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Butler'sAcademicDigestWall StreetbOnly Up-to-Date,Easy-to-ReadSourceor AcademicResearchVolume I, Issue 1 October 1995DrsrnBssEDnnr a Gooo BBr

"Distressed and Defaulted Debt Securi-ti.es:Marhet Dynamics and Inuestment Per-formance," by Edward I. Altman, NYUStern School of Business, 7995. E-mail:ealtman@stern.ny u.edu llThe supply of defaulted and dis-tressed securities has been shrink-ing over the past two-and-a-hal fyears, but that has not hurt theirperformance, says Edward Altman,vice director of the Stern School ofBusiness at NYU. In fact, over thelast eight years, defaulted and dis-tressed debt has returned L4.7 per-cent annually, versus L2.5 percentfor the S&P 500 and 10.9 percent forthe Merrill Lynch high yield index.The distressed debt market-com-posedof companies which have de-faulted on their d 'ebt opl igat ionsand/or f i led for Chapter 11-hasshrunk by two-thirds over the pastf ive years, from $gOobil l ion facevalue ($ZOO illion market) in 1990to $t00 billion face value ($64 billionmarket) in 1995.However, assumingan average default lrice of 45 centsInside This IssueInuestor actiuism not helping perfor-mance ... . . .pageManaging accruals to increase share-holder return... . . . . . . . .pageSpinoff ua\ue... . . . . . . . . page 2Playing stoch splits and stoch diui-dends ... . . . .pageThe effect of tax brackets on corporatedebt \eue\s. . . . . . . . . . . . . . . .page3There's a hole in my pocket, dearNasdaq... .page 3The price impact of institutionalmulti-day trading... page 4Spreads on inactiue stocks .....page 4

on the dollar, Altman predicts thatthis number will increase by $93 bit-lion in face value ($5f billion mar-ket) within the next three years.A glance at the chart below showsthat d is t ressed debt is far morevolatile than either equities or high-is t ( tnVo)Year Debt S&P Bonds

1987 37.9 5.3 4.71988 26.5 16.6 13.51989 -22.8 3L.7 4. 21990 -L7.L -3.1 -4.41991 43.L 30.5 34.6L992 r5.4 7.6 L8.21993 27.9 10.1 L7.21994 6. 7 1.3 -L.26/95 Lz.L 20.2 r2.8y ie ld bonds . The reason? Mos tdefaulted debt securities trade "flat,"that is, they lack the regular interestpayments and dividends that sta-bilize the returns of the other twoclasses. n addition, says Altman,the market is relatively illiquid andthe uncertainty of reorganizationcan cause arge price fluctuations.The low correlation of monthly re-turns between distressed debtand equities (.35) and high-y ie ld ( .60) make them anexcellent diversification toolfor even the most conserva-tive investor, according o Alt-man. He expec ts tha t thegrowth of limited partnerships andinstitutional funds will facilitate thisprocess."Investment attention in defaultedsecurities will not only continue,"concludesAltman, "But will increasein both supply and demand in thenear-term as well as the long run."E

ANarySrsAnr Axlr.vznqRpcnrvnHrcH ManxsoDo Brokerage Analysts ' Recom-mendations Haue Inuestment Value?' byKent L. Womack, Amos Tuck School ofBusiness Administrat ion, 1995. E-mail:Ke nt.Woma ch@D rtm out h.eduThose seven-figure salaries WallStreet analysts have been receivinglately are worth every penny, i fTuck professor Kent Womack's lat-est paper is correct.In the February 1995 study ofover 1,500 recommendation changesmade by 14 top brokerage researchfirms between 1989 and 1991, Wom-ack found that the init ia l pr icechange (over the first three days)following new buy recommendationswas +2.9 percent; new sells fell 4.7percent on average over the sameperiod. Contradicting earlier studiesshowing that stock prices revert toor ig ina l levels af ter the in i t ia leffect, Womack found that over thenext six months buys rose 2.4 per-cent further while the sells plum-metted another 9.1 percent for atotal loss of almost 14 percent. Thiseffect was even more pronounced or\ /, smaller-capitalizationstocks.The greater impact of sellrecommendat ions can beexplained by their relativescarcity (7:1). Because ssu-ing a sell means eopardizingan investment banking rela-t ionship, 8D analyst must fee lextremely negative about the com-pany to do so. The marketp laceknows this and reacts accordingly.DJonathan Butler is a former port-folio manager at Fiduciary Trust.He now writes for Worth Magazine.

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DISCRETION PAYS: CREATIVEACCOUNTING HELPS FIRMS

"The Use of Accruals in Earnings Man-agement: A Permanent Earnings Hypothe-sis," by Paul K. Chaney, Debra C. Jeter,and Cra ig M . Lew is , Owen Schoo l ,Vanderbi l t Uniuers i ty , 1995. E-mai l :Je e dc@cruax.V a n de b lt. ed uIt usually raises eyebrowsas wellas earn ings when manage-ments manipulate incomestatements. But a newVanderbi l t Universitystudy suggests hat theprac t ice o f incomesmooth ing , wherebymanagers tinker withdiscretionary accrualsto reduce the per iod icvolat i l i t y of repor tedearn ings, can benef i t in-vestors as well as the companyitself. In the July 1995 paper, theauthors a lso argue that incomesmoothing, n addition to enhancinga company's returns over time, canlower its cost of capital and help itavoid violating debt covenants.Most companies end to follow thesame rules of thumb for discretion-ary accrual accounting: When thecurrent year's income before dis-cretionary accruals is less than theprevious year's reported earnings,management employs positive dis-

cretionary accruals; when the cu-rent year's pre-discretionary accru-al income is greater than last year'searnings, the discretionary accrualsare likely to be negative.According to the study, incomesmoothing telegraphs to investorswhat the company believes o be its"permanent" earnings. The paperconcludes hat, s ince most man-. agers use discretionary accru-a ls to of fset a one- t ime,non-recurring componentof earnings, the adjustednumber "w i l l enab leuse r s t o a s s e s s t h efuture prospects of thefirm more accurately."And because ong-termaccrualsmust equal zero,companiescannot consist-ently ge t away with usingdiscretionary accruals to boostearnings.This is suppor ted by anotherstudy, by K.R. Subramanyam ofUCLA, which says that net income(which includes discretionary ac -cruals) is a better determinant offuture returns than either operat-ing cash flows or non-discretionaryincome."Discretionary accrualspre-dict changes in future profitabilityas well as improve the ability of netincome to predict changes n future

profitability," saysSubramanyam.fl

E SPINOFFSACTUALLY GOODFOR INVESTORS?

ACTIVIST INVESTORSEAIL TO BOOSTVALUE"Corporate Gouernance and Shareholder

Initiatiues : Empirical Euidence,' by Jona-than M. Karpoff and Paut H. Malatesta,Uniuersity of Washington, 1995. E-mail:karp ofpme ad?. u. w ashington. eduTh e shareholder-initiated proxyproposals on corporate governanceissues that becamewidespread nthe late 1980s and early 1990s haveled to "negligible" improvement inshare prices. So say Jonathan Kar-poff and Paul Malatesta in theirMay 1995 study.The inc rease in shareho lderact iv ism-36 percent of S&P SOOcompanies received proposals in theL992 proxy season-is linked direct-ly to the rise of institutional owner-sh ip . By 1991, fo r example ,institutions held 53 percent of theequity in publicly traded U.S. com-panies, up from 38 percent a decadeearlier.The study states that the larger acompany's size, leverage, and insti-tutional ownership, the more likelyit is to attract attention; similarly,the higher its market-to-book ratio,operating return and sales growth,the less likely it is to be the object ofshareholder activism.Most of the 866 proposalsreceivedby 317 public ly t raded companiesbetween March 1986 and October1990 cal led upon management torepeal poison pill clauses, o requireconfrdential voting, to declassify itsboard, or to refrain from greenmail.The authors conc lude that suchattempts to discipline poorly per-forming managements "typically areviewed by markets as ineffective ...and are poor substitutes for externalcontrol threats."Of the 16 proposa ls tha t wonshareholder approval only one-themotion to get ri d of Avon's poisonpill-resulted in significant sharepr ice appreciat ion, and even thismove can be explained by a concur-rent takeover bid. The companiesatwhich acceptedproposalshad no sig-nificant affect included Armco, Con-Freight, First Bank System, Kmart,Outboard Marine, and Ryder Sys-tems.E

"Corporate pinoffs:Trashor Treasu.re?"Daley,VikasMehrotra, nd Ran-Siuahumar, niu.of Alberta,1995.E-mehrotr@u'1.c .udlbeta. aAre spinoffs good news for share-It depends on the type ofand whether the investorthe parent or theszy University of AlbertaLane Daley, Vikas Mehro-Ranjini Sivakumar.The August 1995 study differ-between "cross- industry"in which the parent compa-and the spinoff are in differentand "own- indus t t y "in which both ar e in the"Cross- indus t ry "usual ly ref lect manage-

ment's desire to isolate poorly per-forming, non-core units that are hin-dering the larger company's overallperformance. "Own-industry" spin-offs tend to occur in companiesthatare outperforming industry peersand usual ly ref lect an ef for t to"unlock a small treasure" by incent-ivizing the division's management.Given these definitions, the stu-dy's central findings are not surpris-ing: In "cross-industry" cases, heparent company experiences "signif-icant performance improvement" (asmeasured by EBITDA and ROA)while the spinof f languishes; the"own-industry" spinoffs, hbwever,exper ience only "modest perform-ance mprovements."C

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THE TRADING FLOOR: RIPOFFSON NASDAQ"Dealer Versus Auct ion Marlzets: A

Paired Comparison of Execution Costs onNasdaq and the NYS.B," by Roger D.Huang and Hans R. Stoll, Owen School,Vanderbi l t Uniuers i ty , 1995. E-mai l :st ollhr}@c tru ax. uande rb ilt. edu

Recen t l y Nasdaq dea le r s have .come under attack for everythingfrom "painting the tape" (reporting 'a trade late in order to stick a cus-tomer with the worst of two trades)to backing away (refusing to honortheir quotes). According to a July1995 paper by Roger Huang andHans Sto l l , the dealers are a lsocharging exorbitant prices for theprivilege of trading on their self-pioclaimed "stock market for the

next hundred years."The study, which compares over5.4 million transactions on Nasdaqand NYSE during 1991, found thatthe average quoted spread for OTCtrades was almost double that forexchange-tradedssues-49.2 centsversus 25.8 cents. Since the quotedspread is not necessarily he bestref lect ion of execut ion costs, thestudy also looked at the effectivespread (to account for trades donewithin a quoted spread) and therealized spread (which calculatestrading expenses asedon the post-trade price reversal). n both cases,Nasdaq execution costsoutweighedNYSE by roughly two to one.

Why do Nasdaq dealers charge somuch? Simply put, because heycan-there is little incentive not to.The authors point to three charac-teristics of the Nasdaq market thatare responsible for the high costs:1) Internalization-when a dealertrades with his own retail clients,there is no competition for the bestprice; 2) Preferencing-when orderflows are directed to select dealerswho oft,endon't offer the best quotebut who promise to trade at theinside'quote; 3) Inter-dealer trad-ing-when dealers post differentquotes on SelectNet, thereby de-creasing the incentive to offer com-pet i t ive quotes on the regularmarket.fl

STOCK SPLITS AND DIVIDENDSA GOOD TIME TO BUY

"Long-Run Common Stock Returns FoI-Iowing Stocle Splits and Stock Diuidends,"by Hermang Desai and Prem C. Jain,Tulane Uniuersity, 1995. E-mail: pjain@mailhos . cs. ulane. edu

If you had loaded up on shares ofcompaniesannouncing stock splitsand div idends between 1976 and1991,you would have outperformedthe market by more than eight per-cent.That is the recent frnding of Her-mang Desai an d Prem Jain of theA.B. Freeman Schoolof Business atTulane. In their May 1995 paper,the professorsexamined 5,723 stocks p l i t s an d 1 , 553 s t o c k d i v i d e n darrnoufteem. n*,s-and eeneluded thatthe market underreacts significantlyto the information conveyed n theseannouncements. They also foundthat companies announcing eitherstock splits or stock dividends hadreturns of 6.7 percent over the mar-ket in the month after the announce-ment.But the outper formance didn ' tstop there. The researchers foundthat, over the one-year period afterthis frrst month, these firms toppedthe market by 8.2 percent. Specific-ally, stock-split firms outperformedby 9.0 percent while stock-dividendfirms beat the market by 5.1 per-cent. For the three-year period fol-

lowing the first month, the announc-ing firms were up more than 7.5 per-cent above he market.The explanation?"Stock splits andstock dividends are generally viewedas signals for future cashdividends,"wr ite the authors. In fact, f i rmsmaking only stock-split or stock-divi-dend announcements outpaced themarket by 5.2 percent over threeyears, while firms that announced asimultaneous increase n cash divi-dends beat the market by 12.3 per-cent. In addition, smaller firms inthe sample group tended to outper-form the market by wider marginsthan larger firms.QHrcnnn Thxns,Hrcnsn Dnnr

"Debt and the Marginal Tax Rate," byJohn R, Graharn, Daaid Eccl.es School ofBusiness, Uniuersity of Utah, 1995. E-mail : finj rg@business. tah.eduThe higher a company's tax rate,the more likely it is to issue debt, ac-cording to an August 1995 paper byJohn Graham, a professor at theDavid Eccles School of Business atthe University of Utah.Studying the marginal tax rate(MTR)-defined as the present valueof expected current and future taxespaid on an additional dollar of in-come earned today-of over 10,000companiesbetween 1981.and 1992,Graham discovered that tax consid-erations account for roughly 15 per-cent of the typical firm's debt policy.

In addition, he found that firms withhigh levels of free cash flow on average decrease heir debt while morgrowth- and research-oriented firmstend to increasedebt holdings.Graham divided all companies nto three groups according to theiMTR: roughly one-third had MTRsequal to the highest rate (46 percenbefore f988); roughly one-fifth hadan MTR of zero; the remainder, jusless than half, fell in between. Theaverage MTR was 24 percent.In h is f ina l analys is , Grahamshows that a hypothetical companwith the highest MTR (46 percentissues 1.52percentmore debt, calculated as a percent of capital structure, than an ident ica l companwith the average MTR (24 percentand, by extension, 3.2 percent morethan a zero MTR company.D

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INFORMED TRADERS HAVEBIGGEST EFFECT ON STOCIS

"Li4uidity, nformationand nfrequentlyTrad.ed Stocks,o by Dauid Easley, NinholasKiefer, Maureen O'Hara, Joseph Paper-rrlan, Cornell Uniuersity, 1995. E-mail:bkrog@costat.aau.dkThe two most commonly cited rea-sons for large spreads in infrequent-ly traded stocks are illiquidity andthe monopolistic pricing power of asingle market maker. In an April1995 paper , Cornel l professorsDavid Easley, Nicholas Kiefer, Mau-reen O'Hara and Joseph Papermanoffer a third: Inactive stocks (whichtend to have smaller capitalizations)are far more vulnerable to informa-tion-based trading, that is, tradingbasedon private information.Using 1990 data from the I.IYSE,the authors found that while high-volume stocks are much more likelyto be affected by an "informationevent" and to at t ract in formedtraders, such activity is more thanoffset by the higher incidence of un-informed traders who provide price-stabilizing background noise.This study has one mportant poli-cy implication: Currently the NYSEallocates a few infrequently tradedstocks to each specialist to diversifyrisk, combining a smooth loss/gainstream with a lumpy one. But sincethe occurenceof information eventsis uncor re lated among inact ivestocks, he authors suggest a betterapproach may be to ass ign suchstocks o a single market maker.Q

PROFESSOR,SUGGESTNET[/WAYTO MEASURE MPACT OF INSTI.TUTIONAL TRADES

"TheBehauiorof StockPricesAround ^Institutional Tfadcs,"byLouisK.C. CIwnand JosefLakonishok,Collegeof Com-ntprce,Uniuersity f llinois, 1995. -mnil:cza@uxh.cso.uiuc.eduAnalysis of the market impact andbxecution cost of institutional trad-in g traditionally has focused onsingle-day, individual orders. Show-ing that only roughly one-fifth of thedollar value of institutional buysand sells is completed within oneday, while over half is completed infour days or more, University of llli-no is professors Louis Chan andJosef Lakonishok argue that it is farmore instructive to use multi-daytrade packages as the standard of

measurement.The study track s 155,789 trade"packages," which include an unlim-ited number of the same kind of or-der (buy or sell) and end only whenan institution remains inactive in astock for five days. The majority ofthe trades are focusedon the largestButler's Academic Digest is pub-lished six times a year. Annual sub-scriptions are $400. Nothing hereinshould be taken as a recommenda-tion to buy or sell securities. Noreproductions allowed without explic-it authorization. Copyright 1995.Butler's Acadernic Digest, 208 East57st St.,Suite 725,New York,NY10022-6501.TeI: (212)230-0247.*Illustrations s*

quintile of stocks; in fact, this groupaccounts for almost 80 percent of thedollar value of buy and sell trades.The median number of shares in buyand sell trades is 6,800 and 6,500,respectively (compared to less than3,000 shares for the median singletrade), while the average packagehas a value of $1.2 million.As a result, package trades, espec-ially buys, have a much greater ef-fect upon market prices than dosingle trades. For example, the aver-age dollar-weighted price change forbuys from the open on the package'sfirst day to the close on its last dayis almost one percent; for singletransactions, the change is only .34percent. The effect is s imilar ,though less pronounced, for sells:the sell packages result in an aver-age price decline of .35 percent, ver-

sus a drop of .04 percent forindividual sell orders.Not surprisingly, the executioncosts for package trades are muchhigher than for single trades. Theestimated round-trip cost (which in-cludes buying and selling) is L.32percent of the first day openingprice. The authors point out thatthis accounts for roughly half of theperformance short fal l betweenactive and index managers. In addi-tion, the study finds that costs are75 percent greater for growth-ori-ented managers than for value man-agers, in large part because growthmanagers require trades to be donemore quickly, which gives tradersless flexibility.O

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