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Abstract:
Market efficiency survives the challenge from the literature on long-term return anomalies. Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent over-reaction to information is about as common as under-reaction. And post-event continuation of pre-event abnormal returns is about as frequent as post-event reversal. Consistent with the market efficiency prediction that apparent anomalies can also be due to methodology, the anomalies are sensitive to the techniques used to measure them, and many disappear with reasonable changes in technique.

Abstract:
Value stocks have higher returns than growth stocks in markets around the world. For 1975-95, the difference between the average returns on global portfolios of high and low book-to-market stocks is 7.60% per year, and value stocks outperform growth stocks in 12 of 13 major markets. An international CAPM cannot explain the value premium, but a two-factor model that includes a risk factor for relative distress captures the value premium in international returns.

Abstract:
We use cross-section regressions to study how a firm's value is related to dividends and debt. With a good control for profitability, the regressions can measure how the taxation of dividends and debt affects firm value. Simple tax hypotheses say that value is negatively related to dividends and positively related to debt. We find the opposite. We infer that dividends and debt convey information about profitability (expected net cash flows) missed by a wide range of control variables. This information about profitability obscures any tax effects of financing decisions.

Abstract:
We use cross-section regressions to study how a firm's value is related to dividends and debt. With a good control for profitability, the regressions can measure how the taxation of dividends and debt affects firm value. Simple tax hypotheses say that value is negatively related to dividends and positively related to debt. We find the opposite. We infer that dividends and debt convey information about profitability (expected net cash flows) missed by a wide range of control variables. This information about profitability obscures any tax effects of financing decisions.

Abstract:
Explores the survival of organizations in which those individuals who are responsible for decision-making are not the same people who experience the financial impact of the decisions. These types of firms have a separation of ownership and control. Firms are viewed as a nexus of contracts, both written and unwritten. The type of contracts considered are those that allocate the steps in the firm's decision process, define residual claims, and provide avenues for controlling agency problems in the decision process. Two hypotheses are proposed in this analysis. The first holds that separation of residual risk bearing from decision management leads to decision systems that separate decision management from decision control. Examination of this hypothesis is done by considering open corporations, large professional partnerships, financial mutuals, and nonprofits. The three areas probed for this hypothesis are (1) specific knowledge and diffusion of decision functions, (2) diffuse residual claims and delegation of decision control, and (3) decision control in nonprofits and financial mutuals. The second hypothesis holds that by combining decision management and decision control in a few agents, residual claims are restricted to these agents. Support for this hypothesis comes from proprietorships, small partnerships, and closed corporations. (SRD)

Residual claims, Decision control, Delegation of authority, Firm ownership, Management decisions, Risk assessment, Contracts & agreements, Risk management, Decision theory, Agency theory, Firm governance, Organizational structures, Firm control

Abstract:
This paper analyzes the survival of organizations in which decision agents do not bear a major share of the wealth effects of their decisions. This is what the literature on large corporations calls separation of ownership and control. Such separation of decision and risk bearing functions is also common to organizations like large professional partnerships, financial mutuals and nonprofits. We contend that separation of decision and risk bearing functions survives in these organizations in part because of the benefits of specialization of management and risk bearing but also because of an effective common approach to controlling the implied agency problems. In particular, the contract structures of all these organizations separate the ratification and monitoring of decisions from the initiation and implementation of the decisions.

Abstract:
The capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Before their breakthrough, there were no asset pricing models built from first principles about the nature of tastes and investment opportunities and with clear testable predictions about risk and return. Four decades later, the CAPM is still widely used in applications, such as estimating the cost of equity capital for firms and evaluating the performance of managed portfolios. And it is the centerpiece, indeed often the only asset pricing model taught in MBA level investment courses.

The attraction of the CAPM is its powerfully simple logic and intuitively pleasing predictions about how to measure risk and about the relation between expected return and risk. Unfortunately, perhaps because of its simplicity, the empirical record of the model is poor - poor enough to invalidate the way it is used in applications. The model's empirical problems may reflect true failings. (It is, after all, just a model.) But they may also be due to shortcomings of the empirical tests, most notably, poor proxies for the market portfolio of invested wealth, which plays a central role in the model's predictions. We argue, however, that if the market proxy problem invalidates tests of the model, it also invalidates most applications, which typically borrow the market proxies used in empirical tests.

For perspective on the CAPM's predictions about risk and expected return, we begin with a brief summary of its logic. We then review the history of empirical work on the model and what it says about shortcomings of the CAPM that pose challenges to be explained by more complicated models.

Abstract:
We estimate the equity premium using dividend and earnings growth rates to measure the expected rate of capital gain. Our estimates for 1951 to 2000, 2.55 percent and 4.32 percent, are much lower than the equity premium produced by the average stock return, 7.43 percent. Our evidence suggests that the high average return for 1951 to 2000 is due to a decline in discount rates that produces a large unexpected capital gain. Our main conclusion is that the average stock return of the last half-century is a lot higher than expected.

Abstract:
We estimate the equity premium using dividend and earnings growth rates to measure the expected rate of capital gain. Our estimates for 1951-2000, 2.55% and 4.32%, are much lower than the equity premium produced by the average stock return, 7.43%. Our evidence suggests that the high average return for 1951-2000 is due to a decline in discount rates that produces large unexpected capital gains. Our main conclusion is that the stock return of the last half-century is a lot higher than expected.

Abstract:
Social and economic activities, like religion, entertainment, education, research, and the production of other goods and services, are carried on by different types of organizations, for example, corporations, proprietorships, partnerships, mutuals and nonprofits. There is competition among organizational forms for survival. The form of organization that survives in an activity is the one that delivers the product demanded by customers at the lowest price while covering costs.

The characteristics of residual claims are important both in distinguishing organizations from one another and in explaining the survival of organizational forms in specific activities. This paper develops a set of propositions that explain the special features of the residual claims of different organizational forms as efficient approaches to controlling agency problems.

Abstract:
The value premium in U.S. stocks returns is robust. The positive relation between average return and book-to-market equity (BE/ME) is as strong for 1929-63 as for the subsequent period studied in previous papers. Like others, we also find a size premium in stock returns. Small stocks have higher average returns than big stocks. The size premium is, however, weaker and less reliable than the value premium. The relations between average return and firm characteristics (size and BE/ME) are better explained by a three-factor risk model than by the behavioral hypothesis that investor overreaction causes characteristics to be compensated irrespective of risk loadings.

Abstract:
The value premium in U.S. stocks returns is robust. The positive relation between average return and book-to-market equity (BE/ME) is as strong for 1929-63 as for the subsequent period studied in previous papers. Like others, we also find a size premium in stock returns. Small stocks have higher average returns than big stocks. The size premium is, however, weaker and less reliable than the value premium. The relations between average return and firm characteristics (size and BE/ME) are better explained by a three-factor risk model than by the behavioral hypothesis that investor overreaction causes characteristics to be compensated irrespective of risk loadings.

Abstract:
There is an impressive body of empirical evidence which indicates that successive price changes in individual common stocks are very nearly independent. Recent papers by Mandelbrot and Samuelson show rigorously that independence of successive price changes is consistent with an efficient market, i.e., a market that adjusts rapidly to new information.

It is important to note, however, that in the empirical work to date the usual procedure has been to infer market efficiency from the observed independence of successive price changes. There has been very little actual testing of the speed of adjustment of prices to specific kinds of new information. The prime concern of this paper is to examine the process by which common stock prices adjust to the information (if any) that is implicit in a stock split. In doing so we propose a new event study methodology for measuring the effects of actions and events on security prices.

efficient markets, effect of information on stock prices, stock splits, dividend increases, market conditions, rate of return, effect of split(s) on return(s), residuals, average dividends, dividend increases, and dividend decreases

Abstract:
The percent of firms paying cash dividends falls from 66.5 in 1978 to 20.8 in 1999. The decline is due in part to the changing characteristics of publicly traded firms. Fed by new lists, the population of publicly traded firms tilts increasingly toward small firms with low profitability and strong growth opportunities characteristics typical of firms that have never paid dividends. More interesting, we also show that controlling for characteristics, firms become less likely to pay dividends. This lower propensity to pay is at least as important as changing characteristics in the declining incidence of dividend payers.

Abstract:
We estimate two internal rates of return for the non-financial corporate sector: (i) the return on the initial market values of the securities issued by firms, and (ii) the return on the cost of their investments. The return on cost is the return delivered by firms on investment outlays. The return on value is an estimate of the overall corporate cost of capital, that is, the return on investment required by the capital market. The estimate of the corporate cost of capital for 1950-96 is 10.72 percent. The return on cost is larger, 12.11 percent, so on average corporate investment seems to be profitable. A byproduct of calculating these returns is information about the history of corporate earnings, investment, and financing decisions that is perhaps more interesting than the returns themselves.

Abstract:
There is a strong presumption in economics that, in a competitive environment, profitability is mean reverting. We provide corroborating evidence. In a simple partial adjustment model, the estimated rate of mean reversion is about 40 percent per year. But a simple partial adjustment model with a uniform rate of mean reversion misses rich non-linear patterns in the behavior of profitability. Specifically, we find that mean reversion is faster when profitability is below its mean and when it is further from its mean in either direction. We also show that the mean reversion in profitability produces predictable variation in earnings.

Abstract:
There is a strong presumption in economics that, in a competitive environment, profitability is mean reverting. We provide corroborating evidence. In a simple partial adjustment model, the estimated rate of mean reversion is about 40 percent per year. But a simple partial adjustment model with a uniform rate of mean reversion misses rich non-linear patterns in the behavior of profitability. Specifically, we find that mean reversion is faster when profitability is below its mean and when it is further from its mean in either direction. We also show that the mean reversion in profitability produces predictable variation in earnings.

Abstract:
Confirming predictions shared by the tradeoff and pecking order models, more profitable firms and firms with fewer investments have higher dividend payouts. Confirming the pecking order model but contradicting the tradeoff model, more profitable firms are less levered. Firms with more investments have less market leverage, which is consistent with the tradeoff model and a complex pecking order model. Firms with more investments have lower long-term dividend payouts, but dividends do not vary to accommodate short-term variation in investment. As the pecking order model predicts, short-term variation in investment and earnings is mostly absorbed by debt.

Abstract:
We examine (i) how value premiums vary with firm size, (ii) whether the CAPM explains value premiums, and (iii) whether in general average returns compensate beta in the way predicted by the CAPM. Loughran's (1997) evidence for a weak value premium among large firms is special to 1963-1995, U.S. stocks, and the book-to-market value-growth indicator. Ang and Chen's (2003) evidence that the CAPM can explain U.S. value premiums is special to 1926-1963. The CAPM's general problem is that variation in unrelated to size and value-growth goes unrewarded throughout 1926-2004. This produces rejections of the model for 1926-1963 and 1963-2004.

Abstract:
The anomalous returns associated with net stock issues, accruals, and momentum are pervasive; they show up in all size groups (micro, small, and big) in cross-section regressions, and they are also strong in sorts, at least in the extremes. The asset growth and profitability anomalies are less robust. There is an asset growth anomaly in average returns on microcaps and small stocks, but it is absent for big stocks. Among profitable firms, higher profitability tends to be associated with abnormally high returns, but there is little evidence that unprofitable firms have unusually low returns.

Anomalies

Abstract:
This paper analyzes investment rules for various organizational forms that are distinguished by the characteristics of their residual claims. Different restrictions on residual claims lead to different decision rules. The analysis indicates that the investment decisions of open corporations, financial mutuals and nonprofits can be modeled by the value maximization rule. However, the decisions of proprietorships, partnerships, and closed corporations cannot in general be modeled by the market value rule.

organizational forms, investment, proprietorships, partnerships, closed corporations, market value rule, residual claims, open corporations

Abstract:
We break average returns on value and growth portfolios into dividends and three sources of capital gain, (i) growth in book equity primarily due to earnings retention, (ii) convergence in price-to-book ratios (P/B) due to mean reversion in profitability and expected returns, and (iii) upward drift in P/B during 1927-2006. The capital gains of value stocks trace mostly to convergence: P/B rises as some value firms become more profitable and move to lower expected return groups. Growth in book equity is trivial to negative for value portfolios, but it is a large positive factor in the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth stocks do not always remain highly profitable with low expected returns. Relative to convergence, drift is a minor factor in average returns.

Abstract:
Financing decisions seem to violate the central predictions of the pecking order model about how often and under what circumstances firms issue equity. Specifically, most firms issue or retire equity each year, the issues are on average large, and they are not typically done by firms under duress. We estimate that during 1973-2002 the year-by-year equity decisions of more than half of our sample firms violate the pecking order. And contradictions are more common among larger firms.

Abstract:
The class of firms that obtain public equity financing expands dramatically in the 1980s and 1990s. After 1979, the rate at which new firms are listed on major U.S. stock exchanges jumps from about 160 to near 550 per year, and the characteristics of new lists change. The cross-section of new list profitability becomes progressively more left skewed, and growth becomes more right skewed. The result is a sharp decline in new list survival rates. We suggest that the changes in the characteristics of new lists are due to a decline in the cost of equity capital that allows weaker firms and firms with more distant expected payoffs to become viable candidates for public equity financing.

Abstract:
Standard asset pricing models assume that (i) there is complete agreement among investors about probability distributions of future payoffs on assets, and (ii) investors choose asset holdings based solely on anticipated payoffs; that is, investment assets are not also consumption goods. Both assumptions are unrealistic. We provide a simple framework for studying how disagreement and tastes for assets as consumption goods can affect asset prices.

Abstract:
The evidence in Fama and Bliss (1987) that forward interest rates forecast future spot interest rates for horizons beyond a year repeats in the out-of-sample 1986-2004 period. But the inference that this forecast power is due to mean reversion of the spot rate toward a constant expected value no longer seems valid. Instead, the predictability of the spot rate captured by forward rates seems to be due to mean reversion toward a time-varying expected value that is subject to a sequence of apparently permanent shocks that are on balance positive to mid-1981 and on balance negative thereafter.

Abstract:
The evidence in Fama and Bliss (1987) that forward interest rates forecast future spot interest rates for horizons beyond a year repeats in the out-of-sample 1986-2004 period. But the inference that this forecast power is due to mean reversion of the spot rate toward a constant expected value no longer seems valid. Instead, the predictability of the spot rate captured by forward raets seems to be due to mean reversion toward a time-varying expected value that is subject to a sequence of apparently permanent shocks that are on balance positive to mid-1981 and on balance negative thereafter.

Abstract:
Valuation theory says that expected stock returns are related to three variables: the book-to-market equity ratio (B/M), expected profitability, and expected investment. Given B/M and expected profitability, higher rates of investment imply lower expected returns. But controlling for the other two variables, more profitable firms have higher expected returns, as do firms with higher B/M. These predictions are confirmed in our tests. Our results are qualitatively similar to earlier evidence, but in quantitative (economic) terms, there are some interesting surprises.

Abstract:
Suppose the ICAPM governs asset prices, and there are a total of S state variables that might be of hedging concern to investors. Can we determine which state variables are in fact of hedging concern? What does it mean to say that these state variables are priced, that is, that they give rise to special risk premiums in expected returns? The goal of this paper is to formulate this problem clearly and show when it can and cannot be solved. Ignoring estimation problems, it is possible to find the set of priced state variables when the state variables are identified (named). When we know the number of state variables but not their names, confident conclusions about even the number of them that produce special risk premiums are probably impossible, unless the number is zero, so the ICAPM collapses to the CAPM.

Abstract:
Suppose the ICAPM governs asset prices, and there are a total of S state variables that might be of hedging concern to investors. Can we determine which state variables are in fact of hedging concern? What does it mean to say that these state variables are priced, that is, that they give rise to special risk premiums in expected returns? The goal of this paper is to formulate this problem clearly and show when it can and cannot be solved. Ignoring estimation problems, it is possible to find the set of priced state variables when the state variables are identified (named). When we know the number of state variables but not their names, confident conclusions about even the number of them that produce special risk premiums are probably impossible, unless the number is zero, so the ICAPM collapses to the CAPM.

Abstract:
Migration of stocks across size and value portfolios contributes to the size and value premiums in average stock returns. The size premium is almost entirely generated by the small-capitalization stocks that earn extreme positive returns and thus become big-cap stocks. The value premium comes from (1) value stocks that improve in type because their companies are acquired by other companies or because they earn high returns and migrate to a neutral or growth portfolio, (2) growth stocks that earn low returns and thus move to a neutral or value portfolio, and (3) the slightly higher returns on value stocks that do not migrate compared with the returns on growth stocks that do not migrate.

Portfolio Management: Equity Strategies, Asset Allocation

Abstract:
We study how migration of firms across size and value portfolios contributes to the size and value premiums in average stock returns. The size premium is almost entirely due to the small stocks that earn extreme positive returns and as a result become big stocks. The value premium has three sources: (i) value stocks that improve in type either because they are acquired by other firms or because they earn high returns and so migrate to a neutral or growth portfolio; (ii) growth stocks that earn low returns and as a result move to a neutral or value portfolio; and (iii) slightly higher returns on value stocks that remain in the same portfolio compared to growth stocks that do not migrate.

Size premium, value premium, average returns

Abstract:
The book-to-market ratio, B/M, is a noisy measure of expected stock returns because B/M also varies with expected cashflows. Our hypothesis is that the evolution of B/M, in terms of past changes in book equity and price, contains independent information about expected cashflows that can be used to improve estimates of expected returns. The tests support this hypothesis, with results that are largely but not entirely similar for Microcap stocks (below the 20th NYSE market capitalization percentile) and All but Micro stocks.

Average Returns, B/M, and Share Issues

Abstract:
This issue of the Journal of Financial Economics contains the first set of studies in the new Clinical Papers section. The objective of this section is to provide a high-quality professional outlet for scholarly studies of specific cases, events, practices, and specialized applications. By supplying insights about the world, challenging accepted theory, and using unique sources of data, clinical studies stand on their own as an important medium of research. Like the medical literature from which the term 'clinical' is borrowed, these articles will frequently deal with individual situations or small numbers of cases of special interest. The JFE intends to take a leading role in encouraging clinical studies, guided by the confidence that expanding our research agenda and providing an outlet for this work will enliven and enrich professional knowledge. We expect these clinical studies to stimulate new high-quality empirical and theoretical research,

Innovation in financing techniques, deregulation, reregulation, and changes in the organization and conduct of commerce are proceeding at a rapid rate. New products and practices are appearing constantly, and the roles and activities of financial institutions are changing dramatically. New ways to communicate these interesting changes to the scientific community are required because the changes provide tests of leading theories and suggest new problems of theoretical interest. Clinical papers, inspired primarily by actual events, can play an important role in this discovery and communication process and, therefore, in the evolution of the science of finance.

The advantages of specialization imply that different groups of researchers will tend to concentrate on theory, empirical tests, and clinical studies. These three groups complement each other. Theory provides logical discipline and precise hypotheses for both empirical and clinical research. Empirical tests direct theorists by identifying irrelevant models and suggest where clinical research might find counterexamples. Clinical studies help set the agenda for both theory and empirical work. Because of this complementarity and the importance of communication between these groups, the Journal of Financial Economics is committed to publishing all three types of research.

Clinical Papers, case studies, perfect and imperfect markets

Abstract:
We extend the evidence of Fama and French (1995) on the post-1962 profitability and equity financing of firms in different style groups (small versus big, value versus growth) to 1926-2006. The emphasis is on whether equity-financed investment varies with cashflows and price-to-book ratios in ways that support or violate the pecking order model of Myers (1984) or the Q theory of investment. The long-term perspective from the results for 1926-2006 provides insights into inferences about the pecking order and Q theory drawn from previous work that focuses on shorter, more recent periods.

Equity financing, pecking order, Q-theory

Abstract:
We examine financing decisions from the perspective of the mispricing model of Debondt and Thaler (1985) and Lakonishok, Shleifer, and Vishny (LSV 1994). In their world value stocks are underpriced, growth stocks are overpriced, and the higher average returns of value stocks are the result of slow price corrections. The financial aggregates of style groups (small versus big, value versus growth) do not suggest that opportunistic financing in response to mispricing is a dominant factor in financing decisions, but regression tests on individual firms suggest that mispricing has marginal effects at least on equity financing decisions.

Opportunistic Financing

Abstract:
The aggregate portfolio of U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suugest that few funds produce benchmark adjusted expected returns sufficient to cover their costs. If we add back the costs in expense ratios, there is evidence of inferior and superior performance (non-zero true alpha) in the extreme tails of the cross section of mutual fund alpha estimates.

Abstract:
Average returns on value and growth portfolios are broken into dividends and three sources of capital gain: (1) growth in book equity, primarily from earnings retention, (2) convergence in price-to-book ratios (P/Bs) from mean reversion in profitability and expected returns, and (3) upward drift in P/B during 1927-2006. The capital gains of value stocks trace mostly to convergence: P/B rises as some value companies become more profitable and their stocks move to lower-expected-return groups. Growth in book equity is trivial to negative for value portfolios but is a large positive factor in the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth companies do not always remain highly profitable with low expected stock returns. Relative to convergence, drift is a minor factor in average returns.

Portfolio Management: Equity Strategies

Abstract:
We study whether the behavior of stock prices, in relation to size and book to market equity (BE/ME), reflects the behavior of earnings. Consistent with rational pricing, high BE/ME signals persistent poor earnings and low BE/ME signals strong earnings. Moreover, stock prices forecast the reversion of earnings growth observed after firms are ranked on size and BE/ME. Finally, there are market, size, and BE/ME factors in earnings like those in returns. The market and size factors in earnings help explain those in returns, but we find no link between BE/ME factors in earnings and returns.

Abstract:
Previous work shows that average returns on common stocks are related to firm characteristics like size, earnings/price, cashflow/price, book-to-market equity, past sales growth, long-term past return, and short term past return. Because these patterns in average returns apparently are not explained by the CAPM, they are called anomalies. We find that, except for the continuation of short-term returns, the anomalies largely disappear in a three-factor model. Our results are consistent with rational ICAPM or APT asset pricing, but we also consider irrational pricing and data problems as possible explanations.

Abstract:
The concept of multifactor portfolio efficiency plays a role in Merton's intertemporal CAPM (the ICAPM), like that of mean-variance efficiency in the Sharpe-Lintner CAPM. In the CAPM, the relation between the expected return on a security and its risk is just the condition on security weights that holds in any mean-variance-efficient portfolio, applied to the market portfolio M. The risk-return relation of the ICAPM is likewise just the application to M of the condition on security weights that produces ICAPM multifactor-efficient portfolios. The main testable implication of the CAPM is that equilibrium security prices require that M is mean-variance-efficient. The main testable implication of the ICAPM is that securities must be priced so that M is multifactor-efficient. As in the CAPM, building the ICAPM on multifactor efficiency exposes its simplicity and allows easy economic insights.

Abstract:
We estimate that the average value of a dollar invested in the U.S. corporate sector is $1.18. When we delete utilities and current assets, where opportunities for value added seem limited, the estimate jumps to $1.68. We use cross-section regressions to study how value is related to dividends and debt. The regressions can potentially identify tax effects, but they cannot disentangle other factors, including bankruptcy costs, agency costs, and asymmetric information. Simple tax stories say value is negatively related to dividends and positively related to debt, but we find the opposite. We infer that dividends and debt convey information about profitability that obscures any tax effects.

Abstract:
Suppose asset pricing is governed by the CAPM or the ICAPM, and the expected one-period simple returns on the net cash flows (NCFs) of investment projects are constant through time. Then the NCFs are priced by discounting their expected values with their expected one-period simple returns. But when NCFs are priced by discounting their expected values with constant CAPM or ICAPM expected one-period simple returns, distributions of NCFs more than one period ahead are likely to be skewed right. Expected payoffs are then larger than median payoffs, and expected payoffs are progressively more unusual outcomes for longer investment horizons.

Abstract:
In aggregate mutual funds produce a portfolio close to the market portfolio but with high costs of active management that show up intact as lower returns. Persistence tests that sort funds on three-factor alpha estimates suggest information effects in the future returns of past winners and losers, but persistence is temporary, it is weak to nonexistent in sorts on average return, and it largely disappears after 1992. Bootstrap simulations that use entire histories of fund returns do not identify information effects in three-factor or four-factor alpha estimates.