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Who are the world's best investors?
IF FINANCE has a single rule, it is that arbitrage should keep prices in line. If they do stray from fundamentals, so the argument goes, savvy investors should step in to correct them.
All good in theory. In practice, less so. Markets can be swept by sentiment, detaching valuations from fundamentals. Economists have surgically documented persistent distortions. Purely mechanical flows, for instance, move markets even when they are known to investors in advance and unrelated to earnings prospects.
When a stock is added to an index, its price inflates. Predictable dividend reinvestments also push up prices. Why does this happen? And who, in time, might correct the market?
Ask on Wall Street for the identity of such arbitrageurs, and you get the usual suspects. Hedge funds and quant shops, armed with analysts and algorithms, are the most natural candidates. The industry has ballooned from overseeing US$1.4 trillion to US$4.5 trillion in assets over the past decade, and is well positioned to spot mispricings. Others suggest short-sellers, ever alert to signs of froth, or retail investors, now keen dip-buyers. One candidate gets mentioned rather less often: staid corporates.
Such businesses are normally seen as passive capital-raisers, not active market participants and certainly not market disciplinarians. Even though they can act on perceived mispricings, firms typically focus more on expanding their own business than on searching for alpha.
Bosses have operational backgrounds. They are more fluent in capital spending than capital markets. And when financial officers do wade into the market – to issue or buy back shares, for example – valuation is just one of many considerations, alongside avoiding taxes, ensuring a healthy credit rating and making sure the firm does not take on too much leverage.
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And yet, a growing body of work suggests that corporations, far from being passive observers, are some of the market's most effective arbitrageurs. In 2000, Malcolm Baker of Harvard University and Jeffrey Wurgler, then of Yale University, found a tight connection between firms' net equity issuance and subsequent stock-market returns.
Years in which companies issued relatively more stock were typically followed by weaker market performance. More tellingly, companies seemed to issue precisely when valuations were rich, and especially when other frothy signals, such as buoyant consumer sentiment, were drawing attention.
Timing the market is impressive; out-trading the professionals is even more so. Yet, firms that issue or retire their own shares routinely do exactly that. In 2022, David McLean of Georgetown University and co-authors showed that corporate-share sales and buy-backs forecast future returns more accurately than the trades of banks, hedge funds, mutual funds and wealth managers.
What explains this prowess? Part of the answer lies in firms' access to private information. Few are better placed to forecast a company's future cashflows than insiders. When a company begins buying back its own shares – or employees convert their options into stock-holdings – investors should pay attention.
But informational advantages go only so far. They do not explain why firm-level issuance predicts aggregate stock-market returns. And firms' decisions are publicly disclosed: if they were merely signals of private insight, copycat investors quickly ought to arbitrage away any return. Instead, the success of companies may reflect not just what they know, but what they are able to do. They are unusually well-placed to act on mispricings.
Start with short-selling. Firms have a natural way to take a contrarian view: when they believe their shares are overpriced, they can issue more of them. For a hedge fund to express a similar view, it must sell short the stock or purchase more complex products, such as put options.
These strategies are not only expensive, requiring the payment of borrowing fees or option premiums, but also expose the investor to large losses and margin calls if the stock price rises. Risks become particularly acute during bouts of volatility, such as in January 2021, when retail investors sent GameStop's share price to astonishing heights. Hedge funds hesitated to short-sell for fear of making losses as investors piled in. GameStop's boss, by contrast, simply issued new shares.
Companies also operate across markets. Almost every business finances itself with some combination of debt and equity. If one becomes unusually expensive, it can easily switch to the other. Yueran Ma of the University of Chicago finds that firms routinely move towards whichever market looks cheap.
Such flexibility is rarely available to institutional investors, which are constrained by benchmarks and mandates. Only 28 of Vanguard's 267 funds can trade both bonds and stocks, for instance.
Last, businesses benefit from insulation. They may face unhappy shareholders, but they do not face redemptions. When institutional investors mess up, their own investors pull out, forcing them to sell at just the wrong time.
Firm hand
The agility this engenders makes companies valuable providers of liquidity, too. As passive investing has grown to make up a fifth of the market, so has demand for stocks in the big indices. Who meets that demand, helping anchor prices?
Marco Sammon of Harvard and John Shim of the University of Notre Dame suggest it is, once again, companies. Intermediaries such as active managers and pension funds buy alongside their passive peers. Firms step in to take the other side of the trade by issuing new shares. Similarly, when governments flood the market with short-term debt, firms respond by issuing longer-dated bonds.
As asset managers become more passive, specialised or tied up by mandates, it is the firms they invest in that keep the market ticking. So thank your nearest chief financial officer.
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