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A Curious Case of Firmspecific Stock Return Volatility: Implications for Economies in Transition

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Title: A Curious Case of Firmspecific Stock Return Volatility: Implications for Economies in Transition


1
A Curious Case of Firm-specific Stock Return
Volatility Implications for Economies in
Transition
Art Durnev
2

Based on
  • A. Durnev, R. Morck, B. Yeung, 2004, Value
    Enhancing Capital Budgeting and Firm-specific
    Stock Return Variation, Journal of Finance.
  • A. Durnev, R. Morck, B. Yeung, P. Zarowin, 2003,
    Does Greater Firm-specific Return Variation Mean
    More or Less Informed Stock Pricing? Journal of
    Accounting Research.
  • A. Durnev, K. Li, R. Morck, B. Yeung, 2004,
    Capital Markets and Capital Allocation
    Implication for Economies in Transition, The
    Economics of Transition.
  • A. Durnev, R. Morck, B. Yeung, M. Fox, 2004,
    Law, Share Price Accuracy, and Economic
    Performance The New Evidence, Michigan Law
    Review.
  • A. Durnev, R. Morck, B. Yeung, 2000, Does
    Firm-specific Information in Stock Prices Guide
    Capital Allocation?, NBER working paper.
  • A. Durnev, R. Morck, B. Yeung, 2004,
    Firm-specific Return Variation and the Use of
    Outside Financing, working paper.
  • and other work in progress

3
Observed stock price synchronicity in the stock
markets of selected countries,1995  
 
Source Morck, Yeung, Yu (2000)
4
Overview
  • Decompose
  • by running
  • High R2 low per capita GDP
  • High R2 in emerging economies
  • Low R2 within developed economies

5
  Country-Level R2, Sorted by GDP, 1995
R2
Source Morck, Yeung, Yu (2000)
6
Overview
  • What is GDP representing?
  • Country size, industrial structure, macroeconomic
    stability, synchronous fundamentals
  • General private property rights, investor
    property rights

7
Good Government Index plotted against R2
8
Overview
  • R2 is low in economies that have good property
    rights respecting government.
  • Conditioned on having a good property rights
    respecting government, protection for outside
    shareholders property rights is associated with
    high firm specific stock return variation .
  • In economies where the institution environment
    encourages informed risk arbitrage, firm specific
    stock return volatility is higher and R2 is
    lower.

9
Overview
  • Informed risk arbitrage can be a story
  • Political factors may be more difficult to
    predict in emerging economies
  • Politicians can confiscate corporate earnings
  • Hard for outsiders to gauge corporate earnings
  • Even if they can predict corporate earnings the
    property rights are uncertain
  • Firm-specific arbitrage becomes unattractive
  • Traders become noise traders
  • Poor investor protection
  • Potential arbitrageurs would see little point in
    gathering and processing information to estimate
    firm-specific fundamentals if any surplus is
    siphoned off by insiders.

10
Overview
  • We interpret that low R2 is indicative of higher
    information contents in stock prices.
  • may or may not be right!!
  • While our interpretation is unorthodox, their
    interpretation if proven right can be very
    useful.
  • The reason is that if we can measure how
    informed stock prices are, we can implement
    empirical research on the functionality of
    capital markets.

11
I. R2 inverse of information index
12
H. J. Heinz and SP 500 index over the five
trading days prior to Dec. 7 1999  
 
13
Wall Street Journal, December 7, 1999 Heinz
Posts Sharply Stronger Net As Restructuring Plan
Progresses Dow Jones Newswires, PITTSBURGH --
H.J. Heinz Co., nine months into a sweeping
restructuring effort, Tuesday posted a sharp
increase in fiscal second-quarter net income and
core results that just topped Wall Street's
target. The maker of Heinz ketchup,
StarKist tuna and Ore-Ida frozen french fries
said net income soared 80 to 415.5 million,or
1.14 a share, from 213.3 million, or 63 cents a
share, a year ago. Figures for the quarter ended
Oct. 27 include a pretax gain of 464.6 million,
or 72 cents a share, on the sale of the company's
Weight Watchers low-calorie foods business. The
bottom line also reflects pretax costs of 43.7
million, or eight cents a share, and charges of
33.3 million, or nine cents a share, booked in
connection with "Operation Excel," the company's
restructuring program. Excluding items, Heinz
said earning increased 6.6 to 234.8 million, or
65 cents a share, from 220.2 million, or 60
cents a share, a year ago. Analysts surveyed by
First Call/Thomson Financial expected earnings to
reach 64 cents a share. Revenue inched up 1 to
2.34 billion from 2.32 billion. The
company launched its four-year restructuring bid
in February. At the time, Heinz said it expected
to cut 3,000 jobs and close some 20 factories,
primarily in Europe. The company also said it
expected pretax restructuring charges to top 900
million. Heinz said Tuesday it intends to
accelerate its restructuring bid to ensure that
all charges will be recognized by the end of
fiscal 2000, a year earlier than expected. The
company said savings should total 215 million by
2002.
14
R2 Inverse of Information IndexAccounting
Evidence
  • Regress current stock return on future changes in
    earnings (Durnev, Morck, Yeung Zarowin (2003))

Informativeness
15
R2 Inverse of Information IndexAccounting
Evidence
  • In regression analyses we control for industry
    characteristics (match-pair design,
    diversification, size), factors having an
    intrinsic effect on informativeness (earnings
    volatility, institutional ownership), effects of
    earnings timeliness (stock return, RD).
  • Future earnings explain more of current share
    price with low R2 firms than with high R2 firms.
  • Suggests that low R2 firms indeed have more
    accurate share prices.

16
II. Informed equity prices and resources
allocation
17
Stock Market Efficiency
  • Malinvestment (poor microeconomic capital
    allocation)
  • Hayek (1941) The Pure Theory of Capital
  • Malinvestment can exist even with the optimal
    aggregate quantity of capital goods if those
    goods are not allocated to their best uses.
  • Major impediment to macroeconomic growth.
  • The Functional Form of the Efficient Markets
    Hypothesis
  • Tobin (1982)
  • EMH gt microeconomic efficiency of capital
    allocation.
  • A stock market exhibits functional market
    efficiency if stock prices direct capital to its
    highest value uses with an acceptably low error.

18
Greater Functional Efficiency
  • Investors trust markets more
  • Investors lacking special information -
    effectively, the great majority - can buy
    securities confident that the prices they pay
    roughly reflect the value of the attached future
    income stream.
  • This increases the overall amount of capital that
    savers provide via financial markets by
    mitigating the well-known lemons effect
    associated with external financing.
  • Managers trust markets more
  • Firms weighted average costs of capital better
    reflect each firms risks and opportunities.
    This should reduce malinvestment.
  • Managers can use stock prices as feedback on
    investors collective assessments of the uses to
    which they are putting the firms capital.
  • Such feedback plausibly also reduces
    malinvestment problems, or (if ignored) invites
    the market for corporate control to reduce them.

19
Greater Functional Efficiency
  • More informed investment community ? firms have
    grater access to outside financing.
  • More informed investment community ? firms
    managers conduct more value maximizing
    investment.
  • More informed investment community ? higher
    economic growth (especially productivity growth).

20
1996-1999 GDP per capita growth rate plotted
against R2
CORR -0.278 PVAL 0.10
Source Durnev, Li, Morck, Yeung (2004)
21
1996-1999 Average growth rate in productivity
plotted against R2
CORR -0.326 PVAL 0.05
Source Durnev, Li, Morck, Yeung (2004)
22
Informed Equity Prices and Growth Cross-Country
Regression Results
  • Results are statistically and economically
    significant
  • Controls initial GDP, schooling, inflation,
    black market premium, government size, openness,
    rule of law, bank credit, stock market size

23
Capital Allocation Precision Measured by the
Elasticity of Capital Expenditure with Respect to
Value Added and R2                
Germany
1
Hong Kon
France
New Zeal
Spain
Denmark
Sweden
Austria
Japan
United K
Belgium
United S
Australi
Ireland
Italy
Peru
Korea, R
Greece
Norway
Netherla
Finland
Canada
Portugal
Capital Allocation Precision
.5
Singapor
Mexico
Philippi
Chile
Malaysia
Pakistan
Turkey
Indonesi
Colombia
India
0
0
.2
.4
R2
CORR -0.500 PVAL 0.00
Source Wurgler (2000)
24
Cross-Industry Results
  • In using the US data, we assume that each
    industry is a country, there is perfect capital
    mobility, all countries have identical monetary
    and fiscal policies.
  • Run firm-level regressions on 1990-1992 daily
    data
  • Define where
  • where

  • where

25
Capital Investment Opportunity Schedule
Informed Equity Prices and Capital Budgeting
Quality
26
Informed Equity Prices and Quality of Capital
Budgeting
  • Marginal q estimation
  • PV of the cash flows of a marginal dollar of
    capital
  • Operationalize for 1993-1997 sample
  • Cross-multiply and simplify
  • Firm-time random effects regression on firm-level
    data by industry

27
Reality Check
  • Estimate industry-level marginal q by running
  • Average coefficients across all industry-level
    regressions

28
The Deviation of Marginal Tobins q from One with
Industries Grouped by Industry-Average Firm-Level
Market Model R2.
A low R2 indicates high firm-specific return
variation relative to market and industry-related
variation. The height of each bar is the group
average deviation of marginal q below and above
one.
29
Informed Equity Prices and Capital Budgeting
Quality
  • Measure malinvestment by the distance between
    marginal q and one
  • ( -1)2 and -1
  • Simple Correlations
  • Marginal q is closer to one in industries where
    stock returns are more asynchronous
  • Multiple regressions
  • Control for fundamentals asynchronicity,
    diversification, size, industry concentration,
    liquidity, leverage, investment in intangibles.
  • Marginal q is closer to one in industries where
    stock returns are more asynchronous.

30
Mean Marginal q for Industries Subsamples with
Marginal q Above One and Below One, Grouped by
Industry-Average Firm-Level Market Model R2.
A low R2 indicates high firm-specific return
variation relative to market and industry-related
variation. The height of each bar Is the group
mean marginal q. The number of observations in
each group is listed at the top of each bar. The
sample sizes for 0 to 10, 10 to 20, 20 to
30 and 30 to 40 are 3, 34, 26, and 11
industries with marginal q above one and 9, 48,
48, and 7 industries with marginal q below one.
31
Informed Equity Prices and Capital Budgeting
Quality
  • Let the data choose such that the LHS
    variable is
  • Best fit is at 0.78-0.83
  • Consider over- and under-investment separately
  • Partition sample into and
    subsamples
  • R2 is associated with proximity to 1 only in the
    subsample
  • Partition sample into and
    subsamples
  • R2 is associated with proximity to 0.8 in both
    subsamples

32
Informed Equity Prices and Value Creation
  • Measure firm value by average q
  • Simple Correlations
  • Average q is higher in industries where stock
    returns are more asynchronous
  • Multiple regressions
  • Control for fundamentals asynchronicity,
    intangible assets, etc.
  • Average q is higher in industries where stock
    returns are more asynchronous

33
Informed Equity Prices and Use of Outside
Financing
  • New long-term debt coverage of capital spending
  • New equity coverage of capital spending

34
  Industry-Level External Financing Grouped by
R2    
CORR(Dld,R2) -0.160 PVAL 0.03 CORR(De,R2)
-0.151 PVAL 0.05
Source Durnev, Morck, Yeung (2001)
35
Greater Functional Efficiency
  • More informed investment community ? firms have
    grater access to outside financing.
  • More informed investment community ? firms
    managers conduct more value maximizing
    investment.
  • More informed investment community ? higher
    economic growth (especially productivity growth).

36
Conclusions Our Spin
  • 1-R2 is a measure of the capitalization of
    firm-specific information into stock prices
  • The extent to which firm-specific information is
    incorporated into stock prices varies across
    countries, firms, and industries
  • This has real effects, viz. 1-R2
  • Growth
  • More use of external financing
  • More efficient capital allocation
  • More value creation

37
  • III. Yet to be answered
  • Why do stock prices of some firms, industries,
    and countries have more information content
    (firm-specific variation) than those of others?
  • What explains variation in firm-specific
    volatility through time?

38
The Information Content of Stock Prices
  • Incomplete risk arbitrage
  • The absence of firm-specific arbitrage
  • Agency problems and firm-specific arbitrage
  • Noise traders and firm-specific arbitrage

39
The Information Content of Stock Prices
  • A lot of stock price variation is firm-specific
    and not related to obvious public information
  • French and Roll (1986), Roll (1988)
  • Risk arbitrage is harder than introductory
    textbooks would have us believe
  • Shleifer and Vishny (1997)

40
The Information Content of Stock Prices
  • Exogenous and endogenous firm/industry
    characteristics
  • Firms/industries that attract analysts are easy
    to value (?)
  • Larger firms are easier to value (?)
  • More diversified units are harder to value
    (confirmed)
  • more focused behavior of managers leads to more
    risk arbitrage
  • More concentrated units are easier to value (?)
  • Younger units are harder to value (?)
  • Companies with more intangibles (RD) are harder
    to value (?)

41
The Information Content of Stock Prices
  • Internet companies (?)
  • Foreign ownership (?)
  • Type of exchange (NYSE, NASDAQ) (?)
  • Business groups (?)
  • Anomalies (momentum, etc) (?)

42
The Information Content of Stock Prices
  • Corporate policy variables such as dividend,
    debt, institutional ownership can signal
    insiders pre-commitment to deliver a
    considerable portion of cash flow to outside
    shareholders.
  • the action of sending back cash to outside
    shareholders and to creditors itself limits the
    insiders ability to abuse outside stakeholders
    rights. Thus, there will be more informed risk
    arbitrage.

43
The Information Content of Stock Prices
  • Higher institutional ownership causes R2
    (confirmed)
  • monitoring from institutions improves
    shareholders property rights and induces more
    informed risk arbitrage
  • institutions may be subject to sentiment shocks
    which become reflected in their trading strategy
  • But, institutions may prefer more liquid heavily
    traded stocks which may tend to be more volatile
  • More leverage causes R2 (confirmed, dual
    causality)
  • But, when leverage increases, shareholders bear
    greater share of the total cash flow risk
  • Companies that have higher dividends have lower
    R2 (?)
  • But, dividend payout can increase information
    sensitivity of equity

44
The Information Content of Stock Prices
  • Cost of arbitrage, Pontiff (1983)
  • transaction cost
  • More expensive, larger firms are easier to trade
  • holding cost variables
  • Dividend payments reduce holding costs by
    reducing the amount of capital that must be
    provided to the arbitrage positions in future
    periods.

45
The Information Content of Stock Prices
  • Examples of high firm-specific variation
    industries
  • Commercial sports
  • Knitting mills
  • Crude petroleum natural gas
  • Tobacco
  • Examples of low firm-specific variation
    industries
  • Engines and turbines
  • General building constructors
  • Department stores
  • Operative builders
  • Drug stores

46
Average R2 Across Stocks Based on Monthly
Returns, 1926 to 1995    
 
Source Durnev, Morck, Yeung (2001)
47
Systematic and Firm-specific Variation in the US
Source Durnev, Morck, Yeung (2001)
48
R2
49
Systematic Variation
50
Firm-specific Variation
51
Changing Returns Synchronicity in Transition
Economies China
Source Li, Morck, Yeung (2004)
52
Changing Returns Synchronicity in Transition
Economies Czech Republic

Source Li, Morck, Yeung (2004)
53
Changing Returns Synchronicity in Transition
Economies Hungary
Source Li, Morck, Yeung (2004)
54
Changing Returns Synchronicity in Transition
Economies Poland

Source Li, Morck, Yeung (2004)
55
Changing Returns Synchronicity in Transition
Economies Romania
Source Li, Morck, Yeung (2004)
56
Changing Returns Synchronicity in Transition
Economies Russia

Source Li, Morck, Yeung (2004)
57
Variation of R2 through time
  • Business cycles
  • Change in laws
  • Liberalization
  • The relationship between the firm-specific stock
    return variation and explanatory variables is
    stronger in later days.
  • The quality of the stock market to process
    information evolves through time and it is better
    in the 90s than in the 60s, 70s, or 80s.
  • lower intensity of noise traders
  • better shareholders protection rights
  • better institutional framework

58
Mandatory Disclosure and R2
  • Mandatory disclosure is not needed (Macey, Choi
    Guzman, Romano)
  • issuers have market incentives to provide the
    optimal level of disclosure
  • much of what is required is not useful, the
    information impounded in share prices comes via
    routes other than mandatory disclosure
  • Mandatory disclosure is needed (Coffee,
    Easterbrook Fischel, Bebchuk, Fox)
  • existence of externalities will result in a
    market failure in the absence of regulation

59
Mandatory Disclosure and R2
  • We study imposition on December 15, 1980 of
    enhanced (MDA)
  • Requires issuer managers to disclose any material
    information that suggests the issuers recent
    results are not necessarily indicative of future
    operating results.
  • We observe a statistically significant reduction
    in R2 after the new requirements.
  • Suggests the enhanced requirements did result in
    revelation of useful information and hence
    improved share price accuracy.

60
Mandatory Disclosure and R2
  • Issuer managers will be more likely, other things
    being equal, to reveal in a timely fashion good
    news than bad news.
  • To the extent that disclosure is voluntary, firms
    with good news will have a higher level of
    disclosure on average than firms with bad news.

61
Mandatory Disclosure and R2
  • Firms with good news in a given year should have
    returns better than the industry average.
  • Firms with bad news in a given year should have
    returns
  • Below the industry average where the bad news is
    revealed during the year.
  • Equal to the industry average where the bad news
    is not revealed during the year (when the bad
    news does eventually become revealed in a
    subsequent year, share price is marked down
    then).

62
Mandatory Disclosure and R2
  • Following the MDA enhancement, we would expect
  • Firms with current or past unrevealed bad news
    that would, but for the MDA enhancement, have
    been in the medium return group are instead in
    the bad return group.
  • The medium return group is now less mixed,
    the firms remaining in the group having more
    informed prices.
  • The goodreturn group does not experience
    significantly improved transparency.

63
Mandatory Disclosure and R2
  • If the regulations increase share price accuracy
  • H Decrease in the R2 of the medium return
    group should exceed that of the good return
    group.

64
Mandatory Disclosure and R2
  • The results suggest that mandatory issuer
    disclosure does result in the revelation of
    useful information and thus adds to share price
    accuracy.

65
1982-1980 Change in Firm-specific Variation
(SSE), Systematic Variation (SSM), and 1-R2 for
Good, Medium, and Bad Return Groups of
Firms    
MEDIUM
SSE
BAD
1-R2
1-R2
SSE
SSM
SSE
SSM
1-R2
SSM
GOOD
66
R2 Inverse of Information Index
  • While supportive evidence is piling up, more of
    theoretical and empirical work needs to be done
    before we can firmly believe that more firm
    specific stock return variation more informed
    stock prices.

67
Additional Evidence
  • Beny (2000) finds that a countrys stock returns
    are less synchronous where insider trading is
    more restricted.

68
Number of Analysts per Firm and
R2                
Germany
United S
30
Netherla
Hong Kon
France
Spain
Italy
Singapor
Sweden
United K
Malaysia
20
Mexico
Canada
Number of Analysts per Firm
Brazil
Belgium
Finland
Japan
Denmark
Norway
Australi
India
Philippi
China
Korea, R
10
Thailand
Indonesi
New Zeal
Austria
Peru
Turkey
Poland
South Af
Taiwan
Greece
Chile
Ireland
Portugal
Czech
Pakistan
Colombia
0
0
.2
.4
.6
R2
CORR -0.271 PVAL 0.09
69
U.S. Home Bias and R2          
1
Taiwan
China
India
South Af
Greece
Japan
Chile
Malaysia
Pakistan
Belgium
Korea, R
Thailand
Philippi
Denmark
Turkey
Indonesi
Germany
Austria
Hong Kon
Singapor
Poland
Brazil
France
.8
Spain
Australi
United K
Italy
Sweden
Portugal
Norway
Canada
Finland
U.S. Home Bias
New Zeal
.6
Netherla
.4
Mexico
Ireland
.2
0
.2
.4
.6
R2
CORR 0.347 PVAL 0.04
70
Earnings Management Measure and R2              
.4
Turkey
India
Indonesi

China
.3
Greece
Pakistan
Negative Earnings Avoidance
Mexico
Poland
Chile
Thailand
South Af
Brazil
Malaysia
Ireland
Italy
Philippi
.2
Singapor
United K
United S
Netherla
Taiwan
Sweden
Austria
Spain
Australi
Germany
Finland
Hong Kon
Denmark
Canada
Portugal
Belgium
New Zeal
France
Japan
Norway
.1
0
.2
.4
.6
R2
CORR 0.464 PVAL 0.00
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