Tuesday, August 13, 2013

Finance is Forward Looking

Here is the abstract of some recent research on hedge fund activism.

The Long-Term Effects of Hedge Fund Activism

It's funny that this is a surprise.  Of course value creation is persistent.  To believe anything else would require a complete and utter rejection of the efficient markets hypothesis at all levels.  Of course prices reflect herding behavior and subjective, fickle discount rates.  But, I think it would be hard to model a functional market that is systematically and persistently ruled by predictable, temporary fluctuations in value perception. The best way for an activist to increase the price of their stock is to increase the value of the firm.

The idea that the market is full of "pump & dumps" and a next-quarter myopia is a belief that managers are happy to play to because it gives them an excuse for butt covering, and it's something the public (including a lot of finance folks) are happy to believe because right-thinking people are supposed to be cynical about finance.  And, there is just enough evidence to back it up because sometimes one of the few indicators we have for future performance is current performance.  If a firm has surprising short term performance, most of the added value the marginal investor is going to factor in is going to come from improved performance expectations in the far future.  I don't think this phenomenon can be measured in any way.  I'd love to know if someone has tried.

Here is a study that found lower expected returns on firms that were engaged in aggressive accounting.  There is some room for markets to be fooled by non-transparent aggressive management in the short run.  But, even here, we will tend to see this effect strongest in very quickly growing firms with uncertain futures - a situation where small changes in the trajectory of expected future profits will have large valuation consequences.

Just as often, I find that the market is skeptical of short term performance, so that many times obviously superior equities are available for some time after results have shown a positive surprise.  Really, the well-documented momentum effect is a kind of anti-short run bias.

All of this really comes down to reputation.  A management team might be able to trade in their reputation to trick the market for a few quarters, but a management team with a damaged reputation is just as likely to shout clearly positive outcomes to a market that's not interested in hearing it until they see a few more quarters of proof.  Eventually, the reputational capital shifts to reflect reality.

Prices do fluctuate as a result of these problems around some intrinsic value, but the fluctuations are a part of a complicated puzzle of incentives and signals.  The market that always short-sightedly chases a couple cents from the next quarter is a caricature.

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