Behavioral corporate finance
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Behavioral Corporate Finance. Malcolm Baker Harvard Business School October 22, 2009. 1998: The market can stay irrational longer than you can stay solvent. 1999: Successful investing is anticipating the anticipations of others.

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Behavioral Corporate Finance

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Behavioral Corporate Finance

Malcolm Baker

Harvard Business School

October 22, 2009


1998: The market can stay irrational longer than you can stay solvent


1999: Successful investing is anticipating the anticipations of others


2008: If you owe a bank a hundred pounds, you have a problem, but if you owe a million, it has


subject to


Rational

Fundamental

Value


There is no other proposition in economics which has more solid evidence supporting it than the Efficient Markets Hypothesis


subject to


Is this the way we make decisions?

  • Basis for individual investors’ intuition

  • Basis for well-capitalized investors’ strategies


Is this the way we make decisions?

  • Basis for individual investors’ intuition


The expert pool player makes shots as if he were a competent physicist and mathematician


Temperature on March 12, March 24… April 5?


How many people does

P&G employ?


H1N1 flu outbreak:

You have two options


Gamble: 50% chance $110;

50% chance -$100


Retirement Plan

Participation


College GPA if your HS

GPA was 2.2, 3.0, 3.8?


Four examples

  • Categorization

  • Anchoring (expectations) and reference points (utility)

  • Inertia

  • Extrapolation


Is this the way we make decisions?

  • Basis for individual investors’ intuition

  • Basis for well-capitalized investors’ strategies


Competitive arbitrage forces prices to fundamental value; irrational traders die out


MCI


Entremed


Royal Dutch and Shell


United Airlines


Why isn’t competition more effective?

  • Model risk

  • Noise trader risk

  • Unwinding or endogenous risk… comes from leverage

  • Funding risk and horizon… comes from e.g. impatient limited partners


Volkswagen


Is this the way we make decisions?

  • Basis for individual investors’ intuition

  • Basis for well-capitalized investors’ strategies


Behavioral finance

Investor errors

  • Categorization

  • Anchoring and reference points

  • Inertia

  • Extrapolation

    +Limits to arbitrage

    =Mispricing


Capital structure, maturity structure, dividend/payout policy… are irrelevant

in perfect markets


Perfect Markets

  • The difference is no one ever thought markets were absolutely perfect

    • Taxes

    • Bankruptcy costs

    • Agency costs

    • Asymmetric information

  • But market efficiency and manager rationalityare largely ignored


Behavioral Corporate Finance

  • Different sources of capital have different costs

    • For exogenous reasons, i.e. in inefficient capital markets with irrational traders

  • Firms respond in two ways

    • Market timing, catering

  • Real consequences for investment

    • Exogenously changing constraints


Behavioral Corporate Finance, V. 1.0

  • Corporate financing decisions appear to be timed well

    • Ritter (1991) and many more

    • Equity issues, stock-financed mergers, repurchases

    • Flows through to investment

  • Consistent with opportunism and real consequences of inefficient markets


Managerial Smarts?

  • Information advantage

    • Meulbroek (1992) and several more on insider trading

    • Earnings management

  • Fewer constraints

    • Particularly in expanding supply

  • Accommodating investor demand

    • Rules of thumb, investment banking


Behavioral Corporate Finance, V. 1.1

  • Still the question of supply versus demand

    • Risk, growth opportunities

  • Use exogenous shocks to investor demand

    • Does the supply of capital, separate from fundamentals, affect investment?


Some Examples

  • Instruments for the supply of capital

    • Flows into high-yield funds  investment by below investment grade firms

    • Chernenko and Sunderam (2009)

    • Many more examples like this emerging

  • Crisis parallel: securitization, screening  real estate, PE


Behavioral Corporate Finance, V. 2.0

  • Mounting evidence for supply effects

    • Independent of fundamentals

  • Still, it would be nice to tie this more closely to investor behavior

    • As opposed to e.g. institutional rigidities


Back to Behavioral Finance

Investor errors

  • Categorization

  • Anchoring and reference points

  • Inertia

  • Extrapolation

    +Limits to arbitrage

    =Mispricing


Categorization and Dividend Policy

  • Test the hypothesis that investors categorize firms according to whether they pay a dividend

    • Remember March versus April

    • Four measures of a ‘dividend premium’

  • Examine the corporate response


Dividend Premium and

Initiations

Dividend Premium

Propensity to Initiate

Dividend Initiations


Reference Points and M&A Pricing

  • Investors are reluctant to sell at a loss

    • Remember H1N1 experiment and loss aversion

    • Shefrin and Statman (1984) and Odean (1998) study individual investors

  • This means it’s hard to do a deal when a firm is selling well off its recent highs


A Discontinuity in Offer

Prices

Offer Price = 52-week High Price

Density

(Offer Price – 52-week High Price) Pt-30


A Discontinuity in Offer

Prices

Density

(Offer Price – 52-week High Price) Pt-30


Past High Prices and

Average Offer Premia

Offer Price  Pt-30

52-week High Price  Pt-30


Inertia and Equity Financing

  • Default setting matters in raising equity

    • Remember 401-K enrollments

    • Follow-on offers require active participation

    • Stock mergers require active opt out

  • Inertia makes price impact in stock financed mergers lower

    • Implications for equity-financed growth


Sleepy Investors


Limits to Arbitrage and FDI

  • Mispriced equity across borders

    • Remember Royal Dutch and Shell

    • A problem is mobility of capital across borders, by mandate or regulation

  • FDI is a form of cross-border corporate arbitrage

    • Source country mispricing drives FDI, especially in the presence of restrictions on private capital flows


Recap

  • The supply of capital, separate from fundamentals, and capital market mispricing have real consequences for corporate finance and investment

    • These effects can often be traced back to investor errors and limits to arbitrage


The crisis: Some parallels

  • Valuation of AAA securities

    • Categorization

  • Real estate prices

    • Extrapolation

  • Deal volumes, raising capital

    • Reference points

  • Models and marks

    • Problematic belief in market efficiency, liquidity


Interactions

  • These behavioral biases interact with incentive problems, fragility of banking

  • Much of this was present in the Internet bubble, but a difference was the players involved

    • Large, leveraged financial institutions, consumers were doubly exposed


All parties believed they were getting a good deal... Many of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives

Coval, Jurek, and Stafford (2008)


There is no housing bubble in this country…

Home prices on average have risen at a 6% annual pace since 1999, and 13% over the past year

Neil Barsky, managing partner of Alson Capital Partners, LLC, 2005


First Pacific Advisors: “What are the key drivers of your rating model?”Fitch: “FICO scores and home price appreciation of low single digit or mid single digit, as home price appreciation has been for the past 50 years.”

FPC: “What if home price appreciation was flat for an extended period of time?”Fitch: “Our model would start to break down.”

FPC: “What if home prices were to decline 1% to 2% for an extended period of time?”

Fitch: “The models would break down completely.”

FPC: “With 2% depreciation, how far up the rating’s scale would it harm?”

Fitch: “It might go as high as the AA or AAA tranches.”


When the music stops, in terms of liquidity, things will get complicated. As long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Chuck Prince, CEO of Citigroup in 2007


[John Thain] didn’t have the same pride of ownership in Merrill that [Richard] Fuld had in Lehman. That is why he was willing to sell $31 billion worth of mortgage-backed derivatives for 22 cents on the dollar in late July.

New York Times, 9/16/2008


Concluding Thought: BCF 3.0

  • We need an integration of behavioral finance and the traditional academic approaches to corporate finance, banking, regulation, and the agency problems of managers and intermediaries


Concluding Thought: BCF 3.0

  • We need an integration of behavioral finance and the traditional academic approaches to corporate finance, banking, regulation, and the agency problems of managers and intermediaries


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