Uniform field theory of corporate finance

Peter Prince

2022-11-25 09:29:00 Fri ET

Uniform field theory of corporate finance

While the agency and precautionary-motive stories are complementary, these stories can be nested as special cases within the uniform field theory of corporate finance by Lambrecht and Myers (JF 2012, 2015). In normal times, shareholders demand regular and smooth dividend payout while corporate incumbents exhibit habit persistence in their managerial rent protection (Fama and French, JFE 2001; DeAngelo, DeAngelo, and Skinner, JFE 2004; Skinner, JFE 2008; Leary and Michaley, RFS 2011; Michaely and Roberts, RFS 2011). This dividend payout depletes the internal cash reservoirs or free cash flows, and in turn induces corporate incumbents to disgorge regular cash for better agency control (Jensen, AER 1986; Stulz, JFE 1990; Dittmar, Mahrt-Smith, and Servaes, JFQA 2003; Dittmar and Mahrt-Smith, JFE 2007; Skinner, JFE 2008; Harford, Mansi, and Maxwell, JFE 2008). The typical investor's response can be different at unique junctures of financial stress throughout the business cycle. When the firm hoards excess cash for precautionary concerns (Opler, Pinkowitz, Stulz, and Williamson, JF 1999; Almeida, Campello, and Weisbach, JF 2004; Faulkender and Wang, JF 2006; Bates, Kahle, and Stulz, JF 2009; Harford, Klasa, and Maxwell, JF 2014), the resultant cash balance serves as a countercyclical capital buffer against adverse external shocks to corporate earnings growth.

 

Changes in the firm's financial flexibility in the form of both available debt capacity and net share issuance have a first-order impact on the firm's capital structure choice (DeAngelo, DeAngelo, and Whited, JFE 2011; McLean, JFE 2011; Denis and McKeon, RFS 2012). To the extent that corporate incumbents spend cash quickly on lumpy and volatile M&A, R&D, and capital overinvestments (Titman, Wei, and Xie, JFQA 2004; Malmendier and Tate, JF 2005, JFE 2008; Hirshleifer, Low, and Teoh, JFE 2012; Harford et al, JFE 2012), cash and share buyback fluctuations absorb the variation in residual income (Harford, Mansi, and Maxwell, JFE 2008; Skinner, JFE 2008). This residual income can be distributed as regular and smooth dividend payout or one-off discretionary share buyback (Harford, Mansi, and Maxwell, JFE 2008; Skinner, JFE 2008; Leary and Michaely, RFS 2011; Michaely and Roberts, RFS 2011; Peyer and Vermaelen, RFS 2009; Dittmar and Field, JFE 2015). This uniform field theory of corporate finance interconnects managerial rent protection to corporate investment, cash retention, capital structure, and payout management.

 

Neoclassic studies show some form of home bias in international stock portfolio under-diversification (Huberman and Kandel, JF 1987; Hansen and Richard, ECMT 1987; Hansen and Jagannathan, JPE 1991; Harvey, 1991; Glen and Jorion, JF 1993). Errunza, Hogan, and Hung (JF 1999) empirically find that home-made portfolios of U.S. domestically traded stocks, ADRs, and MNCs can mimic international stock market indices. Both mean-variance spanning tests and Sharpe ratio tests suggest that portfolio efficiency gains beyond home-made diversification are economically insignificant. This evidence suggests that it is not necessary for U.S. asset managers to trade abroad to reap significantly better international stock portfolio diversification benefits.

 

Eun, Huang, and Lai (JFQA 2008) report evidence in support of the alternative view that regional small-cap stocks exhibit low return correlations with all the other international large-cap, mid-cap, and small-cap stocks. These low return correlations suggest that it is difficult to find common exposures to global factors in the mean-variance spanning tests for small-cap stocks. The extra portfolio efficiency gains from international stock portfolio diversification with regional small-cap funds are econometrically significant. Specifically, the inclusion of small-cap stocks can increase the Sharpe ratio from 0.24 to 0.64+ while this increase is econometrically significant. A geometric interpretation of this evidence is that global diversification with regional small stocks shifts the efficient frontier in the northwest direction.

 

Fama and French (JFE 2012) further find that regional size, value, and momentum stock portfolios do not exhibit common exposures to global Fama-French factors. Alternatively, regional Fama-French factors outperform their global counterparts in explaining the variation in anomalous stock returns on size, value, and momentum tilts. This evidence suggests at best partial global stock market integration, and therefore there is still ample room for international stock portfolio diversification. Future research can delve into the new mean-variance spanning tests and Sharpe ratio tests for different stock anomaly tilts (e.g. size, value, and momentum) and asset classes such as bonds, ETFs, and derivatives.

 

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