Are Executives Any Better at Market Timing Than Average Investors?

The greatest concern of investors and regulators is that insiders too often use their knowledge of 'information asymmetries' to take advantage of both the market - and other investors.

This behavior can be illegal but in the current environment, even when such actions are perfectly legal, there can be a perception that this is immoral or unfair.

Recent research, however, suggests that corporate executives may be no better than average investors when it comes to market timing. And even worse, that they are letting the markets influence them more than they are influencing the markets. The evidence from an examination of share buybacks suggests that at crucial junctures before, during and since the financial crisis this had led to almost comically poor performance in terms of corporate resource allocation decisions.

Comical, that is, unless you are an employee or pensioner whose income and well-being is negatively impacted by the mistakes. The challenge for regulators, board members and others concerned with governance is whether to impose more rules or let the markets winnow out the winners and losers. The latter course would probably be almost everyone's preference had executives not insulated themselves from the consequences of their decisions over the past decade. Mistakes will happen, but that behavior based on a belief that there are no downsides for the well-connected that has to be addressed. JL

The Economist reports:

IT IS easy to accept that small investors might be irrational—piling into dotcom stocks in late 1999, for example, or buying half-built Miami condominiums in 2006. But corporate executives are supposed to be “in the know”. That, after all, is why there are such stringent laws against insider dealing.

Take share buy-backs. Investors often see a decision by a company to buy back its own shares as a positive indicator. If the executives think the shares are a bargain, everyone else should.
Not according to the calculations of Andrew Lapthorne, a quantitative strategist at Société Générale. In January 2008, just as the stockmarket was starting one of its worst years in history, companies in the S&P 500 were using almost 40% of their cashflow to buy back their own shares. By March 2009 equities were finding a bottom, but the proportion of cashflow used to buy back shares had dropped to 19.6%.

An even lower proportion, 5.9%, was being used to purchase shares as 2010 dawned. That turned out to be a pretty good year, with the S&P 500 gaining 12.8%. Executives had recovered their nerve by the start of last year, spending 19% of their cashflow on buy-backs. But 2011 proved to be a flat year for equities.

It seems likely that executives are being influenced by the market rather than the other way round. A rising share price makes managers more optimistic, and encourages them to think the trend will continue. Since a buy-back tends to boost earnings per share (EPS), a virtuous circle can be created. Investors notice the increase in EPS and push the shares up accordingly. The danger is that this is the investment equivalent of a sugar rush and that the EPS improvement cannot be sustained. At the first sign of disappointment, the share price will plunge.

This pattern of behaviour may relate to an old problem: that cash tends to burn a hole in managers’ pockets. A 2003 paper* by Robert Arnott and Clifford Asness found that companies which paid a low proportion of their profits in the form of dividends displayed slower subsequent profits growth than those with a higher payout ratio. The temptation was for executives to use spare cash to go on an acquisition spree. This empire-building was usually a bad idea for shareholders but could be used to justify higher salaries for managers. In similar fashion, modern managers are motivated by share options and buy-back programmes are designed to prop up the share price.

What might be a more rational use of a company’s cashflow? One possibility would be the injection of cash into their pension funds. According to Mercer, a consultancy, American pension funds had a deficit of $484 billion at the end of last year (up from $315 billion at end-2010), a funding ratio of just 75%.

But executives seem to be counting on an equity-market rally to dig them out of the hole. Mr Lapthorne finds that companies are expecting a return of 10%, after costs, from the equities in their pension-fund portfolios.

That is quite an extraordinary expectation, given current market conditions. Over the long run equity returns comprise the current dividend yield plus dividend growth. Since the dividend yield on the S&P 500 is just 2.5%, that requires dividends to grow at 7.5% a year, faster than any plausible forecast for economic growth. A rapid increase in profits might be possible if the starting point was sufficiently low, but American profit margins are at their highest level since the mid-1960s.

The evidence suggests that companies themselves don’t really believe such rosy forecasts. A Duke University poll of chief financial officers shows they have an average forecast for equity returns over the next ten years of 6.3%. So why do their companies allow such predictions for pension returns to stand? The answer is that if they used more realistic numbers, they would have to contribute more money to make up for the shortfall. And that would dent their profits and thus their share prices. So this apparent piece of myopia might be quite rational after all.

The pension-fund problem is not insurmountable. Closing the deficit over ten years would require additional contributions of around $50 billion a year; total corporate profits are around $1.7 trillion a year. Unfortunately, it seems as if executives have no incentive to tackle the issue. They are simply hoping it will go away.

*“Surprise! Higher Dividends = Higher Earnings Growth”, Financial Analysts Journal, Jan/Feb 2003