Sunday, July 19, 2009

Behavioral Corporate Finance 1: The Objective in Decision Making:

Every business needs a central objective that drives decision making. In traditional corporate finance, that objective is to maximize the value of the firm. For publicly traded firms, this objective often is modified to maximizing stock prices. In effect, any decision that increases stock prices is viewed as a good decision and any decision that reduces stock prices is a bad one. Implicitly, we are assuming that investors are (for the most part) rational and that markets are efficient, that stock prices reflect the long term value of equity and that bond holders are fully protected from expropriation.

A central theme of behavioral finance is that markets are not efficient and investors often behave in irrational ways. Consequently, stock prices can not only deviate from long term equity value but managers can exploit investor irrationalities for their own purposes. Asking managers to maximize stock prices in this environment can lead to decisions that hurt the long term value of the firm and in some cases put the firm's survival at risk. Behavioral finance theorists therefore argue that decision making should not be tied to stock prices, though they do not seem to have reached a consensus on what should drive business choices instead.

Here is where I come down in this debate. I agree with behavioral finance theorists that managers should not tailor decisions to keep investors (or analysts) happy in the short term. Too many firms have followed this path to destruction, by buying back stock or borrowing money, just because that is the flavor of the moment. Managers should focus on increasing long term value, but I think it is a mistake to ignore the messages that they get from market reactions to their decisions. When stock prices go up or down on the announcement of an action, there is some aspect of that action that is pleasing or troubling to investors. All too often, markets turn out to be right and managers to be wrong in the long term. In fact, managers who are convinced that their decisions will increase firm value are often operating under some of the same behavioral quirks that affect investors - they are over confident and systematically over estimate their abilities.

I think that the objective in decision making in a publicly traded firm should be value maximization with a market feedback loop.

In effect, managers should make decisions that maximize firm value but should use the stock price reaction to both frame those decisions in ways that appeal to investors, and modify the decisions themselves. Here is a simple illustration of how this process will work. Let us assume that you, as managers of a publicly traded firm, believe that the firm are over levered and that issuing new equity and retiring debt is the action you need to take to maximize long term firm value. Your initial announcement is greeted badly by investors, with your stock price going down. At one level, this reflects the fear (some may say irrational) of any action that increases shares outstanding - the dilution bogeyman. At another, it reflects skepticism about managerial claims that the firm is over levered. Here is how you could modify your decision to meet investor concerns/ beliefs. Rather than issue shares, you may raise equity using warrants (which do not seem to evoke the same fear of dilution) and provide more information to investors about why you believe that you are over levered. I know that there is no guarantee that this will work but I think it is worth a try.

Sunday, July 12, 2009

Behavioral finance and corporate finance

I wrote my first corporate finance book in the 1990s and Corporate Finance remains my favorite subject to teach, since it forces me to think about how businesses should be run and not just about investing in these businesses. It is a constant reminder that it is great business people who create strong economies and not great investors. As a linear thinker who likes my ducks in a row, my vision of corporate finance has always been built around maximizing the value of a business (rather than stock prices) and how investing, financing and dividend policy should be set by a firm (private or public), with this objective in mind.

Over the last two decades, behavioral finance has become the fastest growing area in finance. Much of the early work was directed at how investors behave: studies indicated that investors suffering from over confidence, and with skewed estimates of their own ability and likelihood of success, tend to drive stock prices away from "rational" levels. In the last decade, behavioral finance has started making inroads into corporate finance, looking at how managers in publicly traded firms behave and finding, to no surprise, that they exhibit the same frailties that we see with the investing public. Over confident managers over estimate cash flows on projects, use too much debt and tend to feel that their stocks are under valued (thus explaining the reluctance to use new stock issues).

I must confess that I have been a skeptic about behavioral finance and there is almost no mention of it in any of my corporate finance books. I have tried to at least partially remedy that defect in the third edition of my Applied Corporate Finance book that will get to the book stores later this year. Why this capitulation and why now? Though it is easy to attribute everything to the market crisis of 2008, this has been building up for a longer period and these are some of my reasons:

a. Some of the initial work in behavioral finance was designed more for shock appeal and clearly aimed at shaking up establishment thinking (which needed shaking up). The early papers in the area took great glee in pointing out the failures of traditional finance but offered little in terms of how to do things better. In recent years, there have been two signs that the area is maturing. The first is that disagreements are popping up between behavioral finance researchers on key issues in behavioral finance. The second is that more of the literature in recent years has started looking beyond the descriptive component to prescriptions. In other words, rather than just tell us that managers fail to ignore sunk costs in decision making, we are seeing more discussion of how best to design systems that may minimize the costs from this tendency.

b. Traditional finance, by ignoring management (and human) proclivities, has given both theorists and practitioners an easy pass. It allows academics (who have never had to run a business) to lecture managers about how "irrational" they are in their decision making, and it allows managers to ignore basic principles on investing and financing, by pointing to the ivory towers that academics live in and the unrealistic assumptions they make to get to their conclusions.

As I tried to incorporate what I know about behavioral finance into my corporate finance big picture, I was struck by the tension between describing things as they are and describing things as they should be. It is true that managers often behave in ways that are inconsistent with traditional basic financial principles and it is also true that we can trace the way managers behave to quirks in human behavior. I understand why managers over invest, borrow too much or too little, are reluctant to issue new equity and buy back too much stock. I also believe that I cannot abandon talking about what managers should be doing and why their actions cost stockholders money. I tried my best to walk that fine line in my new edition and I will talk about my conclusions in pieces in the next few posts.

Monday, July 6, 2009

Losers and Winners: The inevitable consequence of risk taking...

I am still astounded by the incapacity of some in the financial media to see the obvious. As an example, consider this article from the Wall Street Journal today:
If you cannot read the whole article, you are not missing a whole lot since I can summarize the basic theme as follows. A lot of the funds that were in the bottom 10% of last year's performers are in the top 25% of performers this year. As my 10-year old would say "Duh". Why is this a surprise? A risk taking fund will move back and forth between the best and worst performing funds on a period to period basis, based upon how the market does. A fund that is exposed to a great deal of market risk (high beta funds) will be among the best performers when markets do well and badly when markets do badly.

My problem with this article is that it tries to look for deeper meaning when there is really is none. The only good thing I can say about funds that did well this year is that they did not decide to become conservative at exactly the wrong time, but the ultimate test is whether you make money in the long term. There is little in the history of any of the funds mentioned in this article that fills me with confidence that they know what they are doing and that the returns that they are making in good years will cover what they will lose in the bad years.