friday, November 30, 2012

Maximize Shareholder Wealth

The goal of a corporation should be to maximize shareholder wealth. Why? Since shareholders have a residual claim, if they are happy, everyone in line before them such as creditors and employees have been financially rewarded. In a new book, Lynn Stout argues that increasing shareholder value is not the goal of a corporation. In fact, her argument extends to the notion that shareholders do not own a corporation, a strange argument from a law professor. She states "No human being can own a corporation-they are independent legal entities," which makes little sense since ownership of stock confers a legal ownership of a corporation. Our response is best summed up by Charles Elson: “What [Professor Stout] is saying is nothing new and is actually quite silly.”

Another argument we disagree with is that corporations sacrifice long-term goals for short-term profit. While we don't disagree that this happens, sacrificing long-term shareholder wealth maximization does not fit with the goal of maximizing shareholder wealth. Choosing short-term results over long-term results is an agency problem that needs correction if it occurs, but not at the expense of shareholder wealth maximization.

Finally, we would like to address the statement made by Professor Stout that companies "...drain out cash through stock repurchases and dividends - all for the purpose of pumping up the share price temporarily." The relevance of dividends and stock repurchases is discussed in the text, but if the company has no positive NPV investments, excess cash should be paid to shareholders. Additionally, given that the S&P 500 companies (excluding financials) have a near record level of cash, we would argue that if anything, companies have not paid out enough to shareholders in the form of dividends and share repurchases.

Tuesday, November 27, 2012

What Are The Odds?

With the Powerball jackpot reaching $500 million, lottery ticket sales are very brisk. So what are the odds of winning? 1 in 175 million. You would have a better chance of randomly predicting the name of a female in the United States (1 in 157 million). While the jackpot is announced at $500 million, it is actually paid over 30 payments with the first payment being made today. If the winner selects the cash option, they will receive "only" $327 million. So, with equal annual payments, what interest rate is being offered? Check for yourself that it is about 3.24 percent. Of course, Powerball payments actually increase at 4 percent per year to keep pace with inflation. Given this growth rate in the payments, what is the nominal interest rate offered on the payments now? Check for yourself that the rate is about 9.82 percent.

Tuesday, November 20, 2012

HP Write-Off

HP announced an $8.8 billion write-off associated with the company's purchase of Autonomy, a British software company HP purchased for $11 billion last year. The reason for the write-off is that HP discovered Autonomy misrepresented not only its past performance but its prospects going forward. The fraud was evidently well hidden as the purchase was audited by Deloitte, which itself was audited by KPMG. HP has filed a complaint with the SEC as well as British securities regulators, with the hope that criminal charges will be filed. Civil charges against the officers of Autonomy also appear to be forthcoming.

Monday, November 19, 2012

A Christmas Present From Walmart

Walmart announced that it was moving its next dividend payment to December so that investors could enjoy the lower dividend tax rate of 15 percent, rather than face a tax rate of up to 43.4 percent (including the healthcare dividend tax) beginning in January. Walmart's total dividend payment is $1.34 billion, so investors will likely save millions of dollars in taxes, a nice package under the Christmas tree.

Friday, November 16, 2012

Twinkies Disappear

In a sad day for junk food lovers everywhere, Twinkies maker Hostess Brands has asked the bankruptcy court judge for permission to liquidate its assets. The company blamed a strike by the Bakery, Confectionary, Tobacco Workers and Grain Millers International Union (BCTGM). The company will continue to ship products until inventory runs out. Of course, Twinkies will likely make a comeback. It is likely that another bakery or private equity firm will purchase the Twinkie name in bankruptcy and bring back the familiar yellow treat.

Thursday, November 15, 2012

Stock Certificates Damaged

The flooding in New York from Superstorm Sandy hit the vault of the Depository Trust & Clearing Corporation (DTCC). While the DTCC is relatively unknown, it holds $35.6 trillion in securities and settled nearly $1.66 quadrillion in trades during 2010. The DTCC is the primary clearinghouse for securities in the U.S. The job of the DTCC is to keep track of the trades made in stocks, bonds, and other securities and track who owns those securities after each trade. Many financial instruments, such as Treasury bonds, are book entry only. This means that ownership of a particular Treasury bond is electronically recorded, often at the DTCC. Physical stock and bond certificates have been rapidly declining in favor of the book entry system, although as the damage from this flooding shows, there are still a significant number of physical financial certificates.

Monday, November 12, 2012

Dividends Jump Before January?

With the impending dividend tax increase from 15 percent to 43 percent, at least some companies are paying special dividends before January 1, 2013 to allow shareholders to be taxed at the lower rate. For example, The Buckle announced a special dividend of $4.50, more than 10 percent of its stock price and Commerce Bancshares announced a $1.50 special dividend.

Eugene Fama Interview

Professor Eugene Fama from the University of Chicago is regarded as a financial leader, with some of the most cited research in Finance. In a recent interview, Fama discusses a wide range of financial topics, including the ability of portfolio managers to beat the stock market, the equity risk premium, CAPM, and a discussion of underfunded pensions, among other topics. As for the equity risk premium, Fama argues that because of an increase in PE ratios, the equity risk premium going forward is about 4 percent, significantly lower than the approximately 7.5 percent historic risk premium since 1926. In the discussion of underfunded pension liabilities, Fama argues that "The sponsor should be discounting the liabilities at the expected return implied by the risk of the liabilities, not the expected return of the assets." To show the link between different areas of Finance, consider that while the interview discusses capital markets, this statement is a fundamental tenant of capital budgeting, that is, the cost of capital depends on the use of funds, not the source of funds.  

Saturday, November 10, 2012

Interest Rate Swaps Go Standardized

Historically, interest rate swaps have been over-the-counter and had counterparty default risk. The Dodd-Frank Wall Street Reform and Protection Act requires that most derivatives go through a clearinghouse. In December, the CME (formerly the Chicago Mercantile Exchange) is debuting interest rate swap futures. Initially, the contracts will have 2, 5, 10, and 30 year maturities. At maturity, the contract converts into an interest rate swap. But, the purchaser or seller can reverse the position prior to maturity, which will allow for interest rate change hedging prior to maturity as well. While trading these futures will require participants to post margin. The advantages of these swap futures are a highly transparent market, the elimination of counterparty risk, and the access to liquidity to exit the contract at virtually any time.

Currency Risks

If your company has operations, sales, or production in different countries, hedging is a necessity. With the recent rise of the U.S. dollar, some companies have become complacent about hedging. While U.S. companies can benefit from a rise in the dollar, it is difficult to predict future exchange rate movements. Hedging should be an ongoing process, even if the company feels exchange rate moves might be favorable. As the article notes, the business of most companies is not to take currency risk, but rather buy or sell a product. Unfortunately, some CFOs try to use currency markets to generate additional revenue. And while this may sound appealing, as with any investment, it is very hard to beat the currency market.

Tuesday, November 6, 2012

Which EPS?

One problem with using financial ratios is that the calculation of these numbers is done differently by different people. You would think that EPS would be calculated the same all over, but in fact there are two common EPS numbers, the basic EPS and the diluted EPS. The basic EPS is calculated as we have done in the textbook, that is, net income divided by shares outstanding. The diluted EPS is the net income divided by the total potential shares outstanding. Many companies use stock options to motivate employees, especially upper management. If there are a large number of employee stock options issued by the company and not yet exercised by employees the number of shares outstanding could grow rather quickly if the options are exercised. The diluted EPS uses the number of shares as if all employee stock options were exercised. This gives a lower EPS, which is a more conservative estimate of the company's EPS.

Luck Or Skill?

The efficient markets hypothesis may be the most bitterly debated topics in Finance. Portfolio managers believe that the market is not semistrong form efficient, otherwise their contribution is negligible. However, many proponents argue that beating the market is nearly impossible. Michael Mauboussin, the chief investment strategist at Legg Mason Capital Management, argues that on the skill/luck continuum, stock picking requires just abount as much luck as roulette or slot machines. In part, he argues that the number of intelligent people in the investment industry means that the distinction between the best and the worst narrows. And, as people become more skillful, luck becomes a more important component of performance.

Friday, November 2, 2012

A Prospectus Is Meant To Be Read

One cause that some have given for the recent financial problems is that the underwriters and sellers of the securities misled investors. With the discussion of various financial regulations, and passage of others, the government agrees. While we have no stance on whether investors were misled in verbal communications, it appears that these claims may be overstated. For example, in the famous Abacus CDO prospectus, Goldman Sachs stated they "..shall not have a fiduciary relationship with any investor," and that the firm "may have conflicts of interest." Even more directly in another deal, Citigroup and Credit Suisse stated that the firms may have conflicts, but also that the firms’ “actions may be inconsistent with or adverse to the interests of the Noteholders.” As an investor, you must remember that just because the SEC approves a prospectus does not mean that the SEC feels the investment is a good idea, but rather that all relevant information is disclosed. It is up to the individual to research the investment and decide for themselves.

Swaps Collateral

One of the major risks with swap contracts is counterparty risk, that is, default by the party on the other side of the contract. Even though the loss from an interest swap contract in the event of default is only the difference between the two payments, this can still result in a negative impact on the remaining party. The Dodd-Frank Act requires that the CME Group and other swap clearinghouses must now require collateral from both swap parties similar to the collateral provided in futures trading. The intent of the collateral is to reduce the risk of default and limit the impact in the event of a default. In order to allow the industry more time to resolve technology problems, the implementation of the collateral rule has been delayed until January 14, 2013.

Thursday, November 1, 2012

Apple Cannabilization

One key consideration in calculating the cash flows from a new project is side effects, including cannibalization, or erosion, of existing product sales. When Apple announced its new iPad Mini, one of the key considerations for Apple should have been the potential cannibalization of sales of the regular iPad. However, as the article points out, not all of the cannibalization is relevant. If Apple hadn't cannibalized some of its iPad sales, Amazon or Google would have taken these sales from Apple with their smaller tablets.

Using Time Value Of Money

Recently, GM decided to remove future pension liabilities from its balance sheet. To accomplish this, GM gave its salaried employees a choice: keep the pension payments as promised, although the pension payments would be made by Prudential, not GM, or take a lump sum payment now. So what information is necessary to make a decision such as this? The main components are the interest rate offered by the pension payments, the rate of return an employee could earn on the lump sum, and the difference in the risk between these two options, including the likelihood of default on the pension payments. While we doubt many GM employees made such a comprehensive analysis, 30 percent of the salaried employees took the lump sum option.