Kevin Coldiron of BGI reviews some of the literature of note on investment topics
Asset Prices and the Business Cycle, IMF World Economic Outlook Chapter III, Spring 2000, http://www.imf.org/external/pubs/ft/weo/2000/01/ index.htm
A long – but very readable – overview of the drivers of asset prices and the impact of these price changes on the real economy. Several sections are particularly topical. The discussion of the link between property prices and the real economy highlights the dilemma facing the Bank of England in deciding how much to allow accelerating house prices to impact monetary policy. Similarly, a section examining productivity and stock price trends discusses an issue US investors have been grappling with for several years. Current equity valuations imply future real earnings growth of more than 25–50% (depending on assumptions about the equity premium). This might just be possible if productivity growth continues. If it recedes to more normal levels, equities appear seriously overvalued. Read the arguments for and against and make up your own mind.
The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options, Lisa K. Meulbroek, Harvard Business School Working Paper
Feel left out because the guy next door just joined a high-tech start-up and is set to become wealthy by exercising stock options? You can at least take some comfort in the fact that he’s stuck holding an inefficient portfolio. Compensating managers with stock options helps align their incentives with those of shareholders. Yet it also forces them to hold poorly diversified portfolios with a large portion of their personal wealth tied up in a single, often highly volatile, stock. Because of this, managers value these options at a discount to what it costs companies to issue them. This paper attempts to directly measure this discount and finds some striking results. Managers in high-volatility internet firms value their options on average at only about half their market price. For these companies this suggests stock options may actually be a very inefficient way to reward employees. For managers (and those who follow and interpret their actions) it means that selling their firm’s stock may make perfect investment sense even if they believe it to be significantly undervalued.
Equity Mispricing: It’s Mostly on the Short Side, Mark T. Finn, Russell J. Fuller, John L. Kling, The Financial Analysts Journal, November/December 1999, pp. 117–126.
George Soros has shut down his two largest funds. In current market conditions he believes “it is too dangerous and crazy to short”. Is he right? This article looks at the profitability of a variety of simple value and growth strategies within the S&P500, comparing returns earned by going long to those earned by selling short. They find that most of the potential alpha from stock selection in this large-cap universe comes from the short side. While some of this opportunity will surely be eaten up by the practicalities of going short (stock borrowing costs, restricted liquidity) the study is yet more evidence that institutional investors should be exploring long/short and market neutral portfolios as a legitimate component of their active investment strategy.
Kevin Coldiron is head of market neutral strategies at Barclays Global Investors in London