Knowledge that Transforms

This paper examines whether firms in noncompetitive industries benefit more from good governance than do firms in competitive industries. We find that weak governance firms have lower equity returns, worse operating performance, and lower firm value, but only in noncompetitive industries. When exploring the causes of the inefficiency, we find that weak governance firms have lower labor productivity and higher input costs, and make more value‐destroying acquisitions, but, again, only in noncompetitive industries. We also find that weak governance firms in noncompetitive industries are more likely to be targeted by activist hedge funds, suggesting that investors take actions to mitigate the inefficiency.

Financial firms raise short‐term debt to finance asset purchases; this induces risk shifting when economic conditions worsen and limits their ability to roll over debt. Constrained firms de‐lever by selling assets to lower‐leverage firms. In turn, asset–market liquidity depends on the system‐wide distribution of leverage, which is itself endogenous to future economic prospects. Good economic prospects yield cheaper short‐term debt, inducing entry of higher‐leverage firms. Consequently, adverse asset shocks in good times lead to greater de‐leveraging and sudden drying up of market and funding liquidity.

The Homeland Investment Act provided a tax holiday for the repatriation of foreign earnings. Advocates argued the Act would alleviate financial constraints by reducing the cost to U.S. multinationals of accessing internal capital. This paper shows that repatriations did not increase domestic investment, employment, or R&D—even for firms that appeared to be financially constrained or lobbied for the holiday. Instead, a $1 increase in repatriations was associated with a $0.60 to $0.92 increase in shareholder payouts. Regulations intended to restrict such payouts were undermined by the fungibility of money. Results indicate that U.S. multinationals were not financially constrained and were well‐governed.

I find that economically meaningless index labels cause stock returns to covary in excess of fundamentals. S&P/Barra follow a simple mechanical procedure to define their Value and Growth indices. In doing so, they reclassify some stocks from Value to Growth even after their book‐to‐market ratios have risen, and vice versa. Such stocks begin to covary more with the index they join and less with the index they leave. Backdated constituent data from Barra reveal no such label‐related shifts in comovement during the 10 years prior to the actual introduction of the indices in 1992.

I study the effects of risk and ambiguity (Knightian uncertainty) on optimal portfolios and equilibrium asset prices when investors receive information that is difficult to link to fundamentals. I show that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility. Specifically, when news is surprising, investors may not react to price changes even if there are no transaction costs or other market frictions. Moreover, I show that small shocks to cash flow news, asset betas, or market risk premia may lead to drastic changes in the stock price and hence to excess volatility.

We study the marginal tax rate incorporated into short‐term municipal rates using municipal swap market data. Using an affine model, we identify the marginal tax rate and the credit/liquidity spread in 1‐week tax‐exempt rates, as well as their associated risk premia. The marginal tax rate averages 38.0% and is related to stock, bond, and commodity returns. The tax risk premium is negative, consistent with the strong countercyclical nature of after‐tax fixed‐income cash flows. These results demonstrate that tax risk is a systematic asset pricing factor and help resolve the muni‐bond puzzle.

We examine how leveraged buyouts from the most recent wave of public to private transactions created value. Buyouts completed between 1990 and 2006 are more conservatively priced and less levered than their predecessors from the 1980s. For deals with post‐buyout data available, median market‐ and risk‐adjusted returns to pre‐ (post‐) buyout capital invested are 72.5% (40.9%). In contrast, gains in operating performance are either comparable to or slightly exceed those observed for benchmark firms. Increases in industry valuation multiples and realized tax benefits from increasing leverage, while private, are each economically as important as operating gains in explaining realized returns.

Recent studies show that single‐quarter institutional herding positively predicts short‐term returns. Motivated by the theoretical herding literature, which emphasizes endogenous persistence in decisions over time, we estimate the effect of multiquarter institutional buying and selling on stock returns. Using both regression and portfolio tests, we find that persistent institutional trading negatively predicts long‐term returns: persistently sold stocks outperform persistently bought stocks at long horizons. The negative association between returns and institutional trade persistence is not subsumed by past returns or other stock characteristics, is concentrated among smaller stocks, and is stronger for stocks with higher institutional ownership.