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UBC Theses and Dissertations

Interrelationship between investors portfolios of stocks and firms' portfolios of assets McNeeley, Lennox John Dick 1969

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T H E I N T E R R E L A T I O N S H I P B E T W E E N I N V E S T O R S ' P O R T F O L I O S O F S T O C K S A N D F I R M S ' P O R T F O L I O S O F A S S E T S by L E N N O X JOHN DICK M c N E E L Y B. Com. University of Br i t i sh Columbia, 1968 A THESIS S U B M I T T E D IN P A R T I A L F U L F I L L M E N T O F T H E R E Q U I R E M E N T S F O R T H E D E G R E E O F M A S T E R I O F BUSINESS A D M I N I S T R A T I O N in the Department of Commerce and Business Administration We accept this thesis as conforming to the required standard T H E U N I V E R S I T Y O F BRITISH C O L U M B I A September, 1969 In p r e s e n t i n g t h i s t h e s i s i n p a r t i a l f u l f i l m e n t o f t h e r e q u i r e m e n t s f o r an a d v a n c e d d e g r e e a t t h e U n i v e r s i t y o f B r i t i s h C o l u m b i a , I a g r e e t h a t t h e L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r r e f e r e n c e a n d s t u d y . I f u r t h e r a g r e e t h a p e r m i s s i o n f o r e x t e n s i v e c o p y i n g o f t h i s t h e s i s f o r s c h o l a r l y p u r p o s e s may be g r a n t e d by t h e H e a d o f my D e p a r t m e n t o r by h i s r e p r e s e n t a t i v e s . I t i s u n d e r s t o o d , t h a t c o p y i n g o r p u b l i c a t i o n o f t h i s t h e s i s f o r f i n a n c i a l g a i n s h a l l n o t be a l l o w e d w i t h o u t - m y w r i t t e n p e r m i s s i o n . D e p a r t m e n t o f (l^cr^i^r^_sj^j^e o^^. ^^^->~-z>^ T h e U n i v e r s i t y o f B r i t i s h C o l u m b i a V a n c o u v e r 8, C a n a d a A B S T R A C T It is widely recognized that a corporation's cost of capital cannot be determined until an analysis is made of how the market values the f irm's common stock. There is , however, no widely-accepted theoretical apparatus linking the market valuation of common stock to a corporation's investment-opportunities schedule, dividend payout function, and capital structure. It is the position of this paper that a fundamental reason for the current stalemate over the theoretical apparatus is the single equation nature of recent capital-budgeting and security-valuation models. Since one equation can deter-mine at most one unknown, manipulation of these models has, for the generation of results, necessitated a variety of ad hoc restrictions to reduce each equation to a relationship between two variables only - as, for example, between share price and capital structure. Two consequences emerge: (a) Since there is no consensus, such restrictions tend to be different, (b) More importantly (sic), such variables as share price , capital budget, dividend payout, and capital structure are in the real world jointly determined, and the suppression of this dependency unnecessarily l imits the relevance of any theoretical results. 1 Similar ly , this thesis explores many of the facets of finance involved in the interrelationship between investors' portfolios of stocks and f i rms ' portfolios of assets. L e r n e r and Carleton r e -jected the one equation model in favour of a two equation model and although a significant contribution to finance was made, again an attempt to simulate real world behaviour by means of equations Eugene M . Lerner and Wi l lard T. Carleton, "The Integra-tion of Capital Budgeting and Stock Valuation, " The Amer ican  Economic Review, L I X (September, 1964), p. 683. resulted in the suppression of reality in favour of mathematical rigour. It is this thesis' contention that equations in modern finance have facilitated the division between practitioners and theoreticians, thwarting developments in finance, and thus re tard-ing growth in industrial development. This division has been furthered by the fact that some academics have never fully under-stood the same business decisions that their models seek to describe. Compounding this problem, at present, research is being conducted which only serves to extend the mistakes made in earl ier research. Consequently, the motive of this paper is not to build another extension or test an existing model but to question the very manner in which some financial models are designed. The model which comes in for the most c r i t i c i s m is that of Markowitz whose work was formulated on investment behaviour which is now obsolete; unfortunately his paper has formed the basis of so much later work in finance. After some of the weaknesses in old precepts have been shown, new ideas will be developed in an attempt to integrate investors' portfolios of stocks and f i rms ' portfolios of assets in a dynamic setting. Although the paper may lack mathematical rigour, it is pract ical in content. There is no attempt to offer a complete solution only to point out how the method of design of models has been faulty and has not shown the realities of real business situations. The purpose of the paper is to show that academics built some models before they should have, before they understood real world behaviour, and before they had investigated the foundations they were building upon. The real world should be more fully investigated, for only through this means will a dynamic model for financial analysis ever be developed that can truly benefit finance and industry. The need for such a model has been furthered by the fact that computers are now available that will facilitate the computations that such a model when developed would require. There has also been a growing awareness in financial c irc les that the period f rom 1963 to date was a time "in which both c lass ica l economics and decision theories were inadequate to ex-plain some of the major events" in the business world. Over these years the major corporate decisions have come from the use of exotic financial instruments as weapons in takeovers, as devices for spinoffs, and as vehicles for financing new concepts. Yet financial theory as taught and developed in our business schools ^John McDonald, "The New Game of Business, " Fortune, L X X I X (May 15, 1969), p. 143. has largely ignored this new era of finance in favour of developing decision models concerned with internal growth. With the demonstration of the power of financial instruments by certain companies in the last few years, the whole business world has awakened to the fact that "one good (financial) deal is 3 usually worth five or ten years of bri l l iant operations" and that "an overpriced stock in the hands of an astute user of that stock is 4 a key corporate resource. " This realization of the power of the new finance is demonstrated by the executive below who states: When L - T - V (Ling - Temco - Vought) took a swing at J . & L . (Jones & Laughlin Steel), and Wall Street with its funny money helped them along. . . . I looked into our plans. I've decided what the game is about. It used to be increased earnings per share, improved return, a bigger share of profitable products --these are all important--but the reality of the game from the chief executives point of view is that if you are a single-product company, you have no choice about where to get a better return or greater earnings per share. So the game is to diversify your efforts, choosing markets and products so that you always have a choice about where to put your money at any one time. ^ Yet theory has yet to follow the business world and the result has been that the aggressive f irms which most need direction to Mart in J . Whitman, " A Road to Instant Wealth--Disparit ies between Market Reality and Corporate Reality" (talk to the Restau-rant Executive Institute, Hotel Warwick, New York City, August 15, 1968), p. 18. 4 Ibid. McDonald, op. cit. , p. 286. help them have no theory to fall back upon. Also finance school are not preparing students for the responsibilities which will fa them in business later. It is therefore the intention of this thes to develop a new hypothesis to describe the new financial era. A C K N O W L E D G M E N T The author wishes to thank the University of Br i t i sh Columbia and McDonald Investments Ltd. for their financial support. The thesis has attempted to integrate both pract ical and theoretical financial behaviour and in this respect the author wishes to thank Dr. James T. C. Mao, Dr . W. Winiata, and Dr. Sarndal for their contributions to the theoretical side and M r . Hugh McDonald and M r . James Harvey of McDonald Investments Ltd. for their contr i -butions to the pract ical side. A special thanks to M r s . J e r r y McDonald and Miss M . K. Douglas for their typing skills and patience. The author is indebted to the late Dr. Les l i e Wong for not only initiating the thesis but also for directing the author's choice of careers . LIST O F F I G U R E S F I G U R E P A G E 1. Determining the optimum portfolio for an investor according to the hypothesis of Markowitz 1 2. F igure showing two alternative portfolios as visioned by Markowitz 17 3. The trade-off between return and r i s k as seen by an investor 45 4. Diagram showing the change in the trade-off between r i s k and return as would occur at the height of a speculative market 46 5. F igure demonstrating the recent appreciation of smal l companies relative to stocks of larger companies 49 6. Diagram showing the case when the returns of all r i sk classes approach one another 51 7. Number of New Offerings over $300, 000 in the United States f rom 1953 to 1969 56 8. Number of mergers in the United States for period 1950-1968 65 T A B L E O F C O N T E N T S P A G E C H A P T E R I M A R K O W I T Z A N D T H E F I R M 1 The hypothesis of Markowitz for the investor 1 Applying the Markowitz hypothesis to the f i r m 4 Diversif ication at f i r m and investor levels 6 C H A P T E R II M A R K O W I T Z A N D I N V E S T O R S ' P O R T F O L I O S 13 The investment practis es of 1950. . . . 13 Abet ter return than the efficient set . . 16 Objections to the Markowitz hypothesis.. 21 Changing investment behaviour 25 C H A P T E R III C H A N G I N G A T T I T U D E S O F I N V E S T O R S . 27 Why the switch to performance investing 28 Correlat ion between high turnover and superior performance 28 Growing competition for investors' monies 29 P A G E Management fee bias 32 Performance versus r i s k 37 C H A P T E R IV A N E W I N V E S T O R B E H A V I O U R M O D E L . 40 Could al l stocks have the same return regardless of r i sk class 40 Money flows on the stock market . . . . 42 The changing trade-off between return and r i s k 44 C H A P T E R V E C O N O M I C I M P L I C A T I O N S O F T H E M O D E L F O R B O T H T H E I N V E S T O R A N D T H E F I R M 51 The investor 51 Owner of a private company 52 Owners of a r i sky listed company . . . 6 l A changing cost of capital 72 C H A P T E R VI RISK 76 Risk as a variable 76 The three r i s k factors 78 The three variables effecting r i sk factor number one 80 The r i s k of a portfolio of stocks . . . . 84 C H A P T E R VII C O N C L U S I O N S 91 B I B L I O G R A P H Y 97 I N T R O D U C TION The thesis begins with a discussion of Markowitz's work on portfolio theory. It is found impossible to use the hypothesis of Markowitz to describe how a f i r m acquires assets. As this early stage it is felt that a f i r m should specialize, and investors should diversify. Next, an attempt is made to use the hypothesis of Markowitz to describe current investment behaviour. It wil l be suggested that there has been a marked change in the behaviour of investors themselves since the time the hypothesis was formulated in 1952. By drawing from observations of recent market behaviour an hypothesis is proposed which allows for a changing trade-off between the two cr i t er ia of investment: return and risk. The hypothesis for the investor is then integrated into the policies of the f i r m , and the power of the interrelationship between the investors' portfolios of stocks and the f i rms ' portfolios of assets is shown. The ability of the new hypothesis to explain many of the current business decisions, such as the mergers and acquisitions of conglom-erates and the growth in new issues, demonstrates its validity. Final ly , before the conclusion is drawn a definition of investment r i sk is presented. C H A P T E R I M A R K O W I T Z A N D T H E F I R M Of all papers in modern finance not one has had such far -reaching influence as H a r r y Markowitz's paper on portfolio building published in 1952. The paper's major contribution was that, "It is necessary to avoid investing in securities with high covariances among themselves. " 1 His rhetoric explains how investment d iver-sification wil l reduce the variance of the expected return, which he defines as the r i sk of a portfolio, especially when diversification is among independent, or better still negatively correlated, securities. Markowitz suggests that investors should try to m a x i -mize the "expected return less variance of return" rule. The maximization of this rule can be described as an efficient set of stocks where at a given expected return there is a min imum attainable variance, and at a given variance there is a maximum attainable rate of return. Investors' habits may be described in general by a utility function with a declining marginal utility of return for a given increase in r isk , the exact shape determined by individual preferences. Where an investor's utility, function is '''Harry Markowitz, "Portfolio Selection, " The Theory of  Business Finance, ed. Stephen H. Archer and Charles A. D'Ambros io (New York: The M a c M i l l a n Company, 1967), p. 599. 2 Figure 1. Determining the optimum portfolio for an investor* according to the hypothesis of Markowitz. tangential to the locus of points in the efficient set we have the optimum attainable portfolio for this particular investor. When applying portfolio theory to the formation of a c o m -pany's assets, care must be taken not to arbi trar i ly apply hypotheses developed for investors' portfolios to the peculiar problems of the f i r m acquiring revenue producing assets. Applying Markowitz arbi trar i ly would mean it is necessary for a company to avoid i n -vesting in assets which will produce returns with high covariances among themselves. However, a f i r m will be least apt in managing assets with returns independently or negatively correlated assets with its existing returns. The synergistic results of merging f irms or acquiring assets will most l ikely occur when the returns involved are positively correlated. Dependence is often the key to acquisitions, as it is only through dependence that a f i r m expands vert ical ly and horizontally. A f i r m specializes in what it can do 3 best. Among alternative projects, what the f i r m can do best is often dependent upon what it is doing at the present moment. Take two f irms X and Y with earnings of Ix and Iy respec-tively. Suppose the earnings in the future for the f irms can be viewed as random variables, but also suppose that the two earnings are perfectly positively correlated with each other. F o r example, the f irms could be in the same industry with s imilar operations. An investor has $100 and must choose between the two. F o r simplicity suppose also the number of outstanding shares of each are the same and the prices of the securities are equal. It can be shown that there is no advantage in owning one security over the other. Let Rx and Ry be the return available to an investor on investing $100 in each. Let Wx and Wy be the proportion of the investor's portfolio in X and Y respectively so that Wx + Wy = 1. Therefore, the expected returns of the portfolio are: Wx- Rx + Wy • Ry (Wx + Wy)T since Rx=Ry=T T since Wx + Wy = 1 Therefore Rxy=Rx=Ry The expected income does not depend on the proportion of the $100 invested in either security. 4 The variance relationship of this portfolio is: Var (Rxy) = - Var (Rx) + w £ - Var (Ry) + 2r Wx Wy V a r (Rx) ^Var (Ry) since Var (Rx) = Var (Ry) = Z Var (Rxy) = WZ. Z + Wz. Z + 2 Wx Wy Var (Z) = (Wx + Wy) 2Z But Wx + Wy = 1 So Var (Rxy) = Var (Rx) = Var (Ry) Diversifying does not reduce the risk of the portfolio no matter what proportion is invested in each security when the securities are perfectly correlated. Finally, a third variable is introduced, defined as relative risk and made up of the variance in returns divided by expected returns. In this particular case the relative risk remains the same no matter how X and Y are diversified. So, since our relative risk remains the same, as well as the income, there can be no advantage in diversifying between two companies whose expected incomes are the same and correlation between the two is perfect. However, suppose instead the companies X and Y, both in the same industry, were to merge. By combining, they may reduce marketing costs, consolidate efforts and services, introduce 5 economies of scale, and employ techniques available to reduce costs and hence increase profits. The greater the dependence between f irms the greater the likelihood that there will be profit potentials to be found in merging. Specialization as the key to success in growth is emphasized by a corporation president who states: We have no aspirations to become one of the so-cal led conglomerates. . . . We are expanding. . . into industrial fields that are related to those we are currently serv ing- -fields where we can best util ize the technical and manu-facturing skills and market knowledge that are so famil iar to us. In short, we intend to do what we know best. ^ What happens to income and r i sk when the dependent f irms merge? By synergistic occurrences the income per share of the resultant merger of the dependent f irms will increase, the variance will remain the same, but the relative r isk , a combination of both income and variance, will be reduced. Ixy ^ Ix + Iy Rxy > Rx + Ry - Var (X, Y) = Var (X) + Var (Y) + 2 Cov (X, Y) But relative r i s k will be reduced. R R (X, Y) = Var (X, Y) "v Var (X) + Var (Y) + 2 Cov (X, Y) Rx, y ' Rx + Ry Since Rx, y ^ Rx + Ry by synergy Statement by Arthur J . Santry, Advertisement, Fortune, L X X I X , (March, 1969), p. 188. 6 The investor who diversified his $100 between the two f irms to no advantage before is now in a better position after the merger , than formerly when he owned shares in each of the separate companies. Therefore, investor diversification does not help when correlat ion is high, but f i r m integration may well be valuable in such situations. Investors and f irms are on two separate and different levels relationships, and hypotheses developed in portfolio management cannot be arb i trar i ly applied to the problem of a f i r m acquiring assets or other f irms. In order to determine a f irm's responsibility to its shareholders in attempting to diversify its holdings in order to reduce r isk, take a pract ical example such as MacMi l lan-Bloede l . This f i r m is heavily entrenched in international trade with foreign competitors and when world monetary policy is in a state of flux there is an increased r i s k involved in holding its shares. Fear of a major competitor such as Sweden devaluating when Britain de-valuated was largely responsible for the pr ice fall of MacMil lan's shares f rom $25. 00 to $19. 00 in the spring of 1968. At this time gold shares flew high as confidence in the dollar fell. Six months later MacMi l lan -B loede l shares had returned to $25. 00 and the gold shares were back where they were before the cr i s i s . The question is, should MacMi l lan-Bloede l diversify either by opening up a gold mine or by taking over an existing mine, or should the 7 responsibil ity of diversification be left at the investor level? F o r the overal l Gross National Product unless synergistic effects are present it would be better for each respective company to remain in its own field of specialization. F o r MacMi l lan-Bloede l shareholders there is no advantage in the company hedging its position unless the majority of shareholders own only the one stock. In reality a company does not operate in divisible markets, and there would not be sufficient gold mines in Canada with enough power through negative correlation to balance the forest products industry. Together with the fact that the markets for takeovers are not perfect, nor unlimited, is the fact that gold shares sell at a premium on account of their ant i -cycl ical nature. Because they sell at a premium this increases their relative r i s k and also decreases some of the power they may exert in stabilizing a portfolio through negative correlation. Therefore, for a f i r m to buy negatively correlated assets might well require expenditures well beyond the economies of the situation. Besides all this, MacMi l lan-Bloede l might well be inept at operating a gold mine. Therefore, it would seem to be the f irm's responsibility to specialize; the investor's, to diversify. If a f i r m can diversify into independent projects without the inherent costs of entering unrelated fields, then it should take advantage of its fortunate 8 circumstances. But under normal conditions a f i r m should be ex-panding in fields where it is more l ikely to find opportunities for exonomies of operation, and these are likely to have income streams with a high correlation to its present income. The income of a combined company is more l ikely to be larger than the separate incomes added together if there is a positive correlation between the incomes; and less l ikely if there is negative correlation. There is a cost in diversifying into unrelated projects that may more than offset the benefits of reduced risk. It is the investor's responsibil ity to diversify because in many respects it is much harder and much less economic for the f i r m to pursue diversification into unrelated 3 fields than for the investor. Therefore, it is not unreasonable for the f i r m to expect its shareholders to be diversif ied and to pursue its line of endeavour in related areas as long as the correlation is not dangerously high between all its incomes. This might endanger the f i rm, especially if revenues are cyc l ica l . If dangerously so, there is a l imit that the f i r m can safely concentrate in assets in which returns are These statements, of course, conflict with reality where there is a type of company known as a conglomerate which purposely enters unrelated fields. However, by using accepted financial theory it is impossible to rationalize the behaviour of these companies. In fact, it is not t i l l later in the paper when a new hypothesis is intro-duced that it is possible to explain the behaviour of these unusual f irms. 9 dependent on one another. This whole problem will be renewed in a later chapter and modified when we integrate the investor into the capital budget, but at this early stage it will be left in this rough form. However, not every f i r m is willing to consider its investors as being diversified; take for example General Dynamics. At General Dynamics more than 3/4 of our activities are sti l l in the defense business; and although our non-defense business has been growing very rapidly, our defense business has been growing as fast. As a result, the ratio between the two remains approximately the same. . . . We all hope that the nation's armament b i l l can be reduced, even though it may not be possible until some dis -tant date. Therefore, as trustees of stockholders' money it is only sound that we achieve a broader diversification in the commerc ia l field. Hence, an understanding of the nature of our business provides direct clues as to our future planning in the merger field. The need for greater balance between defense and commerc ia l business is one of our unique charac-teristics. That is one of our f irst priorit ies in assessing the question of whether to merge or not to merge. This "urge to merge" does not mean that we don't like the defense business; our studies show that it is l ikely to be more stable than regular commerc ia l business for years to come. Rather it means that, as prudent trustees of the stockholders' money, we must provide the broadest supporting foundation we can devise. ^ Myles L . Mace and George G. Montgomery Jr . , Manage- ment Problems of Corporate Acquisitions (Boston: Harvard University Press , 1962), pp. 22-23. 10 The quote is f rom the President of General Dynamics. He has la id out a merger and acquisition formula on the premise that his shareholders are unsophisticated and hold few stocks. The President assumes the shareholders have an unbalanced portfolio to begin with, and then decides on the course the f i r m should take in order to correct the shareholders' mistake. It will be frustrating for the properly balanced fund or portfolio which has a sensible l imi t on its armament stocks, owns General Dynamics, and expects it to maximize its shareholders' equity rather than diversify it. Now General Dynamics will be proceeding into less profitable areas in order to correct the mistake of possibly a minority of share-holders at the expense of the majority. Another example of a company taking on the responsibility of the shareholders is Gulf & Western. Gulf & Western has pretty consistently chosen companies with impress ive and underutil ized tangible assets. It has also quite consciously sought to enter industries that are either intrinsical ly noncyclical , such as auto parts, or that can reasonably be expected not to go down simultaneously--mining and movies, for example. . . . We're like an invest-ment company. . . except that they just sit upstairs and watch the horses run. We get down and manage the horses. ^ Investors have not been enthusiastic over Gulf & Western's stated policy for the stock has only commanded a price-earnings ratio of W i l l i a m S . Rukeyser, "Gulf & Western's Rambunctious Conservatism'", Fortune, L X X V I I (March, 1968), p. 123. 11 between 5. 5 and 14. 5 in the f irst half of 1969 (based on estimated 1969 earnings). In conglomerates of this sort often the lowering of r i s k through diversification is more than off set by rais ing r i sk through over-extension of debt structures needed to make the acquisitions possible. A company does not exist in order to be a prudent trustee of stockholders' money for certainly there are more than enough com-petent financial institutions offering this same service. These examples further il lustrate the difference between the f i r m and the investor, and it might be in order here to review the conclusions for this chapter. It is the investor's responsibility to diversify, as it is easier for h im to invest in diverse operations by diversifying his own portfolio of stocks than it is for the f i r m to enter unrelated areas of operation. The f i r m should, therefore, assume that the majority of its shareholders are diversif ied and so under most circumstances concentrate in its own field of specialization. These conclusions will be altered in later chapters when the influence of the enthusiasm of investors is integrated into a f irm's policy of acquiring assets. Using the accepted theories of finance it is difficult to rationalize the actions of f irms today entering diverse operations at a seemingly ever-accelerating pace. In later chapters 12 i t w i l l be demonstrated that the changing enthusiasm of investors can have a powerful influence on a firm's d i v e r s i f i c a t i o n policy. It i s with this i n mind that the next chapter is devoted to discovering exactly what motivates the investment community. C H A P T E R II M A R K O W I T Z A N D I N V E S T O R S ' P O R T F O L I O S The hypothesis put forward by Markowitz to explain the make-up of a portfolio is one of the long-standing models in financial theory. It is of particular interest to note that it has been accepted by the financial world in a manner uncommon to most models, with-out fierce controversy. Lately, only a few authors have questioned the model. Keith S m i t h 1 attempted to explain Markowitz's relevance in describing real portfolio behaviour, but his explanation only leaves one less convinced as to the adequacies of the model. C l a r k s o n 2 , on the other hand, developed a trust simulation model and calls upon theorists to develop new and pract ical portfolio models that will give greater insight into actual investor behaviour. It is necessary to examine closely the works of the noted practitioners on portfolio selection who were accepted at the time Markowitz formulated His model in order to understand exactly what motivated his thinking. Markowitz himself re ferred to John 1 K e i t h Smith, "Needed: A Dynamic Approach, " Financial  Analysts Journal, XXIII (May-June, 1967), pp. 115-121. Geoffrey Clarkson, Portfolio Selection: A Simulation of  Trust Investment (Englewood Cliffs , New Jersey: 1962). 14 Burr Wil l iams' The Theory of Investment Values and although not directly re ferred to, Graham and Dodd's 1951 edition must also have been representative of the investment ideas of the day. Below is a summation of the investment policy described by Wil l iams in his book on pages 55 to 75 which is re ferred to by Markowitz as the basis for his model. In saying that dividends, not earnings, determine value, we seem to be revers ing the usual rule that is dri l led into every beginner's head when he starts to trade in the market; namely, that earnings, not dividends, make prices . The apparent contradiction is easily explained, however, for we are discussing permanent investment, not speculative trad-ing, and dividends for years to come, not income for the moment only. To our surprise it is "permanent investment" on which the model was built. An even better commentary of the times is provided from Graham and Dodd whose 1951 edition describes portfolio bui ld-ing in much the same manner. T H E A N T I C I P A T I O N A P P R O A C H Short- term Selectivity - To a surpris ing degree the r e c o m -mendation of common stocks in Wall Street, and presumably their purchase by both investors and speculators, are based on near - t erm anticipations. The stocks with the best outlook for the next six or twelve months are considered to be the best ones to buy. Much analytical effort goes into appraising these n e a r - t e r m prospects. Volume, selling prices , and John Burr Wil l iams, The Theory of Investment Values (Cambridge, Massachusetts: Harvard University Press , 1938), p. 58. 15 costs are carefully estimated, often with the aid of studies "in the field. " The concentrated attention paid to these short-period anticipations is often justified by the assertion that no real ly dependable forecasts can be made for more than a year in advance. In spite of this plausible argument we are sti l l surprised at the weight so frequently accorded to the n e a r - t e r m in Wall Street's calculations. The value of a stock does not depend on what it is going to earn this year or next, but on its expect-able average earning power and dividends over a fa ir ly long period of time and on its general prospects over the sti l l longer future. The chief fallacy in buying stocks on the basis of their immediate prospects is that the pr ice of the issue is usually left out of the calculation. That price may already have advanced substantially in anticipation of the very i m -provement that the buyer is counting upon. If he is already paying, and perhaps overpaying, for this improvement, how can he expect to profit f rom it when it comes? Investment Fund Methods and Results - In this connection we venture some observations on the policies followed by investment funds. It is our belief that in their earlier years they placed most of their emphasis on n e a r - t e r m anticipation both of the general market's behavior and of the earnings performance of individual industries and companies. The overall results they achieved were far f rom brill iant. In the last decade we think they have shifted at least part of their emphasis to more basic considerations of va lue- -such as prospective average earning power in relation to current price. Their over-a l l results for 1940-49 have been much better, relative to the course of the general market, than in the years preceding. The champions of the time which Markowitz hoped to simulate with his model are concerned only with permanent investment of highest quality: therefore, it is not surpris ing that Keith Smith has Benjamin Graham and David L . Dodd, Security Analysis (Toronto: The Maple Press Company, 1951), p. 396. 16 not been able to reconcile the model with reality. With permanent investment in mind Graham and Dodd spent sixty pages describing how one could recognize true quality. Their conclusion leaves their comments somewhat suspect, however, for they recommend the purchase of Atlantic Refining and Topeka & Santa F e Rai lroad over IBM; I B M at its 1951 level was considered a dangerously over-pr iced stock which did not have the margin of safety needed to qualify for true investment. On the basis that the Markowitz model might well be insuffi-cient to explain al l but permanent investment, the thesis now examines the Markowitz model itself to question whether the efficient set, in fact, produces optimum results. In tune with the practitioners quoted, Markowitz also presented a model with discounting over an infinite time period which again suggests permanent investment. Examining the model by way of an example, assume there are two portfolios A and B, the former is on the efficient set, the latter is not. Also suppose A has a better return than B, a l -though both have the same r isk , consequently Markowitz's procedure would recommend A over B as the portfolio to purchase. 17 Figure 2. F igure showing two alternative portfolios as visioned by Markowitz. However, it can be shown that B could be superior to A in any period 'except over the infinite time horizon if the stocks could be traded. 18 T O P R O V E : There exists a return greater than that found on the efficient set. G I V E N : where Mfe = number of stocks in portfolio A tta = number of stocks in portfolio B V^ X*& - expected return f rom stock i in time t in portfolio A expected return f r o m stock i in time t in portfolio B U= dis count factor for this r i s k class R. M. E 8. = return on Markowitz efficient set P R O O F : Suppose now we have a time period Z long, beginning X years hence, such that: This does not contradict rK^s which is given. Now f r o m ^ we expand A*0 + A£ * * /d** > ^o+C^ but ** * y ; 1 * > tfo * *Km* so that A* + fC*> *.w.*,v 19 The only case where A on the efficient set would be the optimum is if all subsections of A were greater than all the corresponding sub-sections of all the portfolios to the left of A and at the same r i s k level. Otherwise, over some inter im period, X periods hence, there wil l be some portfolio called B where B | + Z ^ A ^ " I " Z which could make it more profitable to hold B over Z if the transaction costs are smaller than the difference between the two portfolios. By way of numerical example suppose that our investor is con-fronted with two portfolios A and B each with equal r isk. He discounts both portfolios at the same rate, 4 per cent per period, which is applicable to this r i s k class. A's return is $5. 00 per period over an infinite time horizon while B has a $20. 00 return in the f irst tw.o periods and $2. 49 thereafter. A = $ 125 = $5 $ $5 + $5 + + $5 1. 04 ( 1. 04)* (1. 0 4 ) 3 ( 1 . 04)*> B = $100 = $20 + $20 + $20 + t + $2. 49 1.04 (1.04)* ( 1 . 0 4 ) 3 ( 1 . 0 4 ) * * Under Markowitz's hypothesis portfolio A is chosen over portfolio B. However, by taking Z=2 and X=0 a different portfolio might be chos en. B f = $ 37. 72 Ao = $ 10. 44 Bz = $ 62. 28 A*J = $114.56 20 Therefore, by switching f rom portfolio B to A if A is st i l l available after period two we could obtain a return of: $37. 72 + $114. 56 $152. 28 And our total gain attributable to the switch would be: $152. 28 - 125. 00 $ 27. 28 So unless our transaction costs exceed this figure an even better return is obtainable by trading in portfolios than by choosing the portfolio on the efficient set. There will be an opportunity for this trading gain whenever period-to-period returns are not identical among portfolios with s imi lar r i s k levels. S imi lar ly since there are stocks within each of the portfolios whose returns vary this also gives r i se to trading operations. Therefore, the efficient set is only an instantaneous phenomenon which changes over time. Also, the efficient set is different for different time horizons. Returns gauged only over a month may have entirely different stocks in their efficient set than returns gauged over the infinite time period. F r o m our previous example B was most efficient over the two period horizon and A. was the most efficient over the infinite horizon. Some investors such as per -formance funds prefer the trading type of investment with the short 21 horizon, while other investors such as insurance companies prefer permanent investment and thus the longer horizon. The reason insurance companies might choose A is because the size of their incoming funds precludes them from switching large funds among equity issues. If they do hold B then they must make another decision two periods hence to decide where to reinvest their funds. This involves some r i s k that the opportunities expected will not be avai l -able two periods from now and also there will be high overhead costs of a securities trading department capable of handling sporadic cash flows. Markowitz has based his model on the assumption that the variance in return to the shareholder is the r i sk involved in owning a stock. This presumption itself may be questioned. Two methods can be employed by the investor in order to take advantage of the variance in return as measured by changing stock prices. By dollar c averaging, the investor will do best in stocks with high variances. This is accomplished by placing a set dollar amount in a varying stock over time so that an investor will be buying more shares of a stock at lower prices than at higher prices . The average cost of a share is lowered below what the cost would have been if there had Jerome B. Cohen and Edward D. Zinbarg, Investment Analysis  and Portfol io Management (Homewood, Illinois: Dow Jones-Irwin, Inc. , 1967), p. 762. 22 been no variance. Although dollar averaging requires injection of cash over time the second method that can be used does not. The investor maintains a constant percentage of each stock in his port -folio measured by current market values. In the case of stocks with large variances the investor would be selling high and buying low as the stocks gyrate around an average return. In either case the variance is not the r i s k factor since the investor is able to capitalize on it in order to increase his return. This leaves the problem of how to describe r i s k which wil l be defined in Chapter VI. Assume t i l l then that r i s k exists but is not yet defined. The next problem pertaining to the Markowitz model is the assumption that period to period returns can be viewed as random variables. It is hard to conceive that the income of one period does not depend heavily upon the income f r o m the preceding period as the Markowitz hypothesis indicates. The yield (R) on the portfolio as a whole is R — R^X.^ The R^ (and consequently R) are considered to be random variables. ^ But for the R^ to be a random variable, the components of R^ must Markowitz, op. cit. , p. 592. 23 also be random variables and breaking down into its components we find R i = d i f r i t with dj^ as the rate at which the return on the i ^ n security at time t is discounted back to the present. and with r ^ be the anticipated return (however decided upon) at time t per dollar invested in security i . ^ Therefore, since R^ is assumed to be random, so must the com-ponents of R^ be considered to be random. The components of R^ are, of course, the returns per period (r ^ ) . If the r^'s are random variables and can be added linearly then Markowitz has assumed that an investor looking into the future assumes period to period returns are independent of one another. The case for period to period independence is highly suspect. Companies run in cycles; for example, events that cause losses one year can easily compound, causing more losses the following year. Losses cause higher costs of capital, lower prestige, lower morale, and other impairments to growth which themselves compound, causing dependent chains of events. Dependent chains of events can best be viewed mathematically under the general term of Markov chains. Such chains are too complicated to be explored rigourously Markowitz, op. cit. , p. 589. 24 in a finance paper, however, a pract ical example can be given which will i l lustrate the type of event that the Markov chain can describe. Take the Toronto, Montreal , and Ottawa computer area served by three t ime-sharing companies, Computel, System Dimensions, and Mult ip le -Access Computer Corporation. It has been estimated that each of these companies alone has enough hardware to serve the whole area. Consequently there will be a shakeout in the near future and most l ikely only one company wil l prosper. One bad contract or computer breakdown could finish any one of these three companies. Such events could be integrated into a Markov chain but cannot be viewed in a series of random variables about an average return. Not only do Markov chains allow us to introduce dependent chains of events but also allow us to view returns as nonsymmetrical . Markowitz by assuming the returns to be random variables assumes that the returns can be viewed only as symmetrical normal distributions. In a Markov chain this restr ict ion is not present and we could have situations such as "if things turn out right this stock can go through the roof; if not, the downside r i s k is considerable. " Therefore, Markowitz by simplifying his view of the company has substituted mathematical s implicity for business reality. 25 F r o m the above we find that Markowitz should not be inter-preted as an al l - inclusive rule to describe the stock market. At its best his model describes permanent investment and cannot be adapted to a trading situation. To attempt to adapt the model to explain all market behaviour is a mistake as Keith Smith must be beginning to realize. It is of little use to attempt to explain modern market behaviour with outdated models. Since 1950 and the day of the so-cal led permanent investor, volume has increased twenty-fold on the New York Exchange and even more so on smaller exchanges. Even the method of evaluating companies has undergone a rapid evolution. F r o m the beginning of stock investing, the emphasis in analysis and valuation has moved successively f r o m 1. Net worth, book value and physical assets to 2. income return, dividends and yield to 3. earnings and earnings rel iabil i ty to 4. long-range growth rates of earnings and now to 5. instant earnings growth. ^ So in order to develop modern models an examination of recent market behaviour and practises must be made. Below appears a few passages that are examples of recent changes in investment attitudes, part icularly institutional investors. David L . Babson, "Performance - The Latest Name for Speculation?" Financial Analysts Journal, XXIII (September-October, 1967), p. 130. 26 The performance of the third group--the speculative fringe --gives rise to a legitimate challenge to the traditional thesis that the way to make money in the market is to buy stocks with good records of dividends and earnings and put them away. Traditionally conservative institutions --banks, trust com-panies, university endowments, pension funds, insurance companies and the more staid mutual funds--are moving at an accelerating pace towards the performance method and philo-sophy. Technicians, traders, young portfolio manages, incentive pay and talk of high flyers are surprisingly common within the marble halls of that once staid bastions of fiscal tradition. Performance investing has come from suspected intruder to accepted darling among the nation's major institu-tions and their customers. The performance investor specializes in identifying and acting quickly upon the factors that he feels will probably change stock prices, seeking to buy or sell before the general market reacts to these developments. 9 More and more institutional investors are placing emphasis on technical chart analysis--once the province of the in-and-out trader. Where only a few years ago they were primarily concerned with earnings potential five or ten years ahead, now they dump even stocks with superior long-term records if their earnings are projected to slow a little for a quarter or two. 1° There has been an abrupt change in investing attitudes since the early Fifties and the portfolio building model that Markowitz and Graham and Dodd recommended. Institutions have now reverted back to 'speculative trading' as labelled by its adversaries or 'performance investing' as it is called by its admirers. ^Charles D. Ellis,'""Will Success Spoil Performance Investing? Financial Analysts Journal, XXIV (September-October, 1968), p. 117. 10f3abson, op. cit. , pp. 130-131. C H A P T E R III C H A N G I N G A T T I T U D E S O F I N V E S T O R S What has caused this change in attitude at a time when random walk theorists are lending weight to the opinion that technical analysis is a waste of time? The answer lies in the fact that randomness has not been demonstrated on all stock markets. A survey of the stocks that have been tested by the academics would find that those tested are always among the well-known New YoEk stocks, while a s imilar survey of the stocks traded by per -formance funds would find most of these equities on O v e r - T h e -Counter and The Amer ican Stock Exchanges. It is unlikely that randomness would be found in the less sophisticated markets; for the larger the buyer becomes relative to the supply of equity available, the less l ikely it will be that a random or perfect economic exchange will take place when a transaction occurs. The price movement of some of the stocks on smaller exchanges has been compared to the pool operations of the Twenties and although this may be the case it may also simply reflect the buying power of the mutual funds relative to the l imited supply of the smaller companies' stock. In either case, the pr ice reaction will not be random, depending upon how smal l the available equity is relative to the buying power of the funds. 28 Although this argument can be used to explain the growing interest in technical analysis it does not adequately explain the tremendous trading volume and interest that performance invest-ing has precipitated. There are three explanations why institutions have decreased their time horizon--the time they expect to hold their investment--and consequently increased market volume. F i r s t , the switch to performance investing has occurred only within the last three or four years when for the f irst time a strong correlation between mutual funds with high turnover and superior performance has been demonstrated. Up to this point studies had found no significant correlation between the two variables. How-ever, in the period 1965-1966, studies by both Fortune magazine 1 and the brokerage house Donaldson, Lufkin, and Jennette found strong correlation between superior performance and highturnover. Since then there has been a stampede of institutions moving into performance investing even though it has not been shown that the turnover during 1965 and 1966 was itself responsible for the superior performance of the so-cal led "go-go funds. " In fact, one study by Fortune indicates exactly the opposite, and that although turnover correlated with performance during this period the Personal Investing, "The Traders Do Better, Sometimes, " Fortune, L X X I (September 1, 1967), pp. 171-172. 29 majority of performance funds would have done even better if they had not traded their investments as often as they did. Why then were they able to out-perform the buy-and-hold funds? This is because the segment of the market the performance funds invested in, the Over-The-Counter markets, rose considerably relative to the New York stocks found in the portfolios of the buy-and-hold funds. Therefore, it was the peculiarity of the market rather than the superiority of the method employed which enabled the per -formance funds to out-distance all others. In fact, the Fortune study suggests that a buy-and-hold fund in the Over-The-Counter market would likely have performed better than the performance funds at this time, and it is unfortunate that one did not exist during this period. However, this has not deterred many institutions, who have misinterpreted the correlat ion between performance and turnover f rom joining the growing throng of traders, as evidenced by the yearly growth in market volume. The second reason for the shortening of the time horizon, the time one expects to hold a security on buying it, among mutual funds has been the growing competition for the investors' monies. F o r m e r l y funds sold themselves on their past ten or twenty years' performance ^Arthur M . Louis , "Those Go-Go Funds May Be Going Nowhere, " Fortune, L X X V I (November, 1967), pp. 143 et seq. 30 while in today's excited market performance comparisons have shortened from yearly to quarterly returns in a fierce competitive fight for investors' funds. As a consequence unseasoned funds are currently attracting as much investor money as the older funds which have in comparison stagnated. Today the rate of return is the only comparison used between funds, largely because the level of r i sk is impossible to quantify. So while less aggressive funds try to boast of low r i s k levels, they unfortunately cannot boast that they have "a r i sk level 100 quantums lower than competitors while maintaining a return level only 2 per cent lower. " The consumer is unimpressed by this profession of safety and will normally buy on the basis of rate of return alone. Not only have other mutual funds voted to become 'go-go'; but trusts, banks, university endow-ments, and even pension funds have been pressured to make their sole determinant of performance the rate of return obtained. At Mobi l Oi l Corporation, an internal computer program has been created to compare the investment performance of six Pension Fund Trustees. Six institutions had been chosen to manage portfolios under basically s imi lar Trust A g r e e -ments. Under these agreements each had been given complete investment discretion to maximize yield, specifically through purchase of equities, but with the privilege of selecting other investments as they deemed fit. The computer program measures the rate of return of each portfolio on a discounted cash flow basis, thus enabling Mobi l to create meaningful comparisons of performance. The portfolio managers at each of the trustee institutions 31 are appraised (sic) of the evaluation of their performance and of their ranking relative to other portfolios. The avai l -ability of ^future funding to each institution is to a great extent predicated on performance, relative to the performance of the other Trust portfolios. ^ General Motors , which has seven banks administering its vast pension fund, rewards the best performers with the lion's share of new deposits (management fees are based on the amount managed). ^ Mobil and G. M . make their appraisal on returns alone, and in the case of Mobi l on monthly returns. This by itself will force the fund managers to make their selection on the basis of very short - term horizons. Fund managers forsake long-term average return investments with comparatively low r i s k in favour of short-t erm runs most often found in stocks of high risk. This can be demonstrated in the growing gyrations of unlisted stocks as c o m -pared to the lackluster performance of the Dow Jones average in the years 1967 and 1968. The investment policy of these pensions could be compared to a taxicab driver whose remuneration is solely determined on the basis of how fast he gets his passengers to their destination relative to the normal traffic speed regardless of r isks taken. ^Wil l iam L . Weitz, "Comparing Performance of Equity Pension Trusts , " Financial Analysts Journal ( M a r c h - A p r i l , 1967), p. 128. 4 Arthur M . Louis , op. cit. , p. 145. 32 The third factor that may be a contributing factor to the evolu-tion of performance investing could surpris ingly enough be the management fee. The unusual contribution of the management fee to the r is ing volume may best be explained by means of a simple example. It is common knowledge that the growth of any mutual fund is p r i m a r i l y a function of two variables: the existing assets which through the management fee support the advertising expense and the sales staff, and the performance of the fund relative to other funds which is the key sales device of any fund. Suppose there are two pension portfolio managers, A and B, who initially are given $1, 000 each to start and then must divide $1, 000 per quarter for one year according to the performance formula below. 2 Money to A = $1, 000 x (G by A.)  (G by A) 2 + (G by B) 2 Money to B = $1, 000 - (Money to A.) G = dollar gain in assets for previous quarter. Suppose also that A and B receive a management fee of 1/2 percent per quarter on assets that they manage, and by this method it is felt that the portfolio managers' objective will coincide with that of the pension trustees--to maximize the growth of the pension's ass ets. 33 Both fund managers have decision horizons over one year: A sees a 20 per cent, 15 per cent, 10 per cent, and 5 per cent return per quarter on all assets invested by him, while B sees a 5 per cent, 10 per cent, 15 per cent, and 20 per cent return per quarter on any assets he will invest on behalf of the fund. Assume imperfect knowledge on the markets so that A cannot switch into B's portfolio, nor B into A's . It can now be shown how the division of funds and management fee formulas work against the objective of the trustees. In Table I the division of the cash per quarter and gains made by each portfolio manager is demonstrated. The investment return is $1, 937; however, if the fund had invested solely with A their return would have been only $1, 650, while if they'd gone all the way with B their return would have been a healthy $2, 300 or 19 per cent greater than had occurred and 40 per cent better than A would have obtained by himself. B's return would have been so much better as his performance was in the later stages of the year when the fund was larger. Therefore, since A. received the "lion's share' of the funds to manage our formula would be biased in favour of the n e a r - t e r m performer. Worse yet, if we examine the method of reward, A's remuneration is 100 per cent greater than B's, although A's performance is much worse, and so our management fee strongly favours the portfolio manager who maximizes returns in the immediate future. T A B L E I P O R T F O L I O M A N A G E R A P O R T F O L I O M A N A G E R B Quarter Assets Rate of Return Return New Funds Assets Rate of Return Return New Funds 1 $1000 . 20 $200 $941 $1000 . 05 $ 50 $ 59 2 $2141 . 15 $321 $893 $1109 . 10 $111 $107 3 $3355 . 10 $335 $710 $1427 . 15 $214 $290 4 $4400 . 05 $220 $244 $1931 . 20 $386 $756 Total assets at end of period - with A = $4, 864 - with B = $3, 073 Fund at end of period $7, 937 Fees for A = ($1000 + $2141 + $3355 + $4400) x .005 = $54. 48 Fees for B = ($1000 + $1109 + $1427 + $1937) x . 005 = $27. 34 Fund had it been invested entirely - with A = $7, 650 - with B = $8, 300 35 Now suppose A and B are two new mutual funds and the only performance funds on the market competing between themselves for the $1, 000 per quarter available f r o m the investing public for performance investing. Conceivably the growth in assets would approximate our division of 'funds formula. Both funds are new, without a track record, and growth in assets will depend heavily on performance relative to competition and the management fee needed to support the promotion of the fund. Throughout the period A would have larger management fees and could use its performance record as a selling device to show it is better than B in three of the four quarters. F o r instance, by the end of the third quarter even though A's performance is declining they could advertise that "we have averaged 15 per cent return per quarter, while only in the last quarter has the other performance fund been able to return our average, and since their inception they have averaged only a 10 per cent return per quarter. " Besides this, A might invest as it did, hoping by the time later quarters did arrive , better oppor-tunities might be available. A has less chance than B of having to suffer the 5 per cent quarter, and so again the n e a r - t e r m return becomes the favourite. The result is that a fund manager might be indifferent to a 15 per cent over one year with no prospect for reinvesting the funds at a comparable rate, to a healthy 10 per cent 36 per year for many years. Hence it is quite l ikely that our d iv i -sion of funds formula would actually represent reality and as a result early performance has become the name of the game for the mutual funds. There will be a tradeoff between quick p e r -formance which maximizes the management's return and long-term performance in the best interests of the fund members. The size of the tradeoff will be dependent on the division of the fund's function. The more powerful this function the greater will be the tradeoff and the heavier the volume on the market. It is quite l ikely that the division of funds function is quite powerful as evidenced by the following reports on mutual funds. Mates Fund actually rejected some $50, 000, 000 in investor money. On the strength of its top rating . . . its size had grown by a factor of ten in six dizzying months. ^ In the case of Enterprise , success has assuredly bred success. The fund's assets increased by a factor of several hundred during the period discussed, ( 1963 - 1968) growing from $3, 000, 000 to almost one bi l l ion dollars. Most of that was new money, attracted by the fund's impress ive performance. ^ The evidence that mutual funds have become purely return conscious has been recorded and commented upon by the Amer ican Securities Exchange Commiss ion. Michael Lawrence, "Playboy's Guide to Mutual Funds, " Playboy, X V I (June, 1969), p. 187. 6 Ibid. , p. 190. 37 The performance . . . has injected new institutional money into the stock market, greatly increased the turnover of institutional holdings, and made institutions much more wi l l -ing to take r i sks . In the second quarter of 1968, the most recent period for which statistics are available, the S E C reported that institutional turnover was 27 per cent, versus 21 per cent for the year 1967 and about 11 per cent for 1951. The second quarter rate for mutual funds was 47. 3 per cent, almost three times higher than 1961 turnover. The power of the division of funds function will depend on how return-conscious the investing public becomes, and so until the fear of a recession reminds investors of the need to be r isk-conscious there is little likelihood of any decline in the growth rate of market volume. As the thesis is being finished investors are taking a beating as the market discounts a forthcoming slowdown in the economy. It wi l l be noted that the daily market volume of the New York Stock Exchange has declined f r o m an average of 18. 4 mi l l ion shares in 1968 to approximately 10 mi l l ion in June and July of 1969. The management fee and growth rate function of the funds has been shown to create a conflict between the investors' and the fund managers' interests, resulting in shortening of the time horizon and r i s k becoming irrelevant, as there is no incentive to confine the risk. 'Personal Investing, "Musical Chairs in the Market, " Fortune, L X X I V (January, 1969), p. 170. 38 In recent years, however, performance has come to mean something quite different. "Performance" now relates a l -most exclusively to capital appreciation, that is , how much did an account gain absolutely or relatively to some market y average or some other fund. A "high-performance" invest-ment fund is one designed to maximize capital appreciation, and the r i sk assumed is rare ly discussed or measured. Moreover , the period over which this performance is attained has become shorter, as accomplishments are measured and compared not over several years, but rather annually, month-ly, and weekly. Funds are shifted on the basis of recent appreciation results, and risks assumed or objectives sought are given secondary consideration. ^ In 1968 many funds had shortened their horizons to little or no length by trading off liquidity to obtain performance. This is done by taking down treasury shares at up to 50 per cent below market prices for a fixed time period, and being able to show immediate performance by valuing the shares at market to determine the fund's share value. They hope that the asset growth caused by the performance results wil l compensate the fund managers for any undue r isks they might take by holding securities that cannot be sold. The most interesting aspect is that the greatest discounts below market are obtained from the r iskiest companies so that the mutual funds may show the greatest immediate performance by taking down the r iskiest letter stock they can find. The danger lies in the fact that the funds cannot sell this letter stock, and the fund may become insolvent in the event that "Edmund A Mennis, "New Trends in Institutional Investing, " Financial Analysts Journal, XXIV (July-August, 1969), p. 123. 39 shareholders redeem their shares faster than other investors buy them. Such was the case for the Mates Fund which became the f irst fund on record unable to redeem investor's shares on demand. C H A P T E R IV A N E W I N V E S T O R B E H A V I O U R M O D E L This chapter is concerned with a model which adequately describes investor behaviour and f i rms ' reaction to this behaviour in a dynamic setting. One of the most important factors in the interrelationship of f i rms ' portfolios of assets and investors' port-folios of stocks is the changing trade-off between return and r i s k among the investment community. Financial theory to date has largely ignored this important variable or has treated it as a constant. This chapter is devoted to demonstrating the fact that the trade-off between return and r i s k is a'changing variable and also that many of the important relationships between investors and f irms can be explained in the context of this trade-off. In the chapter following this one the power of the model, which is developed, is demonstrated by its ability to explain recent market and f i r m behaviour that has been largely ignored and left unexplained by today's accepted financial theory. The model is developed by f irst understanding under what circumstances all stocks could have the same expected return although having different degrees of risk. A l l stocks could give the same ex-pected return regardless of r isk, given two conditions: 41 1. The majority within the investment community are able to diversify. 2. The stocks within a particular r i s k class and stocks of different r i s k classes behave independently with respect to both r i sk and returns. In the stock market of 1968-1969 with 40 per cent of volume being the trading of institutions, the f irst condition would be a l ikely situation. Now suppose the second conditions, for the moment, were also real ist ic; then an investor able to diversify would be able to obtain the expected return of a r i sk class mere ly by diversifying within it. The higher the r i s k class the more diversification would be required within that class to obtain the expected return of that class with the same certainty as could be obtained with fewer stocks of a lower r i s k class. However, since our investing majority is able to diversify, by assumption, each class of r i s k would give the same return; otherwise, a diversif ier is in a position to capitalize on his position. But since diversif iers are assumed to be in the majority they wil l not be able to effect this successfully. Thus all classes would have the same expected return as would all stocks under the conditions of investors being able to diversify and stocks behaving independently. Extension of this argument can be made to all investment opportunities such as bonds, gold, mortgages and land although two additional cr i t er ia of investment, divisibil ity and liquidity, complicate the situation somewhat. 42 Of particular interest is the minority group, the individual unable to diversify because of l imited funds. Assuming all returns have equalized he would be expected to invest in those stocks with the lowest r isk, however, he would sti l l be better to invest through a financial intermediary that could diversify on his behalf, such as a mutual fund. Now assume there is a period of transition in which the investing majority is changing f rom those unable to diversify to those who are. During such a transition period individuals would be net sel lers transferring funds f r o m personal accounts into financial intermediaries. The financial intermediaries would be bidding up the highest r i sk stocks the farthest which, during the period of market control by non-diversi f iers , had the largest ex-pected return. Eventually, however, a point would be reached where balance would take place and the different r i sk classes would then have the same expected return. Over this period the Dow Jones stocks would have been languid while the r i sk ier stocks on the Amer ican and smaller exchanges would be bid up considerably. Individuals unable to diversify would be net sel lers of the r i sky stocks to the diversif iers , since over the transition period they would lose the high return necessary to compensate the non-diversif ier for their high r isk. Individuals would transfer their monies to lower r i s k stocks, or financial intermediaries able to diversify, or other revenue producing investments. 43 This in fact, is an actual description of what took place on the stock exchanges in North A m e r i c a in the period from 1962 to the enc of 1968. Individuals used to be net buyers quite regularly: in the early 1950's they bought over $1 bil l ion on balance in most years. But in the late 1950's their buying declined, and most of the time since 1962 they have been net sel lers; typically, they have been selling corporate stocks at rates of $3 bi l l ion to $4 bil l ion a year and buying investment-company shares at rates of perhaps $2 bi l l ion a year - -which left them sti l l liquidating stock, on balance, by more than $1 bil l ion a year. The big net buyers, meanwhile, have been the pension funds; the stock market has been "made", in effect, by pension funds' purchases f r o m individuals. There is a nice logic to this situation: stocks are ordinari ly worth more to pension funds because they are less r isky; the funds can diversify and hold on for long periods, and it has been repeatedly demonstrated that the market is a much better bet in the long than the short run. 1 How has this occurred when our second condition, that r isks and returns are not correlated and independent of each other, is not logical , but a necessary ingredient to our proof? Let us sub-stitute another assumption for condition two which would give s imi lar observed r esults --although risks are correlated and cannot, therefore, . be eliminated by homemade diversification, r i s k had become in 1968 almost irre levant to the majority of investors on the market. This does not conflict with reality since f r o m 1962 - 1 P e r s o n a l Investing, "Who did What", Fortune, L X X V (March, 1967), p. 207. there had been an unprecedented eight years without a recession, and any fund which had been hedging against a possible recess ion over this period of time would surely have done poorly while one that had been taking chances over the same period would l ikely have enjoyed a superior performance, enabling it to become very large in assets and thus market power. Investors by 1968 had forgotten about r i s k so that the market reacted as if r i sk was uncorrelated simply because it had been losing its importance as a cr i ter ion of investment. Returning to basic portfolio maximization cr i t er ia as described by Markowitz, the letter A in the equation below would become a variable which would diminish as confidence in the market increased after a recession, whereas Markowitz and others have viewed it as a constant. M A X I M I Z E ( R E T U R N - A x RISK) The change in the value of A has serious implications to the price of al l securities which can best be i l lustrated by the see-saw diagram below. 45 Figure 3. The trade-off between return and r i s k as seen by an investor. Now if the stock market moved f r o m a r i sk adverse recession such as 1962 to a condition where r i sk becomes irrelevant for the sake of returns such as 1968, then the see-saw would move to the point where all investments would give a common return. The fu lcrum of the see-saw could also move up or down reflecting elements such as inflation, money supply, polit ical stability, and tax changes. During 1968 the investment community was pushing 46 the see-saw to the l i m i t i n g situation of F i g u r e 4 where a l l investment yi e l d s approach one another. F i g u r e 4. D i a g r a m showing the change i n the trade-off between r i s k and r e t u r n as would occur at the height of a speculative market. The f i g u r e above demonstrates where the m a r k e t was at the end of 1968. The rates on good quality low r i s k bonds had never been higher while the cost of high r i s k equity c a p i t a l for junior i n d u s t r i a l had never been lower; as evidenced by the a b i l i t y of 47 many small companies with no track record to go public. Why did the partners go public? "Because you can't expand a business on demand loans f rom the bank, and besides the cost of borrowed money is high . . . . We thought it would be better to own 50 per cent of a $10 mi l l ion business than . 100 per cent of one with $1 mil l ion. 2 In 1968 return swallowed up r i s k as the cr i ter ion for invest-ment, the value of A diminished to negligible size. The tremendous profits available to investors take place during the swing of the see-saw caused by the changing value of A, but at each instant A is viewed by the majority of investors as having an equal chance of going up or down. F o r example, junior industrials in the middle of a recession such as 1963 might have had a cost of capital as high as 25 per cent because of their relatively high r i sk of failure and. the market's aversion to r i sk at this particular time. But in 1968, with exactly the same r i s k of failure, the same junior industrial might have a cost of capital as low as 10 per cent, for during the inter im the value of A. which formerly placed a heavy penalty on r i s k had diminished to a size of little or no consequence. During the t rans i -tion period the price of the security should have gone up by 150 per cent solely on the basis of the decline in A. which, while lowering Pat Carney, "Electronics Distributor., Issues Shares, " The  Sun, February 15, 1969, p. 29. 48 the cost of capital, raises the price-earnings ratio by a s imi lar amount. Meanwhile the cost of equity capital to a large public utility over the same period would have remained at 10 per cent, so that any pr ice increase in the utility's shares during the period would have to have come from earnings f rom within the company rather than investor enthusiasm. . . . the traditional institutions are buying into the kinds of stocks the performance funds already own. This raises the general P / E ' s of "performance" stocks while selling down the prices of the traditional "Dow Jones" issues. This shifting process is lifting prices in that area of the market where performance investors operate, giving them an extra advantage in their efforts to surpass the "market averages". ^ Consequently, f r o m 1963 to 196?/ the smaller the stock exchange the higher the average pr ice of the securities on the exchange rose. Charles D. E l l i s , "Wil l Success Spoil Performance Investing, " Financia l Analysts Journal, XXIV (September-October, 1968), p. 117. 49 115 f r A / f \ 1 1 1 1 1 1! > 1 t> b l « fc* t s fc>» t n fc8 Figure 5. Figure demonstrates the recent appreciation of smal l companies relative to stocks of larger companies. (Source: Fortune, January, 1969, p. 169) Those who discovered the National (Stock Exchange) this year have had reason to be pleased. F r o m the end of 1966 to the end of July (1967), prices on the exchange more than doubled on the average. By contrast prices on the Amer ican Stock Exchange--officers have expressed concern at the speculative fever there- -rose by only 56 per cent during the same period . . . . The National lists mainly companies that are too smal l to qualify for the Amer ican Stock Exchange. Personal Investing, "The Peaceful Exchange', " Fortune, L X X V I (September 1, 1967), p. 172. 50 The opposite will occur preceding an expected recession and losses will be heaviest at the right end of the see-saw. Those in the defensive issues near the fu lcrum will suffer or profit the least while the bears who have shorted the right end will profit the most. The change in the variable A determines a large amount of the r i s k in holding a portfolio of securities for much of the r i s k in an investor's portfolio is the chance of miss ing the opportunities available in correct ly judging the changes in the value of A. At any instant in time A is viewed by the majority of investors as having an equal chance of moving up or down. Others, however, are of the opinion that the retreat has almost exhausted itself. . . . "Although it came sooner than I expected, there's a good chance we've seen the . - bottom . . . . The element of r i sk now is heavily weighted on the side of not being sufficiently invested. 3 V i c t o r J . Hi l l ery , " A Stock Market Appraisal , " The Wall  Street Journal, August 11, 1969, p. 23. C H A P T E R V E C O N O M I C I M P L I C A T I O N S O F T H E M O D E L F O R B O T H T H E I N V E S T O R A N D T H E F I R M It would be impossible to enumerate all the implications of a changing A. value for the f i r m and the investor, so only some of the main features will be reviewed. An investor's greatest profits and losses take place in trying to anticipate A so that much of an investor's r i s k is tied up in this variable. Also the changing A value will deter-mine to some extent how funds on the market will flow, the cost of capital for different r i s k classes, and consequently the price of shares of all securities. Imagine for the moment that an investor is confronted by a market situation as in the figure below, where all r isks have the same expected returns. OWitjStwk QUtLVy: <rOi\Gfc IJuaWk C^UKAB Nt«> Isves, A _i t x i-Figure 6. Diagram showing the case when the returns of all r i s k classes approach one another. At this time the investor should be aware that the market is not paying a premium for low risk, so he should be buying defensive securities af their current bargain prices . If he feels the A value is about to increase he should, at the very least, have his portfolio near the fulcrum. If he is an aggressive investor he should be shorting the very stocks that did the best as the see-saw moved towards the horizontal position. As one investment fund reported looking over the f irst quarter of 1969: We have been maintaining a large cash position in the port-folio in order to give us protection during what was anticipated to be a period of market weakness. The securities that show the greatest appreciation in value during r is ing markets—the very securities that have given the Cardinal Funds their excellent investment performance — are frequently the same securities that temporari ly exhibit the greatest weakness during declining markets. Our portfolio is therefore some-times in a vulnerable position over the very short term. As soon as we are satisfied that the prospects for the market have turned decidedly favorable we will invest our substantial cash reserves in the securities most l ikely to benefit f rom a further up-trend. In the meantime we shall stay in a protected position and effect further portfolio shifts to increase our concentration in the most promising securities. 1 On the other side of the investment picture take an owner of a private f i r m who is considering a public offering of a proportion of his equity. The owner should realize that now would be the ideal Ryan Investments Limited , Cardinal Funds - Quarterly  Report (Vancouver: M a r c h 31, 1969), p. 2. 53 time to go public for he could obtain the greatest amount for the equity he gives up. Throughout the history of stock exchanges ther have been periods of speculative fever such as in 1968 which have been accompanied by a flood of new issues taking advantage of the low cost of capital at this particular time. To revert to the early joint-stock companies, the year 1711 . saw the birth of the South Sea Company, the history of which is virtually the history of the f irst Stock Exchange "boom". . . . . . . The temporary success of the Company led to the creation of an enormous number of other joint-stock concerns, which in many instances were formed on the f l imsiest pretexts--one for instance, was called " A Company to carry on an Under-taking of Great Advantage, but Nobody to know What it is, " each subscriber of a £ 2 deposit being entitled to £ 100 per annum. Yet so great was the glamour of the South Sea Bubble that this extraordinary flotation met with immediate "success, " for the promoter opened his office in Cornhi l l , and before he shut it and decamped the same day he had secured 3000 in deposits of two pounds. Among other companies projected at that time was one with capital of a mi l l ion to provide a wheel of perpetual motion, one for trading in human hair, another for the manufacture of square cannon-balls and bullets, and another for importing jackasses from Spain to improve the breed of mules. Yet an-other took for its object the extracting of butter f r o m beech-nut trees, and another designed to exploit an air-pump for the brain while it is curious at this time to learn that other schemes related to "insurance on servants" and "a flying machine. " J . F . Wheeler, The Stock Exchange (London: Dodge Pub-lishing Co. , 1913), pp. 12-13. 54 The next mania was the Railway Boom of 1845 when specu-lators could buy stock without a deposit hoping to sell it the day it was listed at a profit. In the f i r s t nine months of 1845 in Britain there were 1035 new project registrations and in October there were 363 more before the subsequent collapse in that month. The collapse followed the raising of the Bank Rate which "drew attention to the gravity of the situation, and was followed by a heavy fall in all Stock Exchange securities, amongst which Railway shares, instead of being quoted at a substantial premium on their par, or 3 face value, fell to a heavy discount. " There were many other booms of similar nature in the following years. In 1895 there was the Kaffir boom in South African gold shares. 4 This was followed in 1910 with a flood of numerous companies to grow rubber. ^ Modern speculation periods have occurred in 1929, 1962, and 1967-68. The new issues which were floated in 1962 were electronics and in 1967-68 the boom was a combination of computer companies, franchise deals, and nursing homes. Tens of thousand of Americans were gripped last spring by an odd speculative mania. It took the form of a promiscuous passion for new stocks issues . . . . Public offerings of stock 3Ibid. , p. 68. 4Ibid. , p. 71. ^Ibid. , p. 73. 55 in small and often highly speculative enterprises were, in fact, running at record levels. But so fierce was the demand that new issues often doubled in price , and sometimes even tripled or quadrupled, the day they came out. . . . More new issues were probably floated this past summer and fall than in any s imi lar period since 1929, and there are no signs that the flow is diminishing. . . . These figures . . . confirm what many underwriting f irms have been discovering: that over the years it has become much easier to se l l stock in smal l companies to the public. Companies that a few years ago could not have got public financ-ing on any terms are now being wooed by underwriters whose sales pitch is sometimes sat ir ical ly paraphrased on Wall Street as "Why go broke? - -Go public ! Although these observations may seem ridiculous in retrospect some of the new issues in 1968 - 1969 have been of comparable quality. Take Integrated Resources , Inc. headed by a 26 year old with a most admirable financial career. The original backers put up $270, 000 and retained 77 per cent of the equity, selling the remain-ing 23 per cent to the public for $3, 000, 000. The stock tripled to $45 and the original backers had a paper capital gain of $29, 980, 000 on their $270, 000 investment. The company's shares at this price were selling at ten times book value even though the company had no assets besides the cash contributed by the public, no profits, and no operating record. In the prospectus their plans are "to purchase Spencer Klaw, "How to Play the New Issues Game, " Fortune, LXVII (January, 1962), p. 74. 56 industrial equipment and real estate and lease such property to others, to provide investment advice and management services and to acquire operating companies for cash or its securities. " ' As of A p r i l 1969 the company had sti l l not commenced business. boo l»0O 100 53 5<+ S 5 5 b 5 T 5 * S'N to 4>S (.x a fc^ U5 bb ' t"l feS Figure 7. Number of New Offerings over $300, 000 in the United States f rom 19S3 to 1969 ( F r o m Fortune, January, 1969, p. 169) The above chart shows the two periods 1961 and 1968 when new issues boomed in periods of speculative fever. By the summer of 7 "Success Story," Forbes , CIII (May 1, 1969), p. 19. 57 1969 the new issue market after a strong 1968 had once again become a buyer's market and the number of offerings had fallen back sharply. The once-sizzl ing new issue market, deposition of many golden investment eggs in the last couple of years, has taken on a decided chill . The plunge in speculative stocks has almost overnight converted the new-issue market f rom an underwriter's gold mine into a financial disaster area. . . . . . . that 60 of 76 issues initially offered to the public in June were selling Tuesday at discounts from their offering prices . Only a year ago, a s imi lar ratio existed on the plus side. ^ Generally, companies going public offer their shares at a time when it is most opportune for them to do so. When speculation is at its height their cost of equity capital is very low relative to periods when the market is heavily discounting risk. The public because of its blind enthusiasm buys new issues at the worst time; at the time when it must pay the most for the equity given up. Therefore, on the average the return over a long period of time f r o m new issues would be lower than other stocks of the same and even lower r i sk classes. This is because the majority of new issues are floated when the see-saw is nearly horizontal and then suffer declining values as the see-saw moves to a more normal position. Evidence supporting "Jerry Robards, ."New Issues Market is Losing its Sizzle, " The Province (Vancouver), July 15, 1969, p. 38. 58 this proposition has been derived by David Shaw of The University of Western Ontario although M r . Shaw could not explain his findings. New common stock issues in Canada have fared poorly in comparison to the performance of outstanding issues. Poorest relative performance has come from f irms undertaking smal l issues and from f irms financing initial production facilities with equity offerings. Investors in highest r i s k issues have on average received inferior returns, which is paradoxical since theory suggests that investors demand larger returns to compen-sate them for taking additional r isk. 9 M r . Shaw has noted that his results do not match Markowitz's explana-tion of the trade-off between return and risk. However, under the thesis' hypothesis when the majority of the companies that go public do so at a time when their cost of equity capital is the least, then over a long period of time it would be expected that the average return of new issues would be poor relative to the returns available from already outstanding issues. Even more dramatic evidence is offered to us by M r . Shaw in the following table: Industrials by year of issue No. 1 Relative 5_ Relative 1956 7 .895 . 576 57 2 1. 298 . 533 58 3 1. 017 . 662 59 8 . 760 . 868 60 -5 1. 184 . 689 6 1 26 . 964 .479 6 2 19 . 874 . 436 63 11 .873 .891 1 C 7 D a v i d C. Shaw, "Hot New Issues: How Well Do They P e r f o r m ? " , The Business Quarterly , X X X I V (Summer, 1969), p. 52. 1 0 I b i d . , p. 47. 59 The table shows the number of Canadian companies that made public offerings in the years 1956 to 1963. The relative columns give index numbers which show how the shares have performed relative to general market averages since being offered. F o r example, if the companies that went public in 1956 over the five years to 196 1 had performed better than the general market over this same period they would have a S_ Relative figure greater than one. If they had done worse, their 5_ Relative figure would be less than one. It is interest-ing to note that over the five years the companies that have done poorest relative to the market were the ones that were issued in 196 1 and 1962 when the new issue market was enjoying its greatest popu-larity. The best long-term performers were found in 1963 when it was a struggle for a new issue to come on to the market. This is to be expected, of course, because the issues in 1961 and 1962 were brought out when the cost of equity capital for new and thus r isky ventures was relatively low. As the market returns to a more normal position, r i s k is given a greater cost, those stocks with the highest r i s k would perform relatively the worst. Since new issues are of high r i s k those offered under boom conditions such as 1962 could be expected to perform relatively the worst as compared to the general market in subsequent periods. On the other hand, the new issues brought out under poor conditions such as 1963 could be 60 expected to perform relatively better than the general market over the longer term. The evidence compiled by Mr. Shaw seems to bear out what the thesis' hypothesis suggests. Over the near term the 1961 and 1962 issues (average relative = . 919) did better than those of 1963 (relative = . 873) but over the long-term 1963 issues (relative = . 891) did significantly better than those of 196 1 and 1962 (relative = . 457). We conclude that the hypothesis of risk which allows for a changing trade-off between return and risk goes much farther than Markowitz's findings in explaining Mr. Shaw's evidence. In fact, Mr. Shaw by following Markowitz finds himself in a paradox when he discovers that the highest risk issues give the poorest returns. The investment model of the thesis shows that during periods of fierce speculation the cost of capital for a company making a public offering is at its lowest point. This would be the ideal time for an owner of a private company to sell some of his equity interest to the public. On the other hand, an investor in a booming new issue market should be aware of its inevitable collapse. Consequently, his commitments to new is sues,* should be for the very shortest term. This policy could best be executed by buying only at the time of under-writing and selling shortly after the issue is listed on an exchange. By using a rapid turnover he would commit a minimum percentage of his portfolio to the risky new issues. 61 The other great phenomenon in market activity over the period 1963 to 1968 was the r is ing number of takeovers. The takeover rage is another direct result of the fact that there is a changing trade-off between r i s k and return. The explanation of the takeover shows another important relationship between the disposition of investors and the formation of assets of a f i r m . Again, assume the see-saw has moved to the horizontal position, and the decision makers are the owners and managers of a computer leasing company which is considered to be a r i sky enter-prise. Also assume that the officers and directors control 50 per cent of the company's shares and their interest in the company represents 90 per cent of their individual investment portfolios. These men could reflect on their good fortune because as the see-saw moved downwards towards the horizontal, their equity multiplied. F o r example, in 1963 such a company might have had a cost of capital as high as 25 per cent, but by 1968 this could have declined to as low as 10 per cent because investors over the period had become less and less r i sk conscious. This by itself would increase the price-earnings ratio by 150 per cent. But as the see-saw approaches the horizontal it becomes more and more r isky and less and less profitable to maintain a portfolio on the right end of the see-saw. Just as this is the time to move one's investment portfolio towards 62 the fu lcrum it is also time to move the company towards the fulcrum. Reflect on the officer's position for the moment: the equity in the company has appreciated over 100 per cent and they have 90 per cent of their capital tied up in the company. Their shares are held in escrow so they are locked in, and they also don't want to sell and lose control of their company. If they were wise they would real ize that investors have over-bid the company's stock, and they would real ize that when the economic circumstances again remind investors of the fears of a recession that the price-earnings ratio of their company will decline as far as it previously ascended, and probably even more rapidly. So with the fear of losing at least half their fortune, it becomes obvious that the only cure will be to somehow move the company towards the fulcrum. This can be done by taking over an existing conservative company, preferably at least as large as the r i sky company, by using a share exchange offer or making a cash offer f r o m money ra ised by an underwriting of shares. These over-pr iced shares that are distributed are known as Chinese dollars. The raiders , by making the takeover, reduce their own company's r i sk and quickly protect their personal investment port-folio for the inevitable impending market disillusionment with glamour or concept issues. 63 Circumstances make this manoeuvre even easier than one might at f irst think. The large conservative older companies which make the best targets have directors who normally do not control the majority of the shares of the f i rm. Also , the shareholders being tempted to turn over their shares wil l generally sacrif ice the long- term promises of better management offered by the present management for an immediate profit offered to them by the share exchange offer. It does a target company little good . . . to denounce the raider as a horse thief. The mere possibility that a horse thief wil l take over his company makes the stockholder all the more anxious to sell at a profit. Nor does it do much good to tell the individual stockholder with a fat immediate profit that the deal wil l prejudice the long-term interests first. 1 1 Added to this is the fact that at the time of the offering the investment community has the speculative fever which makes it willing to take a chance, on a change in management which will replace the older con-servative directors. The raider's shareholders would have enjoyed a pr ice appreciation in the recent market, and the raiders can use this as a selling point in wooing the conservative company's share-holders to accept their offer. The irony is, of course, the raiders know that they are vulner-able in a market set-back and must get hold of the conservative company •^Gilbert Burck, "How to Fend Off a Take-Over , " Fortune, LXXVIII (February, 1969), p. 83. 6 4 to p r o t e c t t h e i r own s h a r e h o l d e r s and t h e i r p e r s o n a l i n v e s t m e n t p o r t -f o l i o r a t h e r than t h e i r s t a t e d a i m s of a s p i r i n g to r e v i t a l i z e the c o n s e r v a t i v e company to help i t s s h a r e h o l d e r s . Another i r o n y e v o l v e s i f a number of o v e r - p r i c e d c ompanies a r e b i d d i n g i n c o m -p e t i t i o n among one another w i t h t h e i r C h i n e s e d o l l a r s f o r c o n t r o l of a c o n s e r v a t i v e company, b e c a u s e the m o s t o v e r - p r i c e d company can a f f o r d to m a k e the h i g h e s t tender o f f e r . Added to thi s i s the f a c t that a c c o r d i n g to our h y p o t h e s i s the m o s t o v e r - p r i c e d company w i l l a l s o be the r i s k i e s t . T h e r e f o r e , i f the b i d d e r s a r e of the same s i z e the c o n s e r v a t i v e company w i l l be c o m b i n e d w i t h the w o r s t p o s s i b l e p a r t n e r . In fact , when the economy s i g n a l s a r e c e s s i o n the s h a r e s of the c o m b i n e d company w i l l f a l l f a r t h e r than the c o n s e r v a t i v e company's s h a r e s would have gone by t h e m s e l v e s , but not as f a r as the s p e c u l a t i v e company's s h a r e s would have gone. The c i r c u m -stances f o r a ta k e o v e r a r e i d e a l i n a s p e c u l a t i v e m a r k e t d e v o i d of r i s k - c o n s c i o u s i n v e s t o r s , and i t i s l i t t l e wonder that t a k e o v e r s r o s e i n t r e m e n d o u s n u m b e r s up to the end of 1968 as the s t o c k m a r k e t b e c a m e l e s s and l e s s r i s k - c o n s c i o u s . - ! . — ^ _ 1 Figure 8. Number of mergers in the United States for period 1950 -1968. (Source: Fortune, February, 1969, p. 80). Other merger movements took place in the 1890's and in the 1920's, but were small relative to the size and number of the movement of 1967 to 1969. This points out that the number of takeovers increases as a speculative boom accelerates. However, not all attempts at reducing r i s k through diversification are successful. Many of the takeovers in recent years have been financed through debt structures that have added to the r i sk at least as much as the addition of the conservative company has reduced risk. The pr ime example of this has been the conglomerates which have been put together on the premise that they 66 were to reduce r i s k through conscious diversification into unrelated industries. The directors of conglomerates felt they were doing the investor a favour by diversifying on the investor's behalf. The conglomerates, by accumulating pyramids of debt, were ripe to have their share values collapse in the event of an expected recession. Pr ices of most leading conglomerate stocks are down 40 to 50 per cent f rom last year's highs, compared with a decline of 8 p e r c e n t in the Dow-Jones Industrial average and a 15 per cent slide in Standard & Poor's index of low-price common stocks, generally regarded as a barometer of speculative 1 ? activity in the stock market. As a group the conglomerates moved to the right on the see-saw because of their diversification programs, rather than in spite of them. Not only did conglomerates convince themselves of their strength, but some security analysts also became convinced as to their magic. Portfolio diversification is usually framed in terms of number of securities and number of industries. It rests on the concept of the "law of averages. " The broader the number of securities and/or industries, the more fully that law is brought to bear, the more l ikely it becomes that average results will be exper-ienced. It, therefore, follows that where stability or preserva-tion of principal is desired, a portfolio is widely diversified. Where enhancement of principal is desired, a portfolio is consolidated. •••^John J. Abele, "Conglomerates Open Attack on Detractors, The New York Times , M a r c h 1 6 , 1 9 6 9 , p. 4 7 . 67 A conglomerate in effect provides bui l t - in diversification of both companies and industries. A portfolio with substantial representation in conglomerates can be more consolidated in terms of names and, at the same,time, be more diversified in terms of industries represented. 1 3 The portfolios managed by this analyst must represent nothing less than a disaster area today. It is quite easy to see that this analyst has ignored some of the main features of this paper's hypothesis. He has ignored the simple fact that the returns from stocks and part icularly those of the same type, such as conglomerates, will not act as independent random variables which is a necessary condition for the "law of averages" to be applicable. This demonstrates the need for improved portfolio theory to help guide those providing advice to investors with a base to formulate their decisions upon. It has been demonstrated that there are important relationships between investors' enthusiasm and f irms' portfolios of assets. In this regard, take an example of a hypothetical problem where a proper knowledge of investors' enthusiasm will enable the f i r m to correct ly structure its growth through financial manoeuvres. The importance of such an example is demonstrated by the fact that so many conglomerates are in serious trouble today because they went about diversification in the wrong manner. The hypothetical problem 1 : 5 Bennett S. Kopp, "Conglomerates in Portfolio Management, F inancia l Analysts Journal, XXIV ( M a r c h - A p r i l , 1968), p. 148. 68 wil l be able to foreshadow what the future holds in regard to take-over activity. Assume there are two companies, Company A. and Company B, competing in an industry which the investment community is enthusi-astically supporting with a high price-earnings ratio. Both companies have little current earnings and need capital inflow to finance ex-pansion over a number of years. T i l l now both companies appear to be s imi lar; however, they view quite differently the past market speculation which has driven up both their stocks. Company A has come to believe in itself and the industry which it is in and feels the investing public is wise to give its shares such a high p r i c e -earnings ratio. Company B is more skeptical of the recent market advance and feels the investment public is foolish to pay two or three times the true intrinsic value of the company. Company A has not considered diversifying outside its own industry, while Company B wants to reduce r i sk by taking over an enterprise which is soundly financed in a non-cycl ica l industry and has a strong cash and earnings flow. Before the end of the period of speculation Company B takes over a conservative company of comparable size to itself, and by maintaining the same financial r i s k as before, by not piling up debt, is able to move halfway between the two former positions on the see-saw. Company A. makes no takeovers and remains out on the 69 right end of the see-saw. Inevitably the market collapses. "So much was public confidence shaken by this, so t i m i d were capitalists in r i s k i n g money, that speculation for a long time was v i r t u a l l y dead. " 1 4 Company A suffers a market setback which puts its price-earnings ratio back where i t was before the speculative fever hit the market. Company B, with its recent consolidation, suffers only half as much as Company A because the Jcompany B took over had not been responsive to the bear markets of former recessions. Company B, while maintaining some of the capital gains of its share-holders, also has provided through the conservative company an earnings and cash flow base to finance expansion within its glamourous industry. Company A over the same time has declined tremendously i n share value. Company A. needs cash for its expansion but has no earnings, and no underwriter w i l l touch i t . Company A stagnates while Company B, by using it s takeover as its cash supplier, con-tinues to grow and is able to receive further financing f r o m the investment community. Company B which s t i l l has confidence i n its industry must now prepare i t s e l f for the next market boom. This w i l l again r e f l e c t the way i n which an investor w i l l re-adjust his portfolio during a recession. When the investor expects the see-saw Wheeler, op. cit. , p. 52. 70 to swing back down towards the horizontal he should have his port-folio out on the extreme right end of the see-saw. Company B knowing this should now continue to expand within its own glamour industry if the prospects for growth remain the same. Company B can manoeuvre back out to the right end of the see-saw by taking over Company A and others l ike it at bargain prices . This will be quite easy because A must have cash to survive and cannot get it without B's help. B can therefore move back out to the right end very cheaply in preparation to ride the cycle of investor enthusiasm again. This gives a clue to the next round of takeovers. The big winners will be those companies in the glamour industries who have large cash inflows obtained from taking over conservative c o m -panies in the past market boom. One example of a proper manoeuvre in the past market is University Computing Company. Some 2, 900 stockholders of Dallas based Gulf Insurance could hardly believe their eyes. There was Sam E . Wyly . . . offering $80 worth of his U C C stock for each share of their sleepy Gulf Insurance. F r o m 1965 to 1967 Gulf stock had averaged $25. The deal seemed too good to be true. As it turned out, it was too good to be true. Since last December's merger with Gulf, U C C stock has fallen to about half its December price. Thus the transaction is now worth $40 a share, instead of the $80 Gulf stockholders had counted on . . . . 71 . . . the U C C - G u l f merger shows what can go wrong when a new-breed businessman like Wiley uses high price/earnings paper to take over a company several times his own company's size. Gulf's 1968 income fel l , dragging down U C C ' s earnings with it . . . . What does Wyly think about the merger now? "I would do it all over again . . . . U C C now has capital strength at a time when money is tight. We have real financial clout. " But the lesson of U C C ' s comedown in the stock market will be duly noted by big stockholders in asset -r ich laggards thati: may be coveted by asset-thin go-go companies l ike U C C . It may make this kind of takeover somewhat more difficult in the future. 15 The computing company had reduced its r i s k just prior to the market downturn. Although its stock has fallen considerably it would probably have gone farther if the takeover had not been con-sumated. The computing company has been able to guarantee a strong cash flow during a period when most in the industry will require cash but will be unable to raise it because of adverse market conditions. If Wyly is wise he will now begin to pick up his com-petitors who are cash starved. This will prepare his company for the next round of investor enthusiasm. By following a policy directly based on the enthusiasm of the investor, which this paper treats as the changing trade-off between return and risk, a company can grow properly through takeovers and acquisitions. Too Good to be T r u e ? " , Forbes , CI (June 15, 1969), p. 29. 72 Financial theorists have largely been interested in f irms which grow internally. This method of growth is often secondary to growth by using takeovers in many companies and, in particular, aggressive companies. . . . an overpriced stock in the hands of an astute user of that stock is a key corporate resource. There are large measures of truth in the observation that one good deal is usually worth five or ten years of bri l l iant operations. Real values can be created fast through the use of Chinese dollars so that what had been a grossly overpriced stock several years back becomes a reason-able one now because of judicious acquisitions. ^ The thesis' hypothesis of a changing trade-off between r i sk and return is able to explain the phenomenon;of the r is ing numbers of takeovers in highly speculative markets. This section has demon-strated the importance of the relationship between the investors' portfoliojof stocks and f i rms ' portfolios of assets. Further , this section has reinforced the argument of the paper that financial theorists have been focusing their attention on problems that are not relevant to the activities of some corporations and in particular those aggressive corporations which most need expert advice and theories to direct their activities. Now consider the decision maker operating a company facing an investment community which has a variable trade-off between r i s k X D M a r t i n J . Whitman, " A Road to Instant Wealth - Disparities  Between Market Reality and Corporate Reality, " (talk to the Restaurant Executive Institute, Hotel Warwick, New York City, August 15, 1968), p. 18. 73 and return. Should he consider his existing cost of capital as his real cost of capital? F o r example, suppose a f i r m normal ly operates at a certain r i s k level and is required on the average to make a return of 18 per cent before taxes on asset investments. However, currently the f i r m commands a premium for its shares because of the r i s k irrelevance in the stock market and as a result the current cost of capital has declined to 10 per cent. The manager of this f i r m should not expand at this same r i s k level to the point where marginal revenues are equal to marginal costs of capital. This is because inevitably the market will place a larger discount on r isk , and raise the marginal cost of capital. If expansion had been carr i ed out to the 10 per cent level this profitable expansion would at a later date be returning less than the average required rate of return and be a burden on the f i rm. The achievement of these optimum results could best be facilitated in a country where the business cycle is eliminated and replaced by a steady growth pattern. A necessary condition for the full exploitation of the growth potential is a high and steadily expanding level of aggregate demand uninterrupted by major domestic or external deflationary forces. If this condition is fulfilled, entrepreneurs will have optimistic profit and market expectations. Because of the reduction in their macro-economic r i sks , they will maintain a higher rate of investment than they would in a position of slack capacity use, recurrent falls in activity, and downward price movements. ^ l^Angus Maddison, Economic Growth in The West (New York: W. W. Norton Company, Inc. , 1964), p. 18. 74 However, because it is very unlikely that business wil l ever operate in such a state of Utopia in the near future the most optimum results that can be achieved must make allowances for the cycle. Therefore, although in a static situation a f i r m should expand to the point where marginal returns equal marginal costs; in the case of a market boom the f i r m should leave a gap between the two in proportion to the distance that the f i r m is located to the right of the fulcrum and inversely proportional to the size of A. Conversely, in a recess ion a f i r m should expand beyond the point where marginal revenues are equal to current marginal costs of capital in the anticipation that the cost of capital will decline. This might be impossible, of course, if the f i r m is unable to raise the capital for investment. Although the immediate result of such an investment might lower the company's stock price the overall long- term value of the stock would be greater. This argument may be used as an explanation of why many c o m -panies have over many years correct ly practised a min imum fixed rate of return on new investments even though current theory applied to the market experienced in 1968 might dictate that f irms should expand to the point where marginal revenues equal marginal costs. The best long-term results, however, are achieved by expanding only to the point where the investment's marginal return is equal to the marginal cost of capital averaged over a number of years for the r i sk 75 class the company is currently operating within. This leaves the question of which r i sk class a particular company wil l be found in, which is the subject of the next chapter. C H A P T E R VI RISK Risk is the least understood element on the stock market and yet it is one of the pr imary variables determining the price of all securities. R i s k is almost a sixth sense with characterist ics com-parable to taste: it's easy to feel, but hard to measure and impossible to quantify. Risk is also a continuous variable, changing over time, which makes it even more abstruse than taste. Reca l l that Markowitz's definition of r i sk is unsatisfactory, as there are two methods avai l -able to any investor to capitalize upon a return which is a random variable that is normal ly distributed about an expected return. With this in mind the paper will now attempt to describe the r i sk involved for the investor who buys a stock. F i r s t , there are probably more types of r isks than there are types of investors. To demonstrate this point take one particular r i s k faced by mutual funds which pension funds are not subject to. In 1968 the best funds were the performance funds which were buying letter stock in unlisted securities. In 1969 a bear market set these funds back considerably. Investors redeemed shares in these funds faster than new money flowed into the funds. As a consequence such funds had to sell shares that they owned in order to make cash 77 redemptions. However, often the fund finds it difficult to sel l shares where the number it owns rs large relative to the outstanding shares of a company because this in itself will drive the share prices farther down, bringing the fund's share value down and accelerating the redemptions. So these funds f irst must sell their most liquid stocks which are probably also the stocks of the best quality. This increases the proportion of the fund committed to the weaker c o m -panies and hence the fund becomes more vulnerable to further market declines. When it runs out of l iquid investments it can then get caught unable to make redemptions at all . At this point the fund is virtual ly insolvent. Pension funds on the other hand can count on fixed money inflows and do not face the r i s k of sporadic cash flows which might force a fund manager to sell investments on the basis of liquidity rather than desirability. But though each type of investor faces different risks there are a number of r isks which are faced by all investors. These r i sks , the ones no investor can avoid, are the subject of this chapter. If we assume that the only reward common to all investors to be derived from holding a security is the size of the monetary return, r i s k can be defined as the chance of a return less than that expected, no matter how the decline in return may occur. Two distinct situations will cause a decline in return to the shareholder: 78 1. The expected rate of return from the investment portfolio itself declines. 2. The required rate of return from the investment portfolio ris es. The first means the expected return on capital falls, the second means the cost of capital rises. The first situation where the expected return of the whole port-folio falls can occur in various degrees of intensity and is known as the risk of a slowdown, recession, or depression. In such a case an investor in securities to the right of the fulcrum invariably will suffer a loss which may be called risk factor number one defined as: 1. A common decline in the expected returns from securities of the same risk classes found to the right of the fulcrum in such a manner that an investor is unable to reduce his risk of monetary loss through diversifying within these same risk classes. This first risk factor is what determines where on the see-saw the security will be positioned. For example, the home building industry has had very poor returns in past recessions and this type of security would be positioned far to the right of the fulcrum Risk factor number one involved a decline in the return on capital, however, the next two risk factors involve an increase in the cost of capital and therefore do not reflect the internal operations of the companies themselves. When the rate of return required changes, it is the result of changing investor preferences and 79 opportunities and therefore is not a reflection of the f irm's opera-tions but only the investors' choices. As such the second r i sk factor may be defined as: 2. A change in the r i s k preferences of investors who by increasing the value of A in the objective equation, M A X I M I Z E ( R E T U R N - A x RISK), will increase the required rate of return f r o m all r i sk classes in p r o -portion to the distance that they lie to the right of the fulcrum. Instead of the equation M A X I M I Z E ( R E T U R N - A x RISK), the equa-tion should read M A X I M I Z E ( R E T U R N - A x RISK F A C T O R N U M B E R ONE). The f irst r i s k factor positions our company on the see-saw and the second r i s k factor, the change in the variable A, determines which direction and how far and fast the see-saw swings. The third r i s k factor, l ike the second, involves the rais ing of the cost of capital through no fault of the individual company, and is defined as: 3. The change in the fu lcrum which may increase the return required from all investments. The most famil iar example of this is during a period of r is ing infla-tion, the investor must be compensated more and more for consumption foregone. As inflation increases the fulcrum rises and the price of all securities fal l , adjusting to the need to return more. Therefore, there are three r isks present in holding any security and each involves the possibility of any one of these three r i sk factors 80 changing to cause either an increase in the cost of capital or a decline in the return expected on the capital. Each one of the three r i s k factors will cause the same financial result to the investor, a decline in the monetary return f r o m the security, which may takeethe f o r m of either lower dividends or a decline in the market price of the stock. It is this fact, that the financial result is the same no matter which r i s k factor is affecting it, that has made it so difficult for students of finance to discern and define the r i sk inherent in owning stocks. The f irst r i sk factor is the most important and the hardest to understand and will therefore be dealt with in considerable detail. Assume that the stock market is controlled by mutual funds, trusts, and wealthy individuals each having assets large enough to enable them to diversify their portfolio thoroughly. This is a fair assump-tion and is quite possibly true. Now as explained earlier if we did have r i s k classes with increasing scales of return with each succeeding level of higher r isk, but these r isks acted independently, then any diversif ier could obtain the "best" return of the highest r i s k class mere ly by diversifying within it. Such is the case with life insurance companies who in insuring thousands of individuals are able to eliminate r i s k by diversification. F o r example, a company could not exist to insure one individual for one bi l l ion dollars without 81 considerable r isk, although it could easily exist and almost eliminate its r i sk by insuring one mi l l ion people for one thousand dollars each. However, it could only eliminate its r i s k as long as the mi l l ion people which it insures die independently of each other. However, deaths are not always unrelated for certainly deaths due to wars and plagues are dependent upon one another. These unfortunate circumstances impose r isks on the insurance companies who in de-fense write in escape clauses in their contracts in case of war, and hold special reserves in fear of plagues. In a stock market con-trol led by diversif iers all returns would approach a common return as diversif iers compete amongst themselves. But like war and plague a dark cloud known as recession is a common visitor to the stock market. It is this variable that causes dependent reactions within the market and it is this variable which is the largest single r i s k in the market. A common decline in the expected returns f r o m securities of the same r i s k classes found to the right of the fulcrum in such a manner that an investor is unable to reduce his r i s k of monetary loss through diversifying within these same r i sk classes. Each security may be rated according to this cr i ter ion and then can assume a position on the see-saw. This f irst r i sk factor depends on three variables found to a certain extent in every stock: one, the change in expected return 82 due to a recession; two, the amount this return is leveraged through debt issues; and three, the investors' ability to predict how much the return will change in a recession. Each variable is now described in greater detail. The change in return depends on the type of security. F i r s t , our defensive stocks which have little r i s k for their returns are not expected to decline, and may even increase in a recession. Such companies that don't suffer appreciable declines normally supply necessities, and might include suppliers of cigarettes, l iquor, or utilities. Some companies may even have their expected returns increase in a recess ion and might include suppliers of margarine, a butter substitute, and suppliers of gold, a money substitute. As confidence in money declines, the expectation for gold relatively increases, and the price of gold securities r ise . On the other extreme we have stocks that supply goods that there is little demand for when times are tough. These goods have their expected returns decline in the event of a recession and would include luxury boat manufacturers, f a r m machinery producers, and home building companies. These stocks would be positioned closer to the right end of the see-saw. The second variable which determines the strength of r i sk factor number one is the amount of leverage used in financing the company. 83 I N T E R E S T C H A R G E S ON L O N G T E R M D E B T  I N T E R E S T C H A R G E S ON L O N G T E R M D E B T + P R O F I T + I N C O M E T A X E S The higher this ratio the more leverage the company would be using and the further to the right it would sit on the see-saw. This is because the leverage not only increases potential profits in good times but also increases potential losses in bad times. Also the equity holder subordinates his right to income claims and claims on assets, part icularly if the company is in trouble, in exchange for his leveraged income in good times. Thus as debt increases the share-holder accepts greater r i s k to obtain greater leverage on his income, thus increasing his potential gain and also his potential loss. The problem of predicting how a company will perform in a recession is the third variable affecting r i sk factor number one. Many of the recently formed conglomerates could be included in such a group. These new companies although diverse in operations have not been subjected to the stresses of a recession so that they may be viewed as having a considerable amount of internal risk. I'm scared si l ly of them. When things start going badly, you have to understand the corporation to be able to find and correct the trouble. How can you understand a conglomerate? 1 i Ronald Anderson, "Top U. S. Consultant 'Scared Sil ly' by Conglomerate Monster Image, " The Globe and M a i l , November 23, 1968, p. B3. 84 Other variables such as the working capital ratio, the age of receivables and payables, and the voting rights of the fixed income security holders would affect the internal risk to a lesser degree. However, the three internal risk variables will be present to some degree in all securities. Conglomerates, for example, often have extended debt struc-tures because the takeovers that they are built upon are most often financed through debt instruments. Besides this is the fact that they are hard to analyze, and untested under conditions of a recession so that their internal risk will be very high and they will be positioned far out on the right end'of the see-saw. In summation the three variables which determine risk factor number one are: 1. The change in expected return due to a recession. 2. The amount this return is leveraged through debt or other issues senior to equity. 3. The investors' ability to predict how much the return will vary during a recession. Gauging these three factors in a company, the position of the company on the see-saw can be determined. With each stock within an investors' portfolio positioned it is possible to gauge the risk of the whole portfolio by determining where on the see-saw the portfolio itself sits. This may be done by summing the individual 85 distances times the dollar amount invested in each distance. Treat distances to the left of the fu lcrum as negative and to the right as positive and then by dividing by the total dollar amount of the portfolio the distance that the portfolio sits f rom the fulcrum is determined. It is noted that short sales would change the sign again. With the internal r i sk , r i sk factor number one, established it can then be determined how an investor should behave under different market conditions. Generally, if the investor expects a bull market his portfolio should be on the right side of the fulcrum. If he expects a bear market his portfolio should be on the left side of the fulcrum. In a particular case, suppose a speculator or r i sk lover is bull ish over his next investment horizon. He will adjust his port-folio to be on the right end of the see-saw. He may do this by buying stocks with high internal r isks normally situated at the right end of the see-saw, or he may as an alternative short sell the left end. He may also supplement his buying or short selling by using marg in accounts. If he were to short sell bonds at the left end he could obtain more leverage f r o m his broker than he could in trying to leverage speculative stocks on the right end. In this way, it is l ikely that the left side of the see-saw could be extended as far as the right. This shows r i s k factor number two, the change in the value of A, often described as a bull or bear market. 86 In attempting to predict investor sentiments and a bull ish market the investor is interested in where his portfolio sits rather than the particular stocks within it. The r i s k is, of course, that the investor has incorrect ly anticipatedtthe change in the A. value although he may have correct ly gauged the internal r i sk of each stock. On the other hand if the speculator expects a bear market he would attempt to reverse his position entirely by shorting the right end and buying the left, thereby moving his whole portfolio to the left side of the fulcrum. A. conservative investor would act somewhat differently under s imi lar circumstances. In anticipating a bull market his portfolio would be to the right of the fu lcrum but nearer to the fulcrum than the speculator's portfolio. The portfolio is l ikely to contain a smaller proportion of stocks with a high degree of internal r i sk , r i s k factor number one, than the speculator's portfolio. In the event that the conservative investor changes to bearish f rom bull ish he wil l sell some of his stocks and accumulate a greater proportion of his portfolio in bonds. However, it is unlikely he will use short selling as a trading device and we can see that the amount of trading he will require to move from bull ish to bearish will be much less than that required by the speculator. The losses that he might 87 sustain because of unexpected changes in the value of A will there-fore be much less. As a consequence the r i sk that he has tied up in r i s k factor number two will be much less. The speculator is much.more l ikely to get caught out on the wrong end of the see-saw because it will take time to trade out of his positions and completely rearrange his portfolio to accommodate a changing market. The turnover of aggressive mutual funds is much higher than conserva-tive funds and much of this turnover can be attributed to trying to anticipate r i s k factor number two, the changing variable A. Besides the amount of trading required to change f r o m a bull ish to a bearish attitude the speculator is more l ikely to get trapped in his stocks if his portfolio is large. The shares in the. speculative issues are more l ikely to be thinly traded, making it difficult to dispose of large holdings without driving the shares down in value. In 1968 the funds out on the right end of the see-saw did well in a r is ing market as our see-saw moved towards a horizontal position. However, in the f irst half of 1969 the see-saw moved back towards the position that was anticipating a recession and those funds out on the right end that did so well in 1968 suffered extensively in the f irst half of 1969. During this year's f irst half, the composite index of shares l isted on the New York Stock Exchange dropped an average of 8%. The decline for mutual funds was close to 12% . . . . 88 Generally the funds that rose the fastest last year fell the fastest this year. Not one of the ten biggest gainers of 1968 managed to cl imb at al l in this year's f irst half . . . Many of the go-go funds were loaded with thinly held stocks of nursing homes and computer-leasing f irms, which were badly battered by the Government's anti-inflationary drive. . . . The Neuwirth Fund, which last year soared 90% in per-share value to rank No. 1 in the U. S. , fell 16% in the f irst half and dropped to 305th place (among 369 funds). The Mates Investment Fund, which gained 73% last year, has fallen to No. 367. Gibralter Growth, which was in third place in 1968, dropped 13% and is now 254th. A look at an actual investment policy followed by one type of investment fund known as a hedge fund will further the reader's understanding of r isk. A hedge fund is an attempt by the managers to hedge against their inability to predict the stock market's cycles. This is done by using the fund's assets to'.buy and sell short an equal dollar amount of two portfolios. Of course, the portfolio they buy is made up of those stocks they expect to perform the best in the future and those they sell short are those they expect will per form the worst in the same future period. By this method if the general market falls then it is expected that most stocks held will decline but it is hoped that the ones that go down the farthest will be those that were shorted and the ones that they have bought go down the least. Conversely, when the market turns up they wil l profit on the ^"Wall Street - The Funds A r e Fal l ing , " Time, XCIV (July 11, 1969), p. 64. 89 stocks they have bought, and hope the stocks they are short on will not have r isen as far, or even better, that they may have declined in pr ice while the general market rose. By this method the finan-cial manager can hope to profit by being an intrinsic value specialist without having to be a specialist in predicting changes in A, r i s k factor number two. But the r i s k in the swing of the see-saw and changes in the fulcrum is only eliminated if the sum of the risks of the portfolio bought is equal to the sum of the r isks of the port-folio sold short. This could be most easily effected by buying and selling short companies in common industries. For example, buying a computer leasing company and selling one short rather than buying a computer leasing company and selling a utility short. We can see the danger of not balancing the r isks of both portfolios and so the r i s k of cycles can only be negated with the addition of the r i s k that balance is not achieved. It has been shown that r i sk is closely tied to the return of a security if the return is measured in part by the price of the security. Because of this and because of the fact that r i sk is measured in terms of a decline in monetary return from that expected, it has been very hard to separate r i s k and return. Complicating this is the fact that the end result of any of the three most important r i sk factors is the same. The result of the factors coming into force is 90 either a raising of the cost of capital or the lowering of the rate of return expected on the capital. In either case it is impossible to discern f r o m the decline in the return which of the three factors is causing the decline. It is therefore not difficult to see why r i sk has been a factor so hard to define. It is unlikely that this brief chapter has done justice to the subject of r i sk but it is hoped that it will stimulate some innovative thought into this neglected area of finance. C H A P T E R VII C O N C L U S I O N S In a thesis which has not covered a particular problem in depth it is often difficult to make formal conclusions. At f irst glance it might appear that this thesis has not covered any particular subject deeply. However, the motive of the paper was to question the method of building financial models rather than to build or fit one with data. To this end the author is able to conclude that much theoretical work is yet to be done to link theory to real world behav-iour. The author also concludes that the new financial era, characterized by external growth through financial instruments which exploded in the last six years, has not received adequate attention by financial theorists, and as a result students are inadequately p r e -pared for the work that they will face later in business. The author is also of the opinion that the hypothesis presented which demonstrates the power of the interrelationship between f irms and investors, facilitated by a changing trade-off between return and r isk , could well be the basis for studying this new era of finance. The author has not proven the hypothesis, nor was it his inten-tion to prove it, as he felt tlie time that might have been spent 92 accumulating data has been spent more efficiently in innovative thought. Also the lack of any correlation or regression is a demon-stration of one of the motives of the thesis: that the study of financial theory is not perfected to a stage where correlations are the most useful tool for analysis. It is the author's opinion that many correlations conducted in recent years in finance have only added to models whose basic groundwork is faulty. In addition to the above formal conclusions there are a number of important points which seem to be demonstrated by the thesis. The major point is that there appears to be a strong interrelat ion-ship between investors' portfolios of stocks and f i rms ' portfolios of assets. This interrelationship can best be described by a changing trade-off between return and risk. In this context, during periods in which the pr ice of r i s k is falling the investment market is char-acterized by: an increase in the number of new issues; an increase in the volume of stock exchanges, part icularly speculative exchanges; a greater price increase in speculative stocks relative to conserva-tive companies; and a lower than normal cost of capital for speculative ventures. During periods in which the pr ice of r i s k is r i s ing the investment market is characterized by: a decline in the number of new issues; a decrease in merger activity; a decrease in the volume of stock exchange transactions; a greater price decline in speculative 93 companies' stocks relative to conservative companies' stocks; and a higher than normal cost of capital for speculative venture. The author is also of the opinion that conglomerates rather than reduc-ing r i s k through conscious diversification into unrelated industries have often increased their r isk. This is because it is impossible for the investor to predict how a conglomerate will perform in a recession and because the takeovers they make are facilitated by the use of enormous debt structures. The observation that r i sky c o m -panies vary more in price can be attributed to the fact that there is a changing trade-off between return and r i s k among investors. Because r i sk companies have a larger r i sk factor used in determining their pr ice they are bound to have a stronger price reaction to any change in the trade-off between return and r isk. At times a r i sky company has abnormally low costs of capital relative to other times, and it is during these periods that the r i sky company can use its shares advantageously to take over a conservative company and by this manouevre reduce its r isk. In general, a speculative company is wise to take over a conservative company in an unrelated industry when speculative fever is at its peak and then use the cash and earnings of the conservative company to take over related specula-tive companies when the market is r i s k adverse. It was also noted that companies have changing costs of capital as a direct result of 94 investors' varying enthusiasm, however, the best long run per-formance calls for a company to invest to the point where marginal returns equal the average marginal cost of capital (averaged over a number of market cycles) for the r i sk class the company is operating within. It was also observed that r i s k can take many forms, but there seemed to be three r i sk factors common to all investors. The effect of the f irst r i sk factor would be that the expected return on invested capital would fall . The f irst r i s k factor is defined as a common decline in the expected returns f rom securities of the same r i s k classes found to the right of the fulcrum in such a manner that an investor is unable to reduce his r i sk of monetary loss through diversifying within these same r i sk classes. This f irst r i sk factor is itself made up of three variables which are the change in expected return due to a recession, the amount this return is leveraged through debt issues, and the investors' ability to predict how much the return will change in a recession. The second and third r i s k factors in contrast to the f irst are exogenous variables, and when they affect a stock they raise the rate of return required from the capital invested. In the context of the see-saw diagram these two r i s k factors are defined as a change in the r i s k preferences of investors, who, by increasing the value of A in the objective equation, 95 M A X I M I Z E ( R E T U R N - A x RISK), will increase the required rate of return from al l r i s k classes in proportion to the distance that they l ie to the right of the fulcrum, and the change in the fu lcrum which may increase the return required f rom al l investments. Final ly an observation as to why r i s k has escaped definition for so long was made. This was because the result of any one of the three r i sk factors bearing influence on a stock is the same, causing a decline in the monetary return. B I B L I O G R A P H Y A BOOKS Cohen, Jerome B. and Zinbarg, Edmund D. Investment Analysis and Portfolio Management. Homewood, Illinois : Dow Jones -Irwin, Inc. , 1967. Clarkson, Geoffrey. Portfolio Selection; A Simulation of Trust  Investment. Englewood Cliffs , New Jersey, 1962. Graham, Benjamin and Dodd, David L . Security Analysis . Toronto The Maple Press Company, 1951. Maddison, Angus. Economic Growth in the West. New York: W. W. Norton, Inc. , 1964. Lintner, John. "The Cost of Capital and Optimal Financing of Corporate Growth". The Theory of Business Finance, ed. Stephen D. Archer and Charles D'Ambrioso . New York: The M a c M i l l a n Company, 1967, pp. 271-287. . "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets", The  Theory of Business Finance, ed. Stephen D. Archer and Charles D'Ambrioso . New York: The M a c M i l l a n Company, 1967, pp. 671-713. Markowitz, Harry . "Portfolio Selection", The Theory of Business  Finance, ed. Stephen D. Archer and Charles D'Ambrioso . New York: The M a c M i l l a n Company, 1967, pp. 558-601. Tobin, J . "Liquidity Preference as Behaviour Towards Risk", The Theory of Business Finance, ed. Stephen D. Archer and Charles D'Ambrioso . New York: The M a c M i l l a n Company, 1967, pp. 601-625. Wheeler, J. F . The Stock Exchange. London: Dodge Publishing Co. , 1913. Wil l iams, John Burr . The Theory of Investment Values. Cambridg Harvard University Pres s , 1938. 98 B. P E R I O D I C A L S Advertisement. Statement by Arthur J. Santry, President, Combustion Engineering, Fortune, L X X I X (March, 1969), p. 188. Babson, David L . "Performance - The Latest Name for Specula-tion? " Financial Analysts Journal, XXIII (September-October, 1967), pp. 129-132. Burck, Gilbert. "How to Fend Off a Take-Over", Fortune, LXXVIII (February, 1969), pp. 83 et seq. . "The Merger Movement Rides High", Fortune, LXXVIII (February, 1969), pp. 70 et seq. C r u m , M . Colyer. "Performance Investing", Financia l Analysts  Journal, X X V (May-June, 1969), pp. 142-147. Dietz, Peter O. "Pension Funds Performance", Financial Analysts Journal, XXIV ( M a r c h - A p r i l , 1968), pp. 133-138. E l l i s , Charles . "Performance Investing", Financial Analysts  Journal, XXIV (September-October, 1968), pp. 117-120. Klaw, Spencer. "How to Play the New Issues Game", Fortune, L X V I I (January, 1962), p. 172. Kopp, Bennett S. "Conglomerates in Portfolio Management!', Financial Analysts Journal, XXIV ( M a r c h - A p r i l , 1968), pp. 145-148. Laurence, Michael . "Playboy's Guide to Mutual Funds", Playboy, X V I (June, 1969), pp. 187-190. L e r n e r , Eugene M . and Charleton, Wi l lard T. "The Integration of Capital Budgeting and Stock Valuation", The American  Economic Review, L I X (September, 1964), pp. 683-702. Louis , Arthur M . "Those Go-Go Funds May be Going Nowhere", Fortune, L X X V I (November, 1967), pp. 143 et seq. 99 McDonald, John. "The New Game of Business", Fortune, L X I X (May 15, 1969), pp. 143 et seq. Mennis, Edmund A. "New Trends in Institutional Investing", Financial Analysts Journal, XXIV (July-August, 1968), pp. 133-139. "Musical Chairs in the Market", Fortune, L X X I V (January, 1969), p. 170. Rei l ly , Frank K. " A F i r s t Look at O - T - C Volume", Financial Analysts Journal, X X V (January-February, 1969), pp. 124-128. Rukeyser, Wi l l i am S. "Gulf & Western's Rambunctious 'Conserva-tism'", Fortune, LXXVIII (March, 1968), p. 123. Shaw, David C. "Hot New Issues: How Well Do They Perform? ", The Business Quarterly, The University of Western Ontario, X X X I V (Summer, 1969), pp. 42-52. Smith, Keith. "Needed: A Dynamic Approach", Financia l Analysts  Journal, XXIII (May-June, 1967), pp. 115-121. Stern, Walter P. "Performance - Trans i tory or Rea l?" , Financia l Analysts Journal, XXIV (January-February, 1968), pp. 110-113. "Success Story", Forbes , CIII (May 1, 1969), p. 19. "The Peaceful Exchange", Fortune, L X X V I (September 1, 1967), p. 172. "The Traders Do Better, Sometimes", Fortune, L X X V I (September 1, 1967), pp. 171-172. "Too Good to Be True? ", Forbes , CI (June 15, 1969), p. 29. "Wall Street - The Funds A r e Fal l ing", Time, XCIV (July 11, 1969), p. 64. "Who Did What", Fortune, L X X V (March, 1967), p. 207. Wietz, Wil l iam. "Comparing Performance of Equity Pension Trusts", Financial Analysts Journal, XXIII ( M a r c h - A p r i l , 1967), . pp. 127-132. 100 C. B R O C H U R E S Ryan Investments Limited. "Cardinal Funds Quarterly Report", Vancouver, M a r c h 31, 1969. Whitman, Mart in J . " A Road to Instant Wealth - Disparit ies between Market Reality and Corporate Reality". Talk to the Restaurant Executive Institute. Hotel Warwick, New York City (August 15, 1968). D. N E W S P A P E R S Abele, John L . "Conglomerates Open Attack On Detractors", The New York Times, M a r c h 16, 1969, p. 47. Anderson, Ronald. "Top U. S. Consultant 'Scared Si l ly 1 by Conglomerate Monster Image", The Globe and M a i l , November 23, 1968, p. B3. Carney, Pat. "Electronics Distributor Issues Shares", The Sun, February 15, 1969, p. 29. Hi l l ery , Victor J . " A Stock Market Appraisal", The Wall Street  Journal, August 11, 1969, p. 23. Robards, Jerry . "New Issues Market Is Losing Its Sizzle", The Province (Vancouver), July 15, 1969, p. 38. 

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