Knowledge that Transforms

This article proposes a new method for examining the impact on a firm’s investment of uncertainty reflected in its stock-return volatility. We simultaneously address the endogeneity of uncertainty and mismeasurement in Tobin’s Q , but earlier empirical work often neglects one of the two issues. Our nonparametric estimates further suggest that the relation between investment and uncertainty is significantly decreasing and strongly concave. This result contrasts with the existing literature that widely adopts linear regressions. Ignoring nonlinearity or measurement error in Q can lead to a substantial estimation bias. However, the bias due to the endogeneity of uncertainty is small.

Using a novel data set of over 3,500 public and private firms, we construct the network of executive and director connections prior to the 1929 financial market crash. We find that more connected firms have 17% higher 10-year survival rates. Consistent with a working capital channel, the results are strongest for small, private, cash-poor firms, and firms located in counties with high bank suspension rates. Moreover, connections to cash-rich firms that increase accounts receivable matter the most. Our results suggest that network connections can play a stabilizing role during a financial crisis by easing the flow of capital to constrained firms.

Analyzing 48 foreign exchange (FX) rates and 1.2 million FX-related news articles over a 35-year period, using digital textual analysis, we find that a currency reversal investment strategy that buys (sells) currencies with low (high) media sentiment offers strong positive and statistically significant returns and Sharpe ratios. The results are robust and the strategy adds value over other currency premia determinants. Analysts’ forecasts systematically mispredict the reversal strategy. This is the first article to show that price reversals based on media sentiment are a well-defined feature of the FX market.

I show that hedge funds react to unrealized losses on their passive positions by engaging with the management. The hedge fund managers’ psychological response is consistent with cognitive dissonance: They blame the firms’ management and switch to activism. The loss, which is hedge fund-investment specific, is distinct from economic factors such as the firm’s industry-adjusted performance. Loss-driven activism is more likely to be unfocused on specific issues and results in worse firm performance. This study shows that an overlooked consequence of unrealized losses is to trigger an active engagement with the firm.

A short squeeze occurs if borrowed shares are recalled and the short seller is unable to find another source of shares. This forces the short seller to terminate a position early. For most stocks, the probability of a short squeeze is very low. Short squeezes, however, are not unusual for the hardest to borrow stocks. For these stocks, trading costs from squeezes are high and have a significant impact on the returns to short selling. For hard-to-borrow stocks, short sellers also miss out on significant abnormal returns because squeezes force them to close positions.

In this study, we investigate whether and how trust between board members and the CEO (board–CEO trust) affects the performance of mergers and acquisitions. Contrary to conventional wisdom, we find that firms with higher levels of board–CEO trust exhibit poor M&A performance. High trust is associated with low acquisition announcement returns, long-term stock return performance, and post-deal operating performance. This negative effect of board–CEO trust is more pronounced among acquiring companies prone to agency problems. Our results suggest that, in the institutional setting of corporate boards, high trust can be too much of a good thing.

We identify Industry-Neutral Self-Financed Informed Trading (INSFIT) as stock trades financed by offsetting, equivalent dollar-denominated stock trades in the same industry. Approximately 37% of short-term mutual fund trading profits can be attributed to these trade pairs. Consistent with informed trading, INSFIT precedes unusually high media coverage for the underlying stocks. The trades underlying INSFIT are also larger as the release of stock-level news becomes more imminent. Both relative valuation and the hedging of industry exposure motivate INSFIT’s industry neutrality. While INSFIT positively impacts fund performance, active fund managers who execute INSFIT more aggressively obtain smaller trading profits per execution.

This study introduces a new measure of ex ante litigation risk using scrutiny of SEC filings by the source of securities litigation (plaintiffs’ lawyers) to reduce measurement error, relative to existing measures. We show that plaintiff-lawyer views proxy for the largely unobservable factors that make firms more likely to face litigation risk. Lagged views precede the public bad news revelation that triggers litigation and predicts future realized litigation risk (i.e., securities class actions filings and plaintiff-lawyer investigations) and stock market outcomes. Finally, we provide new insights into the plaintiff-lawyer case selection process that otherwise cannot be observed.

We examine the role of peer (e.g., Lipper manager indices) versus pure (e.g., S&P 500) benchmarks in fund manager compensation. We model their impact on manager incentives and then test those predictions using novel data. We find that 71% of managers are compensated based on peer benchmarks. Consistent with the model, peer-benchmarked fund managers exhibit higher effort generating higher gross performance and collect higher fee income. Analyzing advisors’ choice between benchmark types, we show that peer-benchmarking advisors cater to more sophisticated and performance-sensitive investors, and are more likely to sell through direct channels, consistent with investor heterogeneity and market segmentation.

We show that merger announcement returns account for virtually all of the measured size premium. An empirical proxy for ex ante takeover exposure positively and robustly relates to cross-sectional expected returns. The relation between size and expected returns becomes positive or insignificant, rather than negative, conditional on this takeover characteristic. Asset pricing models that include a factor based on the takeover characteristic outperform otherwise similar models that include the conventional size factor. We conclude that the takeover factor should replace the conventional size factor in benchmark asset pricing models.