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Weekly Academic Digest 8/28/2011

This entry is part 2 of 2 in the series Weekly Academic Digest

Negative Alpha Research (Temporary Category)

Taxing Financial Transactions: An Assessment of Administrative Feasibility–ugg, just what we need…more taxes.

This paper considers how a tax on financial transactions could be applied to three broad and partially overlapping categories of financial instruments: (1) exchange-traded instruments; (2) over-the-counter instruments; and, (3) foreign exchange instruments. For each category, the paper examines the factors that would facilitate or complicate the administration of a financial transactions tax, the options for collecting the tax, the types of compliance risks that are likely to be encountered, and measures for mitigating these risks.

Alpha Research

The Asset Growth Anomaly and the Role of Limits to Arbitrage–questioning an anomaly we’ve talked about in the past.

Several studies have documented that companies that increase capital investments or grow their total assets subsequently earn substantially lower risk-adjusted returns. Some studies attribute this phenomenon to investors’ initial underreactions to firms’ overinvestments or overreactionsto changes in firms’ fundamentals. This paper examines the role of the limits to arbitrage in the negative effect of capital investment or asset growth on subsequent stock returns. We hypothesize that if the negative effect is due to investors’ initial mis-reactions, the effect should be more pronounced when there are more severe limits to arbitrage. Our empirical evidence supports the hypothesis. In addition, we find that the effect of the limits to arbitrage on the assetgrowth anomaly is not simply a manifestation of liquidity risk or trading costs consisted of bid ask spreads and trading commissions.

In Promises We Trust: Stock Returns and Annual Report Announcements–seasoned value investors will verify this effect via anecdotal evidence…never trust a CEO promise.

Firms making few promises in annual reports generate positive abnormal returns of up to 6% annually. These returns are not driven by microcaps or known anomalies and are not industry specific. Promises are measured by frequency of the verbs will, shall, and going to. Frequencies of the 100 other most common words (and their three-word combinations) in 10-K reports are unrelated to returns. Promises are costly informative signals, and the evidence favors a risk versus a mispricing explanation. Thus, as predicted by finance theories, firms about which there is less public information are riskier but offer higher returns.

 

Behavioral Finance

Do Psychological Shocks Affect Financial Risk Taking Behavior? A Study of U.S. Veterans–time to rename “shell shock” and call it “stock shock.”

Traditional economic theories assume that individuals are endowed with certain risk preferences that are unaltered by experiences. However, recent evidence indicates that macroeconomic shocks do have an effect on an individual’s willingness to take financial risks. In the context of investment decisions, we examine empirically whether individual’s risk preferences are affected by other types of traumatic life experiences. Using a unique proprietary data set, we investigate whether personal traumatic experiences – such as the combat experiences of veterans – have long-term effects on financial risk taking behavior. We find that having experienced combat decreases the probability of investing in risky assets. Key policy implications are noted.

Behavioral Corporate Finance: An Updated Survey–nice overview

We survey the theory and evidence of behavioral corporate finance, which generally takes one of two approaches. The market timing and catering approach views managerial financing and investment decisions as rational managerial responses to securities mispricing. The managerial biases approach studies the direct effects of managers’ biases and nonstandard preferences on their decisions. We review relevant psychology, economic theory and predictions, empirical challenges, empirical evidence, new directions such as behavioral signaling, and open questions.

General Interest

Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance–think twice about funding your private equity manager’s yacht and Ferrari.

Using a new database of the compensation terms, ownership structures (capital commitments), and quarterly cash flows for a large sample of buyout and venture capital private equity funds from 1984-2010, we investigate the determinants of manager compensation and ownership and how these contract terms relate to the funds’ cash flow performance. Market conditions during fundraising are an important driver of compensation, as pay rises and shifts to fixed components during fundraising booms. We find no evidence that higher compensation or lower managerial ownership are associated with worse net-of-fee performance, in stark contrast to other asset management settings. Instead, compensation is largely unrelated to net cash flow performance. Our evidence is most consistent with an equilibrium in which compensation terms reflect agency concerns and the productivity of manager skills, and in which managers with higher compensation earn back their pay by delivering higher gross performance.

Quantitative Musings

How to be a successful car salesman–wow, the Farnam Street blog is fascinating!

Buy and hold is dead–didn’t we already know that?


 

 

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Quantitative Camping Advice

For those of you taking the kids out for last minute summer vacations:

From REI Website

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Weekly Academic Digest 8/21/2011

This entry is part 1 of 2 in the series Weekly Academic Digest

Alpha Research

“The UMO (Undervalued Minus Overvalued) Factor”–watch out for share issuers and repurchasers.

This document provides an overview of the UMO factor. It describes its motivation, construction, and how to obtain it and use it. Behavioral theories suggest that investor misperceptions and market mispricing will be correlated across firms. The UMO factor uses equity and debt financing to identify common misvaluation across firms. UMO is a zero-investment portfolio that goes long on firms that issue securities and short on firms that repurchase. UMO captures comovement in returns beyond that in standard multifactor models, substantially improves the Sharpe ratio of the tangency portfolio, and carries heavy weight in the tangency portfolio. Loadings on UMO strongly predict the cross-section of returns on both portfolios and individual stocks, even among firms not recently involved in external financing activities, and even after controlling for other standard predictors. UMO was proposed by Hirshleifer and Jiang (2010), who provide further evidence suggesting that UMO loadings proxy for the common component of a stock’s misvaluation. For further details, see Hirshleifer, David, and Danling Jiang, “A Financing-Based Misvaluation Factor and the Cross-Section of Expected Returns,” Review of Financial Studies (2010), 23(9), 3401-3436.

“Demographic Change and Pharmaceuticals’ Stock Returns”–time to start thinking about the baby boomers.

We analyse how demographic change affected profits and returns across pharmaceutical industries over the last 20 years. Fluctuations in different age group sizes influence the estimated demand changes for age sensitive drugs, such as antibacterials for young, antidepressants for middle aged, and antithrombotics for old people. These demand changes are predictable as soon as a specific age group is born. We use consumption and demographic data to forecast future consumption demand growth for drugs caused by demographic changes in the age structure. We find that long term forecast demand changes predict abnormal annual pharmaceutical stock returns for more than 60 firms over the time period from 1986 to 2008. An increase by one percentage point of annual demand growth due to demographic changes predicts an increase in abnormal yearly stock returns in the size of 3–5 percentage points. Short term forecast demand changes does predict negative abnormal stock returns for a time horizon below 5 years. A trading strategy taking advantage of the demographic information earns a significant abnormal return between 6 and 8 percentage points per year. Our results are consistent with the model by DellaVigna and Pollet (2007), where investors are inattentive with extrapolation in the distant future and overreact to information in the near future.

“The Economic Value of Corporate Eco-Efficiency”–socially conscious is profitable? Awesome!

This study adds new insights to the long running corporate environmental financial performance debate by focusing on the concept of eco efficiency. Using a new database of eco efficiency scores, we analyse the relation between eco efficiency and financial performance from 1997 to 2004. We report that eco efficiency relates positively to operating performance and market value. Moreover, our results suggest that the market’s valuation of environmental performance has been time variant, which may indicate that the market incorporates environmental information with a drift. Although environmental leaders initially did not sell at a premium relative to laggards, the valuation differential increased significantly over time. Our results have implications for company managers, who evidently do not have to overcome a tradeoff between eco efficiency and financial performance, and for investors, who can exploit environmental information for investment decisions.

Abnormal Returns From the Common Stock Investments of Members of the U.S. House of Representatives–does this surprise anyone? On one hand, politicians are dolts, but on the other hand, even a dolt can trade on inside information.

A previous study suggests that U.S. Senators trade common stock with a substantial informational advantage compared to ordinary investors and even corporate insiders. We apply precisely the same methods to test for abnormal returns from the common stock investments of Members of the U.S. House of Representatives. We measure abnormal returns for more than 16,000 common stock transactions made by approximately 300 House delegates from 1985 to 2001. Consistent with the study of Senatorial trading activity, we find stocks purchased by Representatives also earn significant positive abnormal returns (albeit considerably smaller returns). A portfolio that mimics the purchases of House Members beats the market by 55 basis points per month (approximately 6% annually).

Do Stock Prices Undervalue Investments in Advertising?–Mad Men provide value unforeseen by the market.

This paper examines the impact of advertising spending on future-period stock returns across various industries from 1980 to 2008. Under the efficient market hypothesis, the stock price should incorporate the value of a firm’s advertising along with other tangible and intangible assets. If so, advertising spending would not be associated with future excess stock returns. Nevertheless, we find that relative advertising spending, measured by the level and changewithin an industry, is associated with positive future stock returns. These risk-adjusted abnormal returns indicate that investors slowly react to the intangible value generated from advertising spending. Abnormal annual returns are more pronounced in small firms, which are less known to investors. Also, firms which maintain intensive advertising after having below average stock market returns have the largest abnormal annual returns. This indicates that investors can be overly pessimistic about advertising spending when the firm’s recent stock price performance has been disappointing. Finally, there is no evidence that stock prices are becoming more efficient over time. This is because the abnormal returns are as strong from 2000 to 2008 as in earlier decades.

Behavioral Finance

Female Leadership and Gender Equity: Evidence from Plant Closure–hire more women.

We use unique worker-plant matched panel data to measure the impact of female leadership on the relative pay of men and women. We measure differences in the wage changes experienced by newly hired men and women displaced from closing plants. We correct for endogenous selection of both the original and new employer, comparing the wage changes of men and women who move from the same closing plant to the same new firm. We observe larger wage losses among women than men immediately upon re-entering the workforce and continuing for the following three years. These differences exist throughout the wage and age distributions. However, we find a significantly smaller gap between men and women who move to a new firm with a higher fraction of female managers: the magnitude of the extra losses to women is cut in half. Moreover, we observe significant changes in the relative treatment of newly hired men and women when the gender composition of the firm’s leadership team changes. Our results suggest an important externality to having women in leadership positions: they improve the prospects of other women inside their firms. To the extent that gender wage differences are not driven by differences in productivity, removing these distortions can improve firm value.

The Price of Street Friends: Social Networks, Informed Trading, and Shareholder Costs–good o’le boy networks: get in, or get screwed.

Recent studies by Cohen, Frazzini, and Malloy (2008, 2010) document that Wall Street analysts and money managers gain from their social ties with public firms. In this study, we examine the cost of such social connections to public firm shareholders. Using a sample of 18,482 firms during 2000- 2008, we document a significant and positive relation between a public firm’s social connections with Wall Street and the firm’s bid-ask spread. One additional connected executive or director at a typical public firm increases her shareholders’ annual trading cost by over $1 million. The present value of such additional trading cost amount to $182 million for the average firm. Social ties based on education or leisure activities exhibit a stronger effect on trading costs than ties based on employment. Local social ties also exhibit a stronger effect than non-local ties. Firms with more ties to Wall Street also exhibit lower abnormal volatility and lower abnormal trading volume around earnings announcements. Our evidence illustrates the importance of social ties in the transfer of privileged information and the significant consequences for shareholders. Finally, SOX substantially reduces, but does not eliminate, the importance of social networks in the transfer of information, and consequently the cost to shareholders.

Quantitative Musings

$1B quant launch?–Who do these guys think they are? Most of us have a hard time scrounging together 10 to 20 bucks!

RENTEC BETTING HARD ON APPLE–Hey Jim, know when to hold them, know when to fold them.


 

 

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Gangsta Hayek versus Thuggin’ Keynes

Love it. Hat tip H. Chen.

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