Fundamental Investment Analysis

This paper documents that the earnings yield and book-to-price combine to predict equity returns in a way that is consistent with the rational pricing of risk. It is well known that earnings yields predict returns in the cross-section, consistent with standard formulas that show that the earnings yield equals the required return when there is no expected earnings growth beyond that from retention. With growth, those same formulas show that the earnings yield is increasing in the required return but decreasing in the growth.

This paper, the second in CEASA's White Paper series on accounting issues, lays out principles under which fair value accounting satisfies the objective of reporting to shareholders. Its "principles-based" approach embraces broad economic concepts but is also pragmatic and specific enough to guide practice.

The separation of ownership and control allows controlling shareholders to pursue private benefits. We develop an analytically tractable dynamic stochastic general equilibrium model to study asset pricing and welfare implications of imperfect investor protection. Consistent with empirical evidence, the model predicts that countries with weaker investor protection have more incentives to overinvest, lower Tobin's q, higher return volatility, larger risk premia, and higher interest rate.

A German broker's clients place similar speculative trades and therefore tend to be on the same side of the market in a given stock during a given day, week, month, and quarter. Aggregate liquidity effects, short sale constraints, the systematic execution of limit orders (coordinated through price movements) or the correlated trading of other investors who pick off retail limit orders, do not fully explain why retail investors trade similarly. Correlated market orders lead returns, presumably due to persistent speculative price pressure.

Obtaining more accurate equity value estimates is the starting point for stock selection, value-based indexing in a noisy market, and beating benchmark indices through tactical style rotation. Unfortunately, discounted cash flow, method of comparables, and fundamental analysis typically yield discrepant valuation estimates. Moreover, the valuation estimates typically disagree with market price. Can one form a superior valuation estimate by averaging over the individual estimates, including market price?

We are currently experiencing a major shock to the financial system, initiated by problems in the subprime mortgage market, which spread to securitization products and credit markets more generally. Banks are being asked to increase the amount of risk that they absorb (by moving off-balance sheet assets onto their balance sheets), but losses that the banks have suffered limit their capacity to absorb those risky assets.

Under U.S. GAAP, reported balance sheet and income statements are based on immediate expensing of R&D expenditures. We capitalize those expenditures and derive adjusted equity book values and earnings using simple amortization techniques (straight-line over assumed industry-specific useful lives). After confirming that such adjustments increase the association of book values/earnings with contemporaneous stock prices (and future earnings), we examine the relation between those adjustments and future returns.

In this paper, we discuss earnings quality and the related concept of earnings management, focusing on the primary financial accounts. For each key line-item from the financial statements, we summarize accounting and economic considerations applicable to that item, discuss implications for earnings quality, evaluate the susceptibility of the item to manipulation, and identify potential red flags. The red flags and specific issues discussed for the individual line-items provide a framework for fundamental and contextual analysis by academic researchers and practitioners.

This paper empirically investigates directors' ownership in the mutual fund industry. Our results show that, contrary to anecdotal evidence, a significant portion of directors hold shares in the funds they oversee. Ownership patterns are broadly consistent with an optimal contracting equilibrium. That is, ownership is positively and significantly correlated with most variables that are predicted to indicate greater value from directors' monitoring. For example, directors' ownership is more prevalent in actively managed funds and in funds with lower institutional ownership.