- Music of all sorts
- Mergers and acquisitions: Their role in the dynamic online marketplace
- Should Apple start paying a dividend? – A discussion in the context of financial theory
- Repeating history: Drawing parallels between Tulip mania and the current financial crisis
- Why the CAPM persists, or Survival through mediocrity
Having already examined Apple as a powerful tech company in a previous blog, I became intrigued by the aggressive merger and acquisition market that has developed among the top tech companies and the increasing importance it now holds. Young tech companies have developed massively since their inception, Google and facebook stand as clear examples of this. These companies are heavily cash rich and actively compete among themselves to acquire the hottest new property in the tech world. There are many reasons for doing this, such as diversification, increasing market share and acquiring young talent and technologies that may grow into important sources of growth for the company in the future.
In this blog I will first look at mergers and acquisitions in a broader sense and then apply this theory to two of the larger, more aggressive tech companies that I have mentioned above, facebook and Google. Through doing this I hope to show the increasing importance of this area of the financial world with regards to the internet marketplace and how without correct regulation this may lead to the creation of powerful oligopolies.
Mergers are the joining of two equal sized companies that agree to join together, while acquisitions or takeovers are the purchasing of the share capital of one company by another. Takeovers can be friendly or unfriendly in nature. Due to the wide range of companies operational in the world today true mergers are relatively uncommon especially in the market I will be exploring. Acquisitions or takeovers on the other hand are relatively common and are of growing importance to the online tech industry with 19 recorded acquisitions by facebook in recent years and a whopping 106 for Google over a period of the last decade.
Acquisitions can take 3 different forms, conglomerate acquisitions, vertical acquisitions and horizontal acquisitions. Each of these has different consequences for the companies involved. Unlike the other forms, conglomerates are the joining of companies in different industries. Due to the different nature of the companies these are the least likely to be successful. It is also the form of acquisition that is least likely to be referred to a competition regulatory body.
Horizontal and vertical acquisitions are the joining of companies in the same industries at the same or different stages of production respectively. These are generally more successful than conglomerates and also more likely to be referred to competition regulatory bodies.
The motives behind mergers and acquisitions are clear to see. Increased levels of synergy, growth, and market share among various other opportunities for the companies involved provide the drive to acquire and merge with other companies.
There are many means of attempting takeovers, and defenses against doing so used by companies in every industry. For the purpose of this blog I will simply acknowledge the existence of these and move on instead to examining a particular market for acquisitions that is particularly dynamic and active in today’s economic climate.
Facebook and Google are both big players on the web. Both are two of the most popular websites in the world and hold increasing amounts of power and capital. By using examples of acquisitions by these companies I will demonstrate the importance of mergers and acquisitions in this marketplace. Google, in particular is a prolific company with regards to acquisitions. It is now the most clicked website in the world and offers a wide range of services to its online customers. If we are to examine the birthplace of these ideas that are driving Google’s popularity it may come as a surprise that of its primary services offered, only gmail and its original search engine are the result of in-house Google innovation.
As I have said earlier Google has acquired 106 companies in the past decade. What I did not make clear was that over half of these acquisitions have been made since the start of 2010. Google has clearly stepped up its search for young talent and startup companies due to the increased competition it is coming under in various areas of its services provided. The evolution of facebook as a global powerhouse has certainly increased competition in the mergers and acquisitions market leading to a bitter relationship between the two. It emerged midway through 2011 that facebook had hired an outside PR company to plant negative news about Google in the public. This is just one example of the increasing competition between the two. Both are extremely cash rich companies and have sped up their search for acquisitions and mergers with young companies.
This is evidenced by Google’s vice-president of corporate development David Lawee’s exclamation mid-way through 2011 that following the acquisition of 48 companies in the previous 12 months, Google intended to step up their M & A activities. More evidence of this can be seen in the creation of the venture capital arm of Google, Google Ventures, in late 2009.
Facebook successfully merged technologies with online communications system Skype in 2011 in order to fill a gap in the market before Google had a chance to do the same. Google has also used acquisitions and mergers
to its advantage extremely successfully in recent years, as is evidenced by their mergers with Youtube and Android, two companies who have been growing in value substantially since their mergers.
These companies are creating the future of the web through their aggressive M & A activities. The robust environment operated in by
these companies is facilitating the rise of two powerhouses of the online world. With such a robust and dynamic marketplace these two companies operate in there are questions regarding the effectiveness of competition regulators, especially due to the fact that these services are provided worldwide making it difficult for them to be held accountable in all the jurisdictions they operate in.
Should these companies continue as they are into the future, there is a danger of Google and facebook, along with other young sites developing powerful oligopolies over their marketplaces. In a young industry where these companies hold vast amounts of private information regarding their customers I hope that competition regulators become more active in examining the legality of these M & A’s due to the danger of these companies becoming overly powerful in their respective industries.
“Google Cranks Up M&A Machine.” Efrati, A. The Wall Street Journal, 05/03/11.
“Facebook Hires PR Firm to Plant Negative News About Google.”Aamoth, D. Time Magazine, 12/05/11.
“For Google, a New High in Deal-Making” Rusli, E.M. The New York Times, 12/07/11.
Prof. Brian Lucey, TCD. JS Applied Finance lecture slides.
“A century of corporate takeovers: What have we learned and where do we stand?” Martynova, M. & Renneboog, L. (2008). Journal of Banking and Finance.
Apple is one of the most successful and popular companies in the world. It is also a company that is going through a state of change as a result of the death of its charismatic former CEO and co-founder, Steve Jobs.
As well as this, it is a company that declined to pay dividends to its stockholders since 1995.
Using my knowledge acquired through the study of applied finance, I will explore the topic of dividends, paying special attention to Apple and offer my thoughts regarding the position of dividends in Apple’s future.
To begin with I will offer a short explanation of my understanding of the significance of dividends, or the lack of them as the case may be and then apply this to Apple’s situation.
Dividends are defined as ‘A distribution of a company’s earnings, decided by the board of directors, to a class of its shareholders,’ (Investopedia).
What a company tends to do with their end of year earnings varies greatly depending on many different factors.
The growth prospects of the company and a history of dividend issues are two of the most important factors.
Dividends hold a special position in finance as they signify the relationship between the stockholders and the management.
How much dividends a company tends to pay can tell you a lot about that company. In general, companies in high-growth markets tend not to issue dividends. This is because companies in high-growth markets generally tend to have good projects that earn the minimum acceptable risk related hurdle rate. Management take it upon themselves to reinvest any earnings made by the company into projects they believe will yield a greater long-term return for stockholders. This is most certainly the case with Apple, who have had a string of exceptionally successful projects in its history under Jobs.
If a company believes that any investments made will yield less than this rate then they should return the cash to the investors in the form of a dividend.
Once a company begins to pay dividends it is very difficult to stop or cut them. This is due to the signaling content of dividends. Because dividends hold a significant position of importance as the relationship between the company and it’s stockholders, any cut or stoppage of dividends can signal problems for the company. This may lead to falling stock prices or worse, although there is some evidence to suggest that the signal strength of dividend changes has declined in recent decades.
The power of dividend signaling is an issue that has lead to companies being hesitant to begin issuing dividends.
This is likely not an issue that would effect any issue of dividends by Apple in the short to medium term as Apple are an extremely cash rich company. They would have no problem financially issuing a modest dividend.
There are many different profiles to stockholders. Some are happy to forego any short term cash inflows from dividends if they believe it will benefit them in the future, others such as retired individuals looking for a cash inflow to supplement their pensions may be primarily interested in companies seen to deliver a consistent dividend. There are no shortage of investors eager to own a piece of Apple, so this lack of dividend payouts is unlikely to deter any significant number of investors from buying shares in the company.
When Jobs re-joined Apple in 1997 they were near bankruptcy. At the time of his death Apple was one of the most popular companies in the world with something in the region of 81 billion dollars in cash and marketable securities in the bank, more than the US government. Jobs always seemed particularly averse to issuing dividends claiming that this large cash saving “gives [Apple] tremendous security and flexibility.” This stands true to this day. Apple are currently in negotiations to buy Israeli company Anobit to supplement their flash storage technology, which may lead to significant increases in the battery life of their products. These ventures justify to a degree Jobs position on the matter.
The question for Apple’s new CEO Tim Cook is whether they really need a safety net larger than the cash available to the world’s largest economy or there are better uses for a portion of this cash, either within reinvestment in the company or a dividend issue.
(Cook and Jobs)
The issue of dividends is sometimes viewed as a declaration by a company that they have passed the rapid growth stage and have matured as a company. Should Apple issue a dividend in the near future, soon after Jobs’ death it may be viewed as a statement that the loss of Jobs has brought about an era of slower growth and innovation for Apple, which may in fact harm the company. Others would view it as a logical step for a company with such massive cash holdings.
Apple would like to maintain their position in the upper-right corner of the below dividends matrix. This affords them the greatest flexibility in setting dividend policy going forward.
Other large-cap tech companies such as Microsoft, Cisco and IBM have all chosen to offer their stockholders regular dividends while continuing to reinvest in projects within their companies.
There are tax issues at play with regards to Apple issuing dividends for Cook to consider as well. As dividends are usually taxed at higher rates than capital gains it may be considered wasteful for Apple to issue dividends considering its recent history of extremely successful enterprises.
A recent 10-k form filed by Apple also shows us that significant portions of Apple’s cash holdings are held abroad. Upwards of 50% of their holdings may be subject to taxes as a result of repatriation. Estimates have put this cost to Apple at around $5 billion should they choose to repatriate this cash for a dividend payout.
All things considered I believe that an Apple dividend payout is inevitable. I also believe a premature dividend payout may be harmful to the company in the short term, and the company will benefit from staying strong and proving that it has the drive to reinvest earnings into successful projects without Jobs to steer the ship. Tim Cook will eventually break from the past and issue a modest dividend payout, that much is inevitable, but not necessarily imminent.
“Do dividends matter more in declining markets?” Fuller, K.P., & Goldstein, M.A. Journal of Corporate Finance, 17 (3), (2011).
“Evidence on Irish financial analysts’ and fund managers’ views about dividends.” McCluskey, T., Broderick, A., Boyle, A., Burton, B., & Power, D. Qualitative Research in Financial Markets, 2 (2), (2010).
“Evidence on the Irish stock market’s reaction to dividend announcements.” McCluskey, T., Burton, B., Power, D. & Sinclair, C. Applied Financial Economics 16 (8), (2006).
“Earnings information conveyed by dividend initiations and omissions.” Healy, P. & Palepu, K.G. Journal of Financial Economics, 21 (2), (1988).
Apple Earnings Releases – Apple.com
Financial History (Dividend History) – Apple.com
“Apple Now Has More Cash Than The U.S. Government.” Rosoff, M. Business Insider, 28/07/11.
“Apple: Dividend time?” Savitz, E. Forbes.com, 03/11/11.
“Apple in talks to buy flash storage maker Anobit.” Kennedy, J. SiliconRepublic.com, 13/12/11.
“Apple dividend a likely possibility” Razi, N. SeekingAlpha.com, 09/12/11.
“Why doesn’t Apple pay a dividend?” Ghosh, P.R. International Business Times, 07/01/11.
Prof. Brian Lucey, TCD. JS Applied Finance lecture slides.
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one”
– Charles Mackay, 1841.
History has a way of repeating itself. Unfortunately for us it is only looking back retrospectively that we come to realize this. Lessons are learned and then swiftly forgotten. In an age of globalization it is more important than ever that we strive to learn from our past. This is especially true with regards to the financial world. Increased interdependence in economies resulting from global trade has created a situation where isolated booms and busts have become a thing of the past. It is part of human nature to think that the future will be better than the past, and that eponymous phrase from Reinhart and Rogoff’s important book on financial crises, that this time is different; this leads to short term thinking which is an extremely dangerous thing given our current situation.
In this blog I will draw parallels between Tulip mania that effected the Dutch in the early 17th century, widely considered to be the first recorded economic bubble, and the sub-prime mortgage crisis that brought about the global recession we are experiencing today. By doing this I hope to make clear that despite appearing to be very different, there are key characteristics that are shared by all financial crises in any time. The message of this blog is simple, if something seems too good to be true, it usually is. In an area that affects every member of society in a world that is increasingly interlinked it is imperative we learn our lessons and proceed into the future with caution.
(Dublin 4, At the heart of Ireland’s property bubble)
The parallels between the US and the Netherlands at the time of the crises are clear to see. The Dutch during their golden age and the US in the 20th century were both seen as preeminent economies at the time, excelling in areas such as trade, science and the military. While the Dutch were not the superpower the US were at the time its fair to draw a comparison between the two thriving economies.
A key difference between the two crises is clear to see, and that is the information available regarding them. In an age of endless databases and analyses the underlying causes of the current global crises are available for those who want them. Contrasting this the information surrounding ‘Tulipomania’ is sketchy at best. Until the 1980’s Charles Mackay’s famous book ‘Extraordinary popular delusions and the madness of crowds’ was the key source of information regarding this bubble. Since then his addressing of the crisis has been questioned regarding its sensationalist nature, but there are still lessons to be learnt.
The central story to Tulip mania is one of irrational speculation and the attachment of prices to objects that far surpass their intrinsic value. The same can be seen in house prices around the world in recent years. In Ireland properties were purchased that doubled or tripled in value in just a few short years. The low interest rates available in the US in the post-dotcom era and intense competition between mortgage lenders for market share lead to mortgages being given to those with questionable credit ratings and then repackaged by the banks to avoid liability on their part. House prices rose and wealth created seemingly out of nowhere. Throughout the history of finance, (not that long in the scale of things), bubbles have burst and been compared to this original example. Each time in retrospect Nassim Taleb’s Black Swan theory may be applied. They are events that cause major impacts and are only rationalized in retrospect.
(Sharp drop off in tulip prices)
The exact events surrounding Tulip mania are unclear, yet the story persists in the form of an economic old wives’ tale. It is known however that as the bubble grew from around 1634 to 1637 the class of individuals involved shifted. Those who had not formerly been involved in the business saw opportunities for quick wealth creation and the middle class became involved in bulb trading. It is generally agreed to have shifted in this direction around 1636. This embedded the eventual burst more deeply into the economy than had it remained within the original bulb trading community. Once again this mirrors the expansion of the property market in the US to those who had not previously been deemed suitable for mortgages.
The financial tools utilized by the Dutch at the time evolved to meet the growing bubble. An innovative futures market was developed for the first time. This left many vulnerable to an extent not realized until after the bursting of the bubble. At the time of expansion it appeared to be a fantastic tool in realizing potential growth prospects of the market, yet in retrospect caused more problems than it solved.
(The Sub-Prime mortgage crisis lead to record numbers of home foreclosures)
The utilization of more complicated and interlinked financial tools such as mortgage securitization and collateralized debt obligations to shift liability is an evolution of this original innovation. While appearing to offer solutions in the financial world, these tools were instead shown to have devestating capabilities.
The eventual crash associated with both bubbles was profoundly different due to the time they inhabited. Tulip mania affected only a small percentage of people to limiting degrees, while the sub-prime mortgage crisis went on to have devastating global effects which are only still being realized today.
(Admirael van der Eijck, one of the most prized tulips)
The frequency of financial crises are increasing and their effects are becoming more severe. The fragility of financial systems, various amplifying factors, regulatory failures and the collapse of asset prices are now issues of such importance that we cannot afford not to learn from the past again. I’m sure this is a sentiment that has been toted before, but in an age of increasing global interdependence I fear these issues will only grow more important. Tulip mania stands as the original reminder of the irrational nature of bubbles, but the current crisis is surely one of the most important.
Each time a recession or bubble occurs the old adage is proclaimed: this time is different. Unfortunately with increasing frequency and devastation associated with these crises we will sink or swim based on our ability to learn from the past.
“This time is different.” Reinhart, C.M. & Rogoff, K.S. Princeton University Press, (2009).
“Irrational Exuberance.” Shiller, R.J. Princeton University Press, (2005).
“Extraordinary popular delusions and the madness of crowds.” Mackey, C. Harriman House Limited, (1841).
“The Black Swan: The Impact of the Highly Improbable.” Taleb, N.N. Allen Lane, (2007).
“Manias, panics and crashes – A history of financial crises.” Kindleberger, C.P. & Aliber, R. Palgrave Macmillan, (1978).
“Famous first bubbles: The fundamentals of first manias” Garber, P.M. The MIT Press, (2000).
“Tulipomania: The story of the world’s most coveted flower and the extraordinary passions it aroused.” Dash, M. Crown, (2000).
“Global financial meltdown: how we can avoid the next economic crisis.” Read, C. Palgrave Macmillan, (2009).
“The Historic Link Between Tulips and The Sub-Prime Mortgage Debacle.” Ficke, G. SelfGrowth.com
Prof. Brian Lucey, TCD. JS Applied Finance lecture slides.
The capital asset pricing model (CAPM) is the default model for risk in equity valuation and corporate finance. It has retained this position since it’s introduction by Jack Treynor in 1961. Unusually this is a position it has maintained despite it having been proven it is not the most accurate model by a long shot.
This is reflected in the graph below plotting CAPM predicted returns against actual excess returns.
In Graham and Harvey’s 2000 survey we see that around 74% of CFOs still use CAPM in their work, and in ‘The Consensus Estimate for the Equity Premius’ by Academic Financial Economists in 2007, 75% of finance professors recommend CAPM for corporate capital budgeting purposes.
What is it that has allowed CAPM to maintain its position despite a long list of shortcomings and detractors?
It is not some sort of sentimental value that has allowed CAPM to hold it’s position of importance in the financial world, but the inherent failings associated with other models developed to this point.
Through exploring the prominent alternatives that have emerged as opponents to the CAPM we can see that while offering statistically significant results in comparison to CAPM, the extra work associated with finding these inputs do not yield proportionally substantial results. Simply put, the work associated with CAPM’s alternatives outweighs any improvements in results from these models.
The simplicity of the inputs associated with the CAPM is a double-edged sword. The risk free rate, beta and expected return on the market portfolio are the foundations of the CAPM and are relatively easy to calculate. Their simplicity to calculate is marred by their overlooking of several areas that have proved significant in calculating risk in equity valuation and corporate finance.
This is where alternatives such as the Fama-French and Carhart Four-Factor model have made inroads.
Fama and French’s model has made the greatest inroads into displacing CAPM yet it is still a long way from being the ‘go to’ model for analysts and academics. They started with the observation that some stocks tended to outperform the market. Small caps and stocks with a high book-to-market ratio were seen as these regular outperformers. Based upon these observations Fama and French constructed a 3 factor pricing model.
This model was based upon the idea that variations in market returns can be explained by exposure to three elements – the marketplace as a whole, small stocks and value stocks.
In their 1993 paper Fama and French claim that their 3-factor model can explain over 90% of the variability in returns in comparison to the rough figure of 70% accounted for by CAPM.
For an example of the 3 factor model’s effectiveness in comparison with CAPM we can look at the equal weight Centre for Research in Security Prices plugged into the models and compared by a fellow blogger and advocate for the Fama-French model.
We can see here the alpha’s vary greatly in the two outcomes. The alpha of the EW CRSP index when put through the Fama-French model being roughly 10% of the CAPM alpha.
It’s clear to see from this example that the Fama-French model offers a much fuller view of what is driving returns when compared to the CAPM.
A rational thinker, unfamiliar with the world of finance, would surely see the Fama-French model as superior to CAPM and would wonder as to why it is not favoured by those in the field of finance. This is where the worlds of academia and application collide. Fama and French’s model proves significant on paper but the real world application of models to the world of finance is more than just results based. The time taken to calculate all the essential inputs for the model is often deemed relatively more costly than the results achieved.
This flaw in the application of models to real world analysis extends to other models such as the 4-factor pricing model.
The fuller views, compared to CAPM, explaining what is driving returns have been seen to get even better when exposed to the Carhart 4-factor pricing model in some cases. This model takes into account the system of momentum investing or ‘fair weather investing’, which has been reported to yield average returns of 1% per month by some academics.
Unfortunately there is no consensus as to the importance of the results shown from this model, which further cements CAPM’s position as the consistent yet flawed model of choice.
The Arbitrage Pricing Model has been called the ‘supply-side’ response to the CAPM’s ‘demand-side’ basis. It is a less restrictive model that assumes an investor will hold a unique portfolio instead of the market portfolio assumed in CAPM. It has been said that the CAPM is a special form of APM.
CAPM has maintained its advantage over the Arbitage Pricing Theory due to the simplicity of its inputs compared to the more complicated nature of the APM.
Having looked at the effectiveness of CAPM in comparison to it’s competing models whether they be APM or a multifactor model it’s clear that CAPM is not the model that offers the clearest picture in equity valuation and corporate finance. This does not change the fact that it remains the default model for risk in these areas.
The CAPM has survived due to its simple and effective nature. The alternative models have a clear advantage in explaining past return but their use in forecasting future returns are about as effective as the CAPM.
It is well and good to herald another pricing model as more effective in the academic world, but in the application of financial know-how to real world markets the expected returns from alternate models are not substantially different enough to warrant the complicated job of calculating up to four additional betas.
Analysts are under no illusions as to the effectiveness of CAPM, but concede that its benefits outweigh the negatives for now.
This has been the saving grace for the CAPM and until the day where a model who’s extra work yields proportionally better results CAPM will survive as the default model for risk in equity valuation and corporate finance.
“Returns to buying winners and selling losers: Implications for stock market efficiency,” Jegadeesh, Narasimhan and Titman, Sheridan. Journal of Finance 48 (1993).
“Common risk factors in the returns on stock and bonds,” Fama and French. Journal of Financial Economics, 33 (1993).
“The Consensus Estimate for the Equity Premium,” Welch, I. Academic Financial Economists, (2007).
“How to use the Fama French Model,” Empirical Finance Blog.
“Toward a Theory of Market Value of Risky Assets” Treynor, J.L. Asset Pricing and Portfolio Performance: Models, Strategy and Performance Metrics, (Unpublished until 1992), (1962).
“Grading the performance of market timing newsletters,” Graham and Harvey,
Association for investment management and research, (1997).
Prof. Brian Lucey, TCD. JS Applied Finance lecture slides.
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