IPO Market Sluggish In 2016

With less than two weeks left in the year, it appears that 2016 will be a slow year for IPOs. Only 105 companies went public in the U.S., raising $18.8 billion, while 2015 had 170 IPOs that raised about $30 billion. The amount raised in 2016 was the lowest dollar amount raised since 2003. One potential reason for the slow IPO market is that many privately held companies have reached lofty valuations, with a growing number of unicorns and decacorns. A recent report argues that many of these private companies have lofty valuations that are not supported by public markets. If this is the case, the only way for investors in these companies to cash out with an IPO is by venture capitalists taking a potential loss on the IPO or waiting until the public stock market feels the valuation is in line with the company value.

Share Repurchases Decline

Even though companies in the S&P 500 repurchased $115.6 billion in stock during the third quarter, this actually represented a decline of 28 percent from the third quarter of 2015 and was the smallest quarterly repurchase since the first quarter of 2013. Apple led the way, repurchasing $7.2 billion of its stock, while General Electric repurchased $4.3 billion of its stock. The top sector for buybacks was IT, with $27 billion in repurchases, while the financials sector spent $25 billion on buybacks.

Dollar Strengthens

With housing starts at a the highest point in nine years and the weekly jobless claims reaching a 43-year low, it appears that the U.S. economy is strengthening. As a result, it now appears likely that the Federal Reserve will increase interest rates in its December 13-14 meeting. This also lead to a stronger U.S. dollar as the dollar reached a 13 1/2 year high against a basket of six major currencies. The U.S. dollar reached its highest level against the euro in almost a year, and its highest level against the yen since early June.

Fewer Negative Bonds

As signs for a more expansionary U.S. monetary increase, the market value of negative yield bonds worldwide fell this week. Since June, the market value of negative yield bonds in the Bloomberg Global Aggregate Index has fallen 28 percent from the peak value of $12.2 trillion. An expansionary monetary policy will likely lead to higher interest rates and a steeper yield curve, at least in the short term. Japan is still the leader in negative yield debt, accounting for 58 percent of worldwide negative yielding debt.

Financial Distress Costs For Sears

For several years, the performance of Sears Holdings has been declining. Now, it appears that the company's suppliers feel that the company may be headed toward bankruptcy. JAKKS Pacific announced last month that it would stop shipping toys to Sears' Kmart stores, fearing Sears would file bankruptcy, making collection on the receivables problematic. Now it appears that other suppliers have reached the same conclusion as at least six suppliers have reduced shipments to Sears for the same reason, including at least one supplier who stopped shipping to Sears entirely. Chairman and CEO Eddie Lampert had extended credit to Sears three months ago to stop speculation by suppliers and some Sears suppliers have been paid in 30 days rather the typical 60 to 90 days. Given that Sears is headed into the Christmas season, the biggest sales season for retailers, problems with suppliers could signal a spiral into bankruptcy for the company.

Record Treasury Bill Sales

The U.S. Treasury Department sold a record $65 billion in one-month Treasury bills at an interest rate of .27 percent. Even with the record dollar sales, the bid-to-cover ratio, that is the ratio of bids to available bonds, was only 3.39, which is the lowest level since March.

Bond Call Provisions

A callable bond is typically only callable on the anniversary date of the bond or coupon date. However, this is not a requirement as the bond indenture is an individual contract specific to that particular bond issue. A common reason bonds are issued is to finance the acquisition of another company. These bonds are generally callable if the deal falls through and the call price is often set at 101 percent of par. Bondholders can be hurt by this fixed price call provision as bond prices can rise in the intervening period between bond issue and the deal being terminated. For example, when Sysco’s bid to buy US Foods  feel through last year, bondholders lost $309 million as the bonds were called at 101, well below current market price, which had reached as high as 113.3. Now, major bondholders are pushing to change the call value of bonds issued to fund acquisitions to a make-whole call premium, which commonly used for bonds issued for purposes other than acquisitions.

AT&T Buys Time Warner

AT&T announced that it had agreed to purchase Time Warner for about $85 billion. Under the terms of the deal, Time Warner shareholders will receive $107.50 per share, half in stock and half in cash. The share price represents about a 20 percent premium to Time Warner's closing price on Friday. Even though the terms of the deal have been announced, Time Warner shareholders and the Department of Justice still must approve the deal, and the chair of the Senate subcommittee on antitrust said the committee would examine the deal as well. Of course this is not the first time that Time Warner has been acquired: In 2000, AOL purchased Time Warner for $160 billion in one of the worst deals in history. In fact, the company had a $99 billion loss in 2003 and things went so bad, the merged company eventually changed its name back to Time Warner.

Ethics In Finance

You may have noticed that there is not a lot of discussion of ethics in your textbook. A major reason is that from a financial view, if the market or society values ethical behavior, unethical behavior by a company will hurt its market value, thus defeating the goal of maximizing shareholder value. Consider the case of Wells Fargo, which is under fire for fraudulently creating up to 2 million deposit and credit card accounts. In addition to the fines paid by the company, last week, California announced that it was barring state transactions with Wells Fargo, including underwriting state bond issues. Today, Chicago announced that it was divesting $25 million that it has invested with Wells Fargo and next week Illinois plans to announce its plans to suspend Wells Fargo from the state investment network. So, while Wells Fargo may have temporarily increased value by fraudulent actions, these actions will now negatively affect shareholder value. 

Ticked Off

If you look at stock prices, you will see bid and ask prices that may only be different by a penny. What you may not realize is that this has only occurred since 2001. Prior to that, stock prices were quoted in eighths or sixteenths, so a price quote of 40 1/8 meant $40.125. Part of the reason for the change was that the bid-ask spread was the dealer profit, which also meant that investors were paying this difference. However, it has been argued that small cap stocks were hurt by decimalization because market makers have less incentive to trade less liquid small cap stocks and this has also lead to less research on small companies. Today, a pilot program was begun in which 10 small company stocks began trading on 5 cent tick sizes, meaning the smallest change in the stock price for these stocks is now a nickel. About 1,200 stocks will eventually be included in the test program, with three different groups with different trading rules. The goal of the study is to determine if increasing the tick size can lead to increased liquidity in small cap stocks.

Ticked Off

If you look at stock prices, you will see bid and ask prices that may only be different by a penny. What you may not realize is that this has only occurred since 2001. Prior to that, stock prices were quoted in eighths or sixteenths, so a price quote of 40 1/8 meant $40.125. Part of the reason for the change was that the bid-ask spread was the dealer profit, which also meant that investors were paying this difference. However, it has been argued that small cap stocks were hurt by decimalization because market makers have less incentive to trade less liquid small cap stocks and this has also lead to less research on small companies. Today, a pilot program was begun in which 10 small company stocks began trading on 5 cent tick sizes, meaning the smallest change in the stock price for these stocks is now a nickel. About 1,200 stocks will eventually be included in the test program, with three different groups with different trading rules. The goal of the study is to determine if increasing the tick size can lead to increased liquidity in small cap stocks.

CEO Pay Ratio

The ratio of CEO pay to that of other workers has been a hot button topic and reports often peg the ratio at 300:1 or higher. A controversial part of the Dodd-Frank Act requires companies to begin reporting the CEO pay relative to the median compensation at that company. In a new survey of 117 companies, the majority of the companies reported a ratio less than 200:1. Surprisingly, the financial services sector, which has drawn considerable scrutiny for CEO pay, has a lower CEO pay ratio, in part because the wages in that industry are relatively high. Industries that have high CEO pay ratios tend to have mare part-time and less-skilled employees.

Monster Write-off

Usually with a new project, a company will wait until after the project has begun to determine if the project will be successful or not. With the Paramount pictures movie Monster Trucks, the company decided that it had it had a monster flop on its hands. The movie, which has been in development since 2013, reportedly cost $125 million. Even though the movie won't be released until January 2017, Paramount announced that it would write off $115 million related to the movie. Write-offs due to poor box office receipts usually occur after a movie is released, but the move is not unprecedented. For example, in January 2015, DreamWorks wrote off $155 million due to unreleased films, which is the option to abandon. Whether Monster Trucks is ultimately released will help determine if the remaining development costs are written off.

Microsoft Pays Shareholders

Microsoft announced that it was raising its dividend by 8 percent and would buy back an additional $40 billion in shares after the company concludes its current $7.1 billion buyback, which is left from the company's previous $40 billion buyback. The buyback amounts to about 9 percent of outstanding shares, although because of the company's ESOP, the number of outstanding shares will be reduced by less than that amount. The dividend increase means that Microsoft is allocating nearly $1 billion more toward dividends this year than last. Total dividends paid by Microsoft this year should top $12 billion.

Corporate Overseas Cash Grows

The cash held by foreign subsidiaries of U.S. companies has reached a record $2.5 trillion. Microsoft and GE both hold more than $100 billion overseas, while Apple and Pfizer have $91.5 billion and about $80 billion, respectively. Overseas cash now tops cash held domestically, which reached $1.94 trillion. Of course, much of the reason for the foreign cash holdings is the U.S tax system, which taxes repatriated earnings at 35 percent, the highest corporate tax rate in the world. Although various tax breaks on the repatriation of cash have been floated, naysayers argue that the last repatriation tax break in 2004 resulted in little investment. Rather, repatriated cash was used for dividends and stock buybacks. We should point out that a repatriation tax break would actually be a boon to the IRS. Consider, if the repatriation tax rate were lowered to 15 percent, companies would only get $.85 for every dollar repatriated. Assuming a 35 percent personal tax rate, investor would only receive about $.55 in dividends after tax per dollar repatriated, an effective tax rate of about 45 percent.

Ethics And Legislation

Unfortunately, most legislation is the result if unethical behavior. As part of the Sarbanes-Oxley Act, the SEC passed Rule 13a-14 that said CEOs and CFOs are required to sign and attest that the financial statements filed with the SEC do not include material misstatements or omissions. In 2013, a judge found that the CEO and CFO of Basin Water were not liable for sham transactions since they were not directly involved in the transactions. The 9th U.S. Circuit Court of Appeals recently overturned this decision and stated that "a mere signature is not enough for compliance" and is allowing the SEC to sue for disgorgement of gains. The recent ruling makes it even more important for CEOs and CFOs to run ethical companies.

Accounting Cash Flow Makeover

The Accounting Statement of Cash Flows received a makeover as FASB updated the treatment of eight different cash flows. As you will read, whether the updates provide any meaningful change is not clear, as two Accounting professors interviewed have differing opinions on the update. Unfortunately, FASB did not address what we feel is a glaring weakness in that interest expense is still considered an operating cash flow, rather than being included correctly in the financing cash flow section.

Currency Trading Shrinks...Maybe

So how much currency do you think is traded daily? According to a recent report published by the Bank for International Settlements (BIS), average daily trading in April 2016 was about $5.1 trillion! This was down from $5.4 trillion per day in April 2013. However, if the dollar had not appreciated over the period, average daily volume would have risen about 4 percent. Spot currency trades were about $1.7 trillion per day, swaps accounted for about $2.4 trillion per day, and the rest of the trading was for other over-the-counter foreign currency derivatives. The U.S. dollar was on one side of 88 percent of trades, while the euro was on 31 percent of trades.

Negative Yield Triangular Arbitrage

A question we often get is if the material we discuss is actually relevant to the real world. However, we can see the application of triangular arbitrage with the seemingly strange desire of investors to purchase the $9 trillion in below zero interest sovereign debt. A Japanese 3-month government bill is currently returning about negative .24 percent. The buyer can borrow at the yen 3-month LIBOR, which is about negative .02 percent and receive the dollar LIBOR at .82 percent. The buyer then executes a yen-dollar swap, which results in a dollar-hedged yield on the trade of 1.24 percent. With the 3-month U.S. Treasury yield about .25 percent, and increase in annualized return of about one percent is a huge increase for portfolio managers.

High Yield Bond Defaults Expected To Rise

Standard & Poor's Ratings Services expects default rates on high yield bonds to increase to 5.6 percent over the next 12 months, which implies that 99 issuers will default. The increase is due in large part to the decline in oil prices, although a delay in an interest rate increase by the Federal Reserve could offset the increase risk. However, in large part due to the low and negative interest rate environment, investors are pouring money into high yield investments resulting in a decline in the yield spread of high yield bonds dropping from 815 basis points in February to 560 basis points in July.

Indexes Win Again

One method that has been used to examine if the stock market is semistrong form efficient is the performance of actively managed mutual funds. A recent study by S&P indicates that most actively managed mutual funds still lag the appropriate market index. From 2011 to 2015, over 88 percent of mutual funds failed to beat the S&P Composite 1500. And 84 percent of large cap funds failed to outperform the S&P 500. In fact, over the past five years, the fund category with the best performance for retail investors relative to its index was the mid-cap value category, with only about 30 percent of mutual funds in that category outperforming the S&P Midcap Value 400. Small cap growth funds were the worst, with only about 8 percent of funds beating the S&P SmallCap 600 Growth index. So, even if you don't believe the stock market is efficient, as this shows, it is very difficult to outperform the stock market.

2016 Working Capital Survey

CFO just published the 2016 working capital survey by REL Consulting. The 1,000 large U.S. companies included in the survey had about $1 trillion in excess working capital based on companies in the survey matching the top quartile performers. Overall, the cash conversion cycle increased by 2.5 days, although much of this was driven by the oil & gas sector. If this sector was excluded, the cash conversion cycle actually fell by .1 day.

The best performer in the cash conversion cycle was Murphy Oil a negative 463 days due to a payables period of 600 days! Some of the other top performers in the cash conversion cycle were Noble Energy (negative 295 days), ITC (negative 282 days), Anadarko Petroleum (negative 245 days), and Apple (negative 66 days). On the other end of the performance scale, some of the longest cash conversion cycles were at United Therapeutics (794 days), Zoetis (344 days),  Eli Lilly (277 days), and KLA-Tencor (246 days).

What Is Dell Really Worth?

While students often expect that stock price valuation should result in an exact price that everyone agrees with, this almost never happens in practice. Take the court case involving Dell's management buyout (MBO). When the MBO went through in 2103, the price calculated by management experts, through a year-long process, was $13.78 per share. However, a group of dissident shareholders had independent experts value Dell at $28.61 per share, a difference of $28 billion. In the valuation, both parties used the same components: the forecast cash flows for a specific period, the value of the cash flows beyond that period, and the discount rate (WACC). However, the experts differed on the company's capital structure, as well as the cost on equity. In the end, the court used its own assumptions and arrived at a share price of $17.62 per share. As you can see from Dell, experts can use the same technique and arrive at widely differing answers when valuing a company.

Dow 150,000!

With the DJIA at about 18,500, it may be hard to imagine the DJIA hitting 150,000, yet there is a good chance the Dow hitting or exceeding that mark in your lifetime. Even though the number may seem impossible, such is the power of compounding. As this article points out, for the Dow to hit 150,000 by 2046, the annualized return only needs to be about 7.25 percent. One important note on the Dow is that it is a price index, not a total return index, so it excludes dividends. Unfortunately, many people, including business writers, have little idea of the effect of compounding. In 1995, when mutual fund pioneer Bill Berger predicted that the Dow would hit 116,200 by 2040, the business writer audience laughed. However, based on the level of the Dow when he made the prediction, such a move only required an annual return of about 7.5 percent. While we hope you take many things from this textbook, time value of money and compounding is perhaps the most important. 

A Critical Examination Of Earnings

A recent article made us think about the importance of definitions. The article states: "After all, in the long-run stocks are fundamentally driven by earnings and expectations for earnings growth." While we agree in part with this statement, we bet most people reading the article automatically think of earnings as net income and EPS. In reality, "earnings" is often used loosely to relate more to cash flow, which is a more important driver of stock price than accounting earnings. Remember, accounting numbers can be distorted much more easily than cash flow. There is another factor that is equally, if not more important, that is the required return. In increase in the required return on the market or a stock can often have a large impact on stock prices.

Delta Loses Big On Fuel Hedge

Companies with significant risks, such as currency or commodity risks, often hedge exposure to that risk. An industry with a a history of hedging is the airline industry, with companies often hedging fuel prices. However, not all hedges make money. For example, Delta Airlines recently announced that it lost $450 million on its fuel hedges in the second quarter of 2016 as it closed all of its hedges for the year. Delta is not alone as other airlines such as U.S. Airways and United have abandoned fuel hedges, citing lower fuel prices. We would like to point at that lower prices are not a good reason to eliminate hedges. By eliminating its hedges, Delta is now subject to the risk of increasing fuel costs. A hedge is designed to reduce volatility, so a reason to not hedge is the lack of volatility, not low prices, a fact often missed. Looking at the quote in the article from CNN Money: “Fuel prices are up 60% from their January lows, but they’re down 20% from a year ago. So, even with the cost of canceling its fuel contract, Delta will save money on fuel … in the second quarter.” While we agree that Delta will make more money with lower fuel prices compared to January, if fuel prices increase, Delta will not make as much as they could have going forward.

You Can't Keep A Good Twinkie Down

In 2013, facing imminent bankruptcy, Hostess, the maker of the iconic Twinkie, was sold for $410 million. Since then, the company has been turned around and a deal was recently announced that values the company at about $2.3 billion. Private equity group Gores Group bought Hostess and will take the company public. So, while you have been able to eat Twinkies, you will soon be able to invest in them again.

SunEdison Bankruptcy

In April 2016, solar energy company SunEdison filed for Chapter 11 bankruptcy.  Yesterday, the company won court approval for a $1.3 billion operating loan, but in an indication of the contentious nature of the bankruptcy, part of the loan is designated to fund a creditor probe into the company's activities, particularly in November. During that time, the company reconstituted the boards of two yieldcos, fired the conflicts committees of those yieldcos, and named Sun Edison's own CFO as the CEO of both yieldcos. A shareholder lawsuit in the bankruptcy argues, in part, that the corporate governance was insufficient as conflicts committees were reformed when the yieldcos would not prepay for solar projects that were being developed in India.

PE Ratio Math

As we mentioned in the textbook, when you are examining ratios, it is important to not only learn if a ratio has changed, but why it has changed. A recent article about the PE ratio highlights our discussion. Most people believe that an increasing PE is due to an increasing stock price, but as with any fraction, a change can also occur due to a change in the denominator. Currently, the PE ratio of the S&P 500 is about 19, above the 5-year and 10-year averages of about 16. As a result, many market analysts are predicting a declining stock market. However, even with a falling PE ratio, stock prices can still increase as long as earnings per share increase at a faster rate than stock prices. While we are not predicting the stock market, the article does note there are many periods in stock market history that earnings growth exceeded stock price growth, PE multiples declined, yet the bull market continued.

T-Mobile's Stock Giveaway

T-Mobile recently announced that it would reward customer referrals with a share of the company's stock. When a customer refers a friend who joins the company's network, T-Mobile will credit the customer's account in the amount of the stock price at the time, and for subsequent referrals, it will give the customer a share of the company's stock. T-Mobile will not issue new shares for the stock awards, but will purchase its shares on the open market. Of course, Uncle Sam will benefit as well. While the billing credit is not taxable, the shares of stock awarded will have to be listed as taxable income by the recipients. And when the stock is later sold, taxes will have to be paid on any capital gains above the original price.

Regulation A+ Funding

The IPO market has slowed down in recent years. From 1980-1989 and 1990-1998, an average of 204 and 401 companies went public each year, respectively. Compare that to the 2001-2015 period, when an average of 119 companies went public each year. Although there are various reasons as to why the IPO market has slowed so dramatically, the end result is that raising capital has become more difficult for small companies. Regulation A+, part of the JOBS Act, allows companies to raise up to $50 million in a 12-month period under certain conditions. Importantly, Regulation A+ allows companies to raise funds from non-accredited investors. While there are several possible qualifications to be an accredited investor, such as an income of over $200,000 per year, the number of accredited investors is limited. Removing the accredited investor restriction opens funding to a much larger number of potential investors. As this article discusses, with a tight IPO market, we may soon see a surge in Regulation A funding.

Share Repurchases And Value Creation

A recent article on the McKinsey & Company website discusses the effect of dividends versus stock repurchases. We are happy to report that the article comes to the same conclusion as the textbook: Repurchases do not necessarily create value and are equivalent to paying a dividend of the same amount. However, the article does bring out a couple of interesting points. First, while repurchasing debt (re-leveraging the company) results in a higher EPS, this is offset from the lower company risk due to less debt. The value of the company is unchanged (M&M), and the PE ratio should fall. Second, a more important point is that the company should undertake profitable, positive NPV projects, if available, rather than repurchase stock. In other words, a stock repurchase is essentially a capital budgeting project. A company should only repurchase its stock if the NPV from the repurchase is greater than other capital budgeting projects. Of course, if the market is efficient, the NPV from a stock repurchase is zero.

Rogue Trader Cat Bonds

In the textbook, we discussed cat bonds. Cat bonds, which are often issued by insurers or reinsurers, have a trigger based on natural catastrophes. Credit Suisse is taking the concept of a cat bond even further. The company has approached investors about a cat bond like issue that has a trigger that would cover operational losses due to events such as rogue trading or cybercrime. A major drawback is that quantifying the costs of cybercrime is a difficult process. If the Credit Suisse operational risk cat bond succeeds, we will likely see more of these bonds in the future.

Atlanta Braves (Stock) Sinks

The Atlanta Braves have the worst record in the National League so far this year, and the tracking stock has mirrored the team's on field performance. Liberty Media, the owner of the Braves, issued tracking stock on Monday that tracks Liberty Media's Braves ownership. Tracking stock is stock that is intended to track the performance of a particular unit of the company. Tracking stock generally has no voting rights, but is often used to track the performance of specific units of the company and may occur ahead of a public offering. The Braves tracking stock was a sinker ball as the stock dropped 40 percent on the first day of trading, then about 10 percent the next day.

The Stock Market Wins Again

The first quarter of 2016 was the worst on record for large cap mutual funds as fewer than 1 in 5 beat the stock market. Growth funds performed particularly poorly, as only 6 percent beat the S&P 500. About 20 percent of value funds and 29 percent of core funds beat the S&P 500. Small cap fund managers performed better, with 80 percent beating their benchmark.

Private Company Valuation

With a public company, the price per share is easy to obtain by looking at the stock market. For private companies, stock prices are more difficult. Although you can price a private company using multiples or free cash flow techniques, the valuation of private companies by mutual funds shows how much disagreement exists. For example, cloud-based storage company Dropbox is valued at $9.40 per share by T. Rowe Price, while Hartford Financial Services Group has a value of $15.20 per share. The valuations on database software company are even wider, ranging from $8.06 to $18.55. As Jeff Grabow, head of the valuation practice at EY states, “Valuation is as much an art as it is a science.”

Bond Yield Spreads Increase

The yield spread spread between investment grade corporate bonds and non-investment grade, or high-yield bonds, is often viewed as a risk premium on credit risk. So far this year, this yield spread has increased, signalling an increased cost to credit risk. For the first quarter, $454 billion on new investment grade corporate debt was issued, an increase from the $446 billion sold in the first quarter of 2015. However, high-yield issuance was only $36 billion, down dramatically from last year's $86 billion. While low interest rates have garnered much of the attention in the press, non-investment grade bond yields have increased. For example, Western Digital recently sold $3.35 billion in bonds at a 10.5 percent coupon. The credit rating on the bond's was BB+, just one notch below investment grade.

First Quarter Returns

The S&P 500 finished up about .8 percent for the first quarter, but what were the best and worst performers? Among all assets, gold and the Bovespa (Brazilian stock market) performed the best, with both up about 15 percent for the quarter, while silver prices increased about 11 percent. Among the losers were DJStoxx 600 Banks (European banks), the FTSE MIB (Italian stocks), and the Chinese yuan renminbi.

Dividends Dry Up

Even though motorists are happy with lower gas prices, investors in oil and natural gas companies are feeling pinched away from the pump as $7.4 billion in dividends have dried up. For example, Anadarko Petroleum reduced its dividend by 81 percent and Kinder Morgan and Devon Energy both reduced dividends by 75 percent. Kinder Morgan was the largest dividend cut in terms of dollars ($3.44 billion), followed by ConocoPhillips ($2.42 billion). Chevron has chosen another alternative as it is reduced its capital spending and is considering increasing its debt to maintain the company's dividend. The steep decline in energy prices has also hit capital budgeting as oil and gas companies have resulted in the cancellation of more than $100 billion in new projects.

Cat Bonds

Historically, cat bonds have been issued by insurers or reinsurers to cover major losses. For example, a cat bond could have a trigger if the insurance company had to pay more than $2 billion in claims dues to a hurricane. However, many companies are finding that insurance companies are unwilling to cover major risks, or are charging a large premium to do so. As a result, corporations are seeking to insure losses directly with capital markets rather than through an insurance company. For example, Amtrak just issued $275 million in cat bonds that cover damage to its Northeast corridor infrastructure due to storm surges, wind damage, or earthquakes. And, last year, Kaiser Permanente issued $300 million in cat bonds to cover earthquake risk.

Activist Investing Increases

Activist investing has been on the rise in recent years. According to CFO, FactSet reported 355 activist campaigns in 2015, with 127 resulting in at least one board seat, while Ernst & Young reported 516 activist encounters. However, today's activist investors seem to be more collaborative than corporate raiders of the past. Importantly, the rise in activist investors appears to have lead to increased conversations between management and investors, which is a positive result. In fact, clear conversations between management and investors can head off confrontations as management may have information that shows an action desired by investors is a bad idea. While activist investing does not seem to be slowing any time soon, it does appear that in many cases, it has resulted in management becoming more focused on company performance and becoming more transparent.

Junk Bond Defaults Rise in 2016?

Moody's Investor Services expects default rates on junk bonds to increase to 4 percent this year, up from the 3.5 percent default rate in 2015. The default rate for all bonds is expected to be 2.1 percent for 2015. Low commodity prices, widening yield spreads, and potential interest rate increases by the Federal Reserve are reasons given by Moody's. During 2015, there were 109 corporate defaults, totaling $97.9 billion.

Valuation Models Go Up In Smoke

Students often ask us how stocks are valued in the "real world." While analysts go into more depth than we do in this textbook, commonly used models are PE ratios, EV/EBITDA ratios, and free cash flow models, which we have discussed. However, in some cases, these valuation models go up in smoke. Take a look at Cannabis Sativa (CBDS), which is trading at just under $2 per share and has a market cap of about $31 million. The company has had negative earnings for the past three years, but more importantly, had revenues of $8,000 through the first 9 months of 2015 and $7,000 in 2014! Since the company has had no earnings, the PE ratio is not reported, but the PS ratio is almost 2,000. All-in-all, CBDS is priced at an extremely high growth rate.

Warren Buffett Vs. GAAP

A basic purpose behind accounting procedures, including GAAP, is to standardize financial statements. However, many companies are currently pushing non-GAAP earnings, which can exclude a number of non-recurring items. The write-down of an asset or restructuring are common non-recurring items. Another major item than can cause a big difference between GAAP and non-GAAP earnings is stock-based compensation, often in the form of employee stock options or restricted stock. As Warren Buffett argues: "If compensation isn't an expense, what is?"  We would advise you to learn about accounting, not only because a lot about a company from reading its financial statements, as Buffett warns "Accounting tells you a lot and it can be used in many ways to deceive."

Correlations They Are A Changin'

From what you have learned about what is often referred to as Modern Portfolio Theory (MPT), a diversified portfolio can significantly lower the risk of your investment. To create a diversified portfolio, you should choose assets with low correlations (covariances). However, this can be more difficult than it seems. A recent article on Bloomberg discusses how correlations between various asset classes have changed over time. For example, if you look at the 1988 to 1997 period, the correlation between the S&P 500 and the S&P GCSI Total Return Index, which measures the return on a broad class of commodities, you would find the correlation between these two asset classes was –.20, a very low correlation that would provide substantial diversification benefits. However, in the past 10 years, the correlation between these two asset classes has increased to .50, which would only provide moderate, if any, diversification benefits. We agree with the author's conclusion that even with a high correlation, owning a greater variety of assets is safer than owning only a few assets.  However, we would like to extend this conclusion and state that you should rebalance your portfolio based on the changing correlations.

Ratios And Lease Accounting

Beginning December 15, 2018, new FASB accounting standards will require public companies to include both capital and operating leases on balance sheets. Currently, only operating leases are reported. The effect of this new standard will be an increase in the reported value of assets and liabilities, which will result in an apparent overnight jump in the book value of many companies. According to one estimate, over $1 trillion will be added to balance sheets. Because of this increase in assets, several commonly ratios such as return on assets and the equity multiplier will be dramatically changed for companies that use lease financing. Of course, trained analysts have already been adjusting balance sheets for estimated lease liabilities. Although not mentioned in the article, there could be unintended consequences. For example, if a company has bonds containing a covenant that prohibit the company from exceeding a specific debt-equity ratio, the increase in liabilities could potentially cause a breach of that covenant.

It's Market Efficiency By A Length - Or Several Lengths Now

Back in 2013, we posted about Warren Buffett's bet with the founders of the Protégé Partners hedge fund that the S&P 500 would outperform a hedge fund index chosen by Protégé Partners over a 10-year period. At that time, the S&P had cumulatively outperformed the hedge fund index by about 8.5 percent. Even though the hedge funds outperformed the S&P 500 in 2015, the Vanguard Admiral index fund is up a  cumulative 65.7 percent in the last eight years, while the hedge fund index is up only 21.9 percent. One scenario for a possible comeback for the hedge funds, which is outlined by Ted Seides, the man who engineered the bet for Protégé, is a severe market downturn. Of course, he added about such a circumstance: "No one wins when that occurs."

Negative Corporate Bond Yields

Last year, we posted about how the size and number of negative interest rates were increasing in Europe, and how one member of the Federal Reserve was pushing for negative U.S. interest rates. Since then, negative interest rates have increased again in size and number. For example, Sweden increased its central bank rate from negative .35 to negative .50 percent and Japan moved its central bank interest rate into negative territory. What is also surprising is that the market has joined into the negative interest rate fray as 2-year Swedish government bonds yield negative 1.12 percent. And, recent comments by Janet Yellen indicate that even the U.S. Federal Reserve may consider negative interest rates, although the legality of such a move in the U.S. is not clear. While negative interest rates by central banks are uncommon, they are not without precedent. What is without precedent is negative corporate bond yields, which happened last week as the yield to maturity on Nestle corporate bonds went negative!

Golf And Investing

A recent article discusses how golf and investing may be related, but also talks about several behavioral biases that can affect investors. For example, loss aversion shows up in golf as golfers are more likely to make a putt of the same difficulty for par than they are to make the putt for birdie (one under par). Another behavioral bias discussed is probability neglect, that is, people tend to worry about bad outcomes that have a very low probability, such as a plane crash or losing 40 percent of their investment. By overweighting events with a low probability, investors can incur large opportunity costs. Finally, an informational cascade occurs when investors believe the signals from other investors, even if they do not agree. For example, if a stock you view positively begins to drop, you may sell based off what other investors are doing, rather than what your research has revealed to you. As the article notes, smart investors aren't loss averse, they don't neglect probability, and believe in their own analysis. 

Star Fund Managers Stumble

There is much disagreement over whether the stock market is efficient and what level of efficiency exists. Even if it is argued that the market is inefficient, it is still very difficult to identify those who can consistently beat the market as the recent performance of several well-known star mutual fund managers shows. For example, Bill Miller showed holes in his performance in 2008 when the Legg Mason Capital Value Trust fell 55 percent. Even worse, as the S&P 500 has fallen about 9.2 percent this year, the Legg Mason Opportunity fund, which he currently manages, is already down about 28 percent. Similarly, the Baron Partners fund is down about 24 percent for the year, the Federated Kaufman fund is down about 21 percent, and the Jacob Small Cap Growth fund is down about 27 percent. Each of the managers of these funds has been touted as a star manager during their career, but it appears none will be a star this year.

Future Interest Rates

We are often asked where to find the market expectations for stock returns. While there is no easy answer to that question, the market expectations on future interest rates are much easier to find. Recent comments by Janet Yellen indicated that there was a low probability of an increase in the Fed Funds rate. As the article indicates, the probability that interest rates will increase can be can be seen by Fed Funds futures, If you are not familiar with futures contracts, they are contracts traded and priced today that will be executed at some point in the future. Although there is more that goes into futures prices, futures prices can be used, in part, as the market expectation of the future price. And to show you how quickly markets can adapt, when the original Yahoo! Finance article was written, the probability that the Fed would raise interest rates by February 2017 was about 27 percent. As this is written, one day later, the probability has dropped to 6 percent.

Oil Prices Hurt Capex

Capital expenditures are affected by many factors, including corporate profits and sales. The recent drop in oil prices has caused a sharp drop in capital expenditures by oil companies. For example, BP dropped its capital expenditures for 2015 to $18.7 billion, significantly below its planned capex of $24-$26 billion. ExxonMobil dropped its 2015 capex by 25 percent to $23.2 billion, and Anadarko plans to drop its capex for 2016 to one-half of its initial budget. 

Hedging Exchange Rate Risk

As we mentioned in the textbook, companies often want and need to hedge exchange rate risk. A recent article in Treasury and Risk gives a good primer on methods to hedge exchange rates. First, a company must have an accurate forecast of foreign cash flows. With any forecast, GIGO (garbage in, garbage out) applies to hedging exchange rates. If the forecast is inaccurate, the company will over hedge or under hedge its exchange rate risk. Another suggestion made in the article is a layered hedge, which may help to reduce volatility. This means that a company does not hedge all of its exchange rate risk at a particular point in time, but rather hedges part of the expected exchange rate risk, then adds to the hedge over time as the date of the currency exchange approaches. If you are interested in hedging exchange rates, we suggest you read further. 

Timing The Stock Market

Students (and a lot of investment professionals) think that timing that market, that is leaving the stock market before it goes down, is a good strategy. And while we would like to sell our stocks before a price drop, it is easier said than done. A recent article highlights the danger of missing the good days in the stock market. Fidelity Investments calculated the return from investing $10,000 in the S&P 500 from January 1, 1980 through March 31, 2015. If you were invested every day, your portfolio balance would have grown to $503,741. However, if you missed the five best days in the market, your balance would have been about $309,431, a 40 percent decrease! Missing the 50 best days would have dropped your portfolio balance to $41,803, or about eight percent of the value of being invested every day. There are about 252 trading days per year, so missing 5 days (or 50 days) out of about 8,800 days can have a serious impact on the value of your investments.

Divestitures Expected To Increase

A recent survey by EY indicates that corporate divestitures are expected to increase in the next two years. Forty nine percent of the companies surveyed indicated possible divestitures in 2016, and only five percent of companies did not plan a divestiture over the next two years. Seventy percent of the companies that are planning a divestiture expect to reinvest in core businesses, invest in new products and markets, or make an acquisition. Divestitures have proven to be a method to increase shareholder wealth in recent years as companies that have divested more than 10 percent of their value have outperformed the stock market by more than six percent.

Companies Plan To Decrease Cash

In the second quarter of 2015, S&P non-financial firms held $1.4 trillion in cash. And the percentage of companies that increased cash and short-term investments was expected to increase in the fourth quarter of 2015. However, a recent survey indicates that more companies are expected to decrease cash in the first quarter of 2016 than companies that increase cash balances. Overall, Treasurers appear to be doing very little with cash, waiting to see what happens in October when the SEC's new money market rules take effect.

American Airlines Political Risk

Although we don't delve deeply into political risk as it is beyond the scope of the textbook, it is a risk borne by multinationals as American Airlines found out. American recently announced that it would take a $592 million special charge in the fourth quarter as a result of Venezuelan currency controls. Venezuela's socialist government forces airlines to sell airfares in bolivars, but makes conversion of the bolivars into U.S. dollars difficult. As a result, American has bolivars trapped in Venezuela.

Welcome

If you are reading this post, you likely have just begun your Corporate Finance class. While you may be apprehensive about the topic, we believe you can learn a lot of very applicable and important topics, not only for your business acumen, but skills that will help you in important personal financial decisions, such as paying points up front to reduce your mortgage interest rate, or how much your repayments will be increased if you take out that extra student loan. Or, should you take annual cash payouts or lump sum if you hit the Powerball jackpot tonight? We wish you well in your Finance class and believe this textbook will increase your understanding of Finance and won't be in  Japanese to you at the end of the semester.

David Bowie: Financial Genius

We were saddened to hear of the death of groundbreaking singer and musician David Bowie. And while you may know him from Ziggy Stardust and the Spiders from Mars and his numerous other works, you may be surprised that he was pretty good in finance as well. In 1997, Bowie was the first to issue "celebrity bonds," better known as "Bowie bonds." He sold the royalties from 25 albums released from 1969 to 1990 for $55 million to Prudential as bonds with a 7.9 percent coupon rate. Because the bonds carried interest, they were considered a loan, which meant that Bowie got the money without the tax liability. Then, in 2000, Bowie launched BowieBanc in conjunction with USBancshares.com, although that venture was short-lived. Fortunately, we predict the legacy of David Bowie will be with us much longer.

The Return On Powerball

At the current projected value of $450 million, tonight's Powerball jackpot will be the sixth largest lottery payout in history. The winner has a choice of $275.4 million today today, or 30 payments of $15 million with the first payment today. So, what is the break-even interest rate on this choice? Verify for yourself that it is about 3.8 percent. Good luck and we hope you are "stuck" with this choice.

IPO Investing

You have probably read the box in the textbook from our favorite IPO guru, Professor Jay Ritter. Recently, Dr. Ritter wrote an article for Forbes that discusses a specific type of IPO that has proven profitable for investors. Growth capital-backed IPOs, which are companies backed by venture capitalists or private equity firms and invest in tangible assets, have proven to be winners. Since 1980, these firms have a 3-year average return of 61 percent if bought at the end of the first day of trading. Dr. Ritter's recommendations for 2014 had an 11 month return of 20.6 percent, which is a return we would like. So which 2015 IPOs does he recommend? Summit Materials (SUM), DavidsTea (DTEA), Blue Buffalo Pet Products (BUFF), and Surgery Partners (SGRY) all meet the growth-capital IPO criteria.