Thursday, 27 October 2016

The Overwhelming Evidence that Market Leverage Significantly Destroys Shareholder Value

I have recently written a paper, entitled 'Leverage as a Weapon of Mass Shareholder-Value Destruction; Another Look at the Low-Beta Anomaly' which can be downloaded here.

It challenges the idea that adding debt to a balance sheet in any way makes a company more efficient - in fact it suggests that it leads to significant loss of shareholder value. It uses the fact of the (very well researched) 'low-beta' anomaly, which shows that higher risk stocks significantly under-perform lower risk stocks in the long term; the current explanations for which are based on the idea that investors mis-price these stocks for behavioral reasons. I show that this can not possibly explain the anomaly and that there must be a destruction of shareholder value of the order of around 8-10% per year between the highest and lowest leveraged stocks.

This goes against all shareholder activist lobbying that adding debt is good. It is good for management, and it is good for the financial sector but it is not good for shareholders.

A quote from the paper explaining possible reasons is included below:
Whatever the source of the market leverage, some effects are the same. Since the market tends to rise in the long run, a firm with more market leverage would expect higher profits per share and larger share price increases. These expected higher profits and higher share prices have nothing to do with the skill of the company's management; they are merely a consequence of higher leverage.

Unfortunately, history shows that managers as a group tend to lack the necessary humility to identify leverage as the driver behind their better returns. If hubris is not a universal trait amongst managers of a leveraged ship riding a rising tide, at the very least one could point to numerous examples where it exists. Over-confidence in one's managerial skill can result in sub-optimal decision making, perhaps culminating in purchases of other companies at inflated valuations in the belief that the magic touch can be applied to them too. There is no doubt that many mergers and aquisitions are value destroying (see Moeller et al. 2004 for market reaction to acquirers); it would make sense that the ones most likely to be most value destroying are the ones where managers had false belief in their skill. Easy success can definitely lead to sub-optimal decision making, and it would be no surprise if it turned out that this were the case in practice.
Unearned success for the company may lead to other suboptimal decisions. The board may decide they need to travel by private jet. The CEO may want to sponsor a Formula One team. Offices may be upgraded. If a company is doing better than its competitors, very few people will notice that it is not doing quite as well as it should be, given its leverage. 
On top of this, manager compensation is often linked to share price or profit targets. This means that even though managers display no more skill, in a company with higher leverage, shareholders will pay more money to executives. These payments are not recouped if the share price then falls, so even if the market as a whole does not go up on average, the higher the leverage, the higher the expected payouts. This pay structure intrinsically encourages more leverage, since the managers are effectively being given an option whose value, like that of all options, is higher under conditions of higher volatility.
Similarly costly, debt issuance means large fees to bankers. In general, financialisation of a company in this way can result in higher fees paid to intermediaries. These arise both as direct charges for debt issuance (with the initial debt offering and subsequent refinancing), and from increased need for costly underwriting of rights issues or other equity capital raising.
High interest payments can often lead to a company cannibalising research and longer-term investment in order to meet payments and maintain dividends. High debt companies may be more short-term in their outlook. And although dividends are more flexible in a downturn, linking company payouts to performance of the company, debt interest must always be paid regardless of the longer-term consequences.

Another possible reason for suboptimality of high beta portfolios comes from the idea that the market volatility of a company can be a lot higher than the fundamental volatility of the company’s prospects. The fact that many CTA funds successfully trade momentum strategies suggests that this is the case for indices. The momentum of single stocks relative to the index is documented by, for example, Moskowitz et al (2012). The tendency of share prices to overshoot on both the upside and the downside is a result of of investor herding and risk aversion, as well as general uncertainty and the impossibility of accurately identifying fundamental value. At the same time, the future of a company's share price is path dependent. If the share price comes close to zero, bond holders will force the company into administration. If it subsequently turns out that the market had moved too far, it is too late for the shareholders. Rising leverage therefore increases unnecessary bankruptcies. If it is true that market volatility is higher than fundamental volatility, then the bond holders' option is worth more and the shareholders (who are writing the option) lose out.
Often there may be tax benefits for choosing debt over equity (eg. Graham 2000). Whatever benefits these give to shareholders, however, appear to be dwarfed by the costs.
It should be noted that the argument here is not whether returns can be increased by taking on debt. In general, taking on moderate levels of debt will increase company profitability per share. But if an investor wishes to take higher risk and make higher returns, then they can do this by borrowing money on their own account and investing in lower-risk shares. The point is that investors may be better off borrowing themselves than allowing the company to borrow on their behalf. In fact, fund managers can often borrow at a lower rate than corporates because of the liquidity of their underlying positions. The evidence appears to suggest that by borrowing on behalf of the investors, managers are increasing their own compensation and possibly running the company suboptimally. 

The abstract is as follows:

The 'low-beta' or 'low-volatility anomaly' is one of the most researched in the field of 'alternative beta'. Despite strong published evidence going back to the 1970s that high beta/volatility stocks underperform relative to expectations generated by the Capital Asset Pricing Model (CAPM), the anomaly still persists. The explanations given for this are all behavioural; that investor biases lead to overpricing of high volatility stocks. This paper shows that investor biases cannot be the explanation for the anomaly. Instead, it is proposed that the anomaly stems from a destruction of shareholder value. The strong implication is that the more market leverage a firm has, the more shareholder value is destroyed. Although the prevailing view for a long time has been that adding debt is good for shareholders, making balance sheets more 'efficient', there is in fact a considerable volume of evidence that the opposite is true; evidence which has been incorrectly interpreted for many years. Some possible mechanisms for this shareholder-value destruction are proposed. 

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