Investments in Fallen Angel Stocks

209 Pages·2012·5.18 MB·English

by  Bernd Mühlfriedel

Technische Universität München
Lehrstuhl für Entrepreneurial Finance
unterstützt durch die KfW Bankengruppe
Univ.-Prof. Dr. Dr. Ann-Kristin Achleitner

Investments in Fallen Angel Stocks
An empirical analysis of quality indicators of disgraced growth companies

Bernd Mühlfriedel, CFA

Vollständiger Abdruck der von der Fakultät für Wirtschaftswissenschaften
der Technischen Universität München zur Erlangung des akademischen Grades eines
Doktors der Wirtschaftswissenschaften (Dr. rer. pol.)
genehmigten Dissertation.

Vorsitzender: Univ.-Prof. Dr. Christoph Kaserer
Prüfer der Dissertation: 1. Univ.-Prof. Dr. Dr. Ann-Kristin Achleitner
2. Univ.-Prof. Dr. Gunther Friedl

Die Dissertation wurde am 03.04.2012 bei der Technischen Universität München
eingereicht und durch die Fakultät für Wirtschaftswissenschaften am 15.07.2012
angenommen.
II
III
Table of Contents
LIST OF FIGURES ............................................................................................. VIII

LIST OF TABLES .................................................................................................. IX

LIST OF ABBREVIATIONS .............................................................................. XII

1
  INTRODUCTION ............................................................................................... 1

1.1
  Relevance of Topic ................................................................................... 1

1.2
  Objectives of Research ............................................................................. 4

1.3
  Structure of Thesis ................................................................................... 5

2
  INVESTMENT AND FALLEN ANGELS ....................................................... 6

2.1
  Characteristics of an Investment ............................................................ 6

2.2
  Definition of an Investor .......................................................................... 7

2.3
  Characteristics of Fallen Angels ............................................................. 8

2.3.1
  Negative Earnings Surprise .......................................................... 11

2.3.2
  Subsequent Negative Abnormal Shareholder Return ................... 14

2.3.3
  Above-average Growth before Negative Earnings Surprise ........ 14

2.4
  Good versus Bad Fallen Angels ............................................................ 17

2.4.1
  Time Horizons for Abnormal Return ............................................ 17

2.4.2
  Separation into Good and Bad Fallen Angels according to
Share Price Performance ............................................................. 19
3
  UNDERLYING PHILOSOPHIES OF SCIENCE AND
RELEVANT FRAMEWORKS FROM FINANCIAL THEORY ............... 22

3.1
  Underlying Philosophies of Science ...................................................... 22
3.2
  The Efficient Market Hypothesis and its Shortcomings ..................... 23

3.2.1
  Key Elements ................................................................................ 24
IV
3.2.2
  Criticism of the Efficient Market Hypothesis ............................... 25

3.2.3
  Differences in Risk Definitions ..................................................... 29

3.3
  Behavioral Finance ................................................................................. 33

3.3.1
  Key Elements ................................................................................ 34

3.3.2
  Overreaction Theory and Mean Reversion .................................. 39

3.3.3
  Underreaction Theory .................................................................. 43

3.3.4
  Reconciliation between Overreaction and Underreaction
Theories ........................................................................................ 44

3.3.5
  Other Cognitive Biases ................................................................. 48

3.4
  Perspective of the Investment Practice ................................................. 50

3.5
  Summary ................................................................................................. 52

4
  INVESTMENT STYLES ................................................................................. 54

4.1
  Overview on Investment Styles ............................................................. 54

4.1.1
  Function and Definition of Investment Styles ............................... 54

4.1.2
  Classification of Investment Styles ............................................... 55

4.2
  Value versus Growth Investing ............................................................. 58

4.2.1
  Value Investment Style .................................................................. 58

4.2.2
  Growth Investment Style ............................................................... 62

4.2.3
  Comparison of Value and Growth Investment Styles ................... 65

4.3
  Investment Styles and Fallen Angels .................................................... 66

4.3.1
  Previous Attempts to Reconcile Value and Growth
Investment Styles .......................................................................... 66

4.3.2
  Fallen Angel Investing as a New Attempt to Reconcile
Value and Growth Investment Styles ............................................ 70
5
  DEVELOPMENT OF POSSIBLE INDICATORS FOR ANGEL
QUALITY ......................................................................................................... 72

5.1
  Input from Value Investing Practice .................................................... 72

5.2
  Framework of Possible Influence Factors on Angel Quality .............. 73

5.3
  Financial Stability .................................................................................. 74

5.3.1
  Current Ratio as Measure of Short-Term Liquidity ..................... 75

5.3.2
  Equity Ratio as Measure of Capital Structure Stability ............... 76
V
5.4
  Profitability ............................................................................................. 77

5.4.1
  Gross Profit Margin ..................................................................... 78

5.4.2
  Return on Assets ........................................................................... 79

5.5
  Cash Flow ................................................................................................ 80

5.5.1
  Free Cash Flow Margin ............................................................... 81

5.5.2
  Cash Flow from Operating Activities-to-Net Income Ratio ......... 82

5.6
  Cost Structure ......................................................................................... 83

5.7
  Mergers & Acquisitions ......................................................................... 84

5.8
  Valuation ................................................................................................. 86

5.8.1
  Price-to-Book Ratio ...................................................................... 86

5.8.2
  Price-to-Earnings Ratio ............................................................... 88

5.9
  Negative Earnings Surprise ................................................................... 89

5.9.1
  Standardized Unexpected Earnings ............................................. 89

5.9.2
  Cumulative Abnormal Return ....................................................... 90

5.9.3
  Cumulative Abnormal Return-to-Standardized Unexpected
Earnings Ratio .............................................................................. 91

5.10
  Overview of Hypotheses ......................................................................... 92

6
  EMPIRICAL TESTS OF ANGEL QUALITY INDICATORS .................... 94

6.1
  Introductory Remarks ........................................................................... 94

6.2
  Raw Dataset Description ....................................................................... 94

6.2.1
  Selection of Geography ................................................................ 94

6.2.2
  Selection of Benchmark ................................................................ 95

6.2.3
  Selection of Time Horizon ............................................................ 96

6.2.4
  Calculation of Abnormal Returns ................................................. 98

6.2.5
  Time Frame Around Earnings Surprise ....................................... 99

6.2.6
  Descriptive Statistics of Raw Dataset ......................................... 102

6.3
  Processing of Raw Dataset into Base Dataset and Subsets ............... 105

6.3.1
  Exclusion of Stocks ..................................................................... 105

6.3.1.1
  Criteria for Fallen Angel Stocks ................................. 105

6.3.1.2
  Industry Characteristics .............................................. 107

6.3.1.3
  Strength of Analyst Coverage .................................... 107
VI
6.3.1.4
  Time Period Between Negative Earnings
Surprises ..................................................................... 108

6.3.2
  Development of Base Dataset Subsets According To
Industry Classifications .............................................................. 109

6.4
  Methods of Testing of Angel Quality Indicators ............................... 112

6.5
  Test Results for Angel Quality Indicators .......................................... 114

6.5.1
  Financial Stability Ratios ........................................................... 114

6.5.1.1
  Current Ratio .............................................................. 114

6.5.1.2
  Equity Ratio ................................................................ 117

6.5.2
  Profitability Ratios ..................................................................... 121

6.5.2.1
  Gross Profit Margin .................................................... 121

6.5.2.2
  Return on Assets ......................................................... 124

6.5.3
  Cash Flow ................................................................................... 126

6.5.3.1
  Free Cash Flow Margin .............................................. 126

6.5.3.2
  Cash Flow from Operating Activities-to-Net
Income Ratio .............................................................. 129

6.5.4
  Cost Structure: Selling, General & Administrative
Expenses Ratio ............................................................................ 131

6.5.5
  Mergers & Acquisition Activities: Goodwill Ratio .................... 134

6.5.6
  Valuation Ratios ......................................................................... 137

6.5.6.1
  Price-to-Book Ratio .................................................... 137

6.5.6.2
  Price-to-Earnings Ratio .............................................. 140

6.5.7
  Negative Earnings Surprise-Related Ratios ............................... 142

6.5.7.1
  Standardized Unexpected Earnings ............................ 143

6.5.7.2
  Cumulative Abnormal Return .................................... 145

6.5.7.3
  Cumulative Abnormal Return-to-Standardized
Unexpected Earnings Ratio ........................................ 147

6.5.8
  Summary of Results of Empirical Tests ...................................... 150

6.6
  Robustness Testing ............................................................................... 152

6.6.1
  Level of Sales Growth ................................................................. 152

6.6.2
  Length of Time Period between Negative Earnings
Surprises ..................................................................................... 154

6.6.3
  Length of Post-Earnings Announcement Drift ........................... 155

6.6.4
  Measures of Angel Quality ......................................................... 156
VII
7
  CONCLUSION ................................................................................................ 157

7.1
  Summary and Recommendations for the Investment Practice ....... 157

7.2
  Outlook and Potential for Future Research ...................................... 158

APPENDIX 163
VIII
LIST OF FIGURES
Figure 1: Constituting characteristics of a fallen angel stock ................................. 10

Figure 2: Comparison of structures of mean-variance and behavioral
portfolios ................................................................................................. 36

Figure 3: Overview of equity investment styles ..................................................... 55

Figure 4: Possible influence factors on angel quality ............................................. 74

Figure 5: Chart of Dow Jones Industrial index 1960-2009 .................................... 97

Figure 6: Chart of S&P Composite 1500 index 1996-2009 ................................... 97

Figure 7: Industry distribution in the raw dataset ................................................. 103

Figure 8: Negative earnings surprise frequency distribution in the raw dataset .. 106

Figure 9: Share of good and bad fallen angels across industries for AQ13 ......... 111
IX
LIST OF TABLES
Table 1: Effects of earnings announcements on financial market participants ..... 13

Table 2: Measures of angel quality and their use in the thesis .............................. 20

Table 3: Fundamental differences between modern portfolio theory and
behavioral finance ................................................................................... 38

Table 4: Overview on value and growth investment styles .................................. 65

Table 5: Overview of hypotheses and related independent variables ................... 92

Table 6: Sector distribution in the raw dataset .................................................... 104

Table 7: Mean and median values across different industries for angel
quality AQ13 ......................................................................................... 109

Table 8: Number of fallen angels according to angel quality and industry ........ 111

Table 9: Short-term liquidity as measured by current ratio and angel quality
– results of univariate tests of base dataset (AQ13) split by
industries ............................................................................................... 115

Table 10: Short-term liquidity as measured by current ratio and angel quality
– results of LOGIT regression of base dataset (AQ13) split by
industries ............................................................................................... 116

Table 11: Capital structure as reflected by equity ratio and angel quality –
results of univariate tests of base dataset (AQ13) split by industries ... 118

Table 12: Capital structure as reflected by equity ratio and angel quality –
results of LOGIT regression of base dataset (AQ13) split by
industries ............................................................................................... 119

Table 13: Gross profit margin and angel quality – results of univariate tests of
base dataset (AQ13) split by industries ................................................ 122

Table 14: Gross profit margin and angel quality – results of LOGIT
regression of base dataset (AQ13) split by industries ........................... 123

Table 15: Return on assets and angel quality – results of univariate tests of
base dataset (AQ13) split by industries ................................................ 124

Table 16: Return on assets and angel quality – results of LOGIT regression of
base dataset (AQ13) split by industries ................................................ 125
X
Table 17: Free cash flow margin and angel quality – results of univariate tests
of base dataset (AQ13) split by industries ............................................ 127

Table 18: Free cash flow margin and angel quality – results of LOGIT
regression of base dataset (AQ13) split by industries ........................... 128

Table 19: Cash flow from operating activities-to-net income ratio and angel
quality – results of univariate tests of base dataset (AQ13) split by
industries ............................................................................................... 130

Table 20: Cash flow from operating activities-to-net income ratio and angel
quality – results of LOGIT regression of base dataset (AQ13) split
by industries .......................................................................................... 131

Table 21: Sales, general and administration ratio and angel quality – results of
univariate tests of base dataset (AQ13) split by industries ................... 132

Table 22: Sales, general and administration ratio and angel quality – results of
LOGIT regression of base dataset (AQ13) split by industries .............. 133

Table 23: Goodwill ratio and angel quality – results of univariate tests of base
dataset (AQ13) split by industries ......................................................... 135

Table 24: Goodwill ratio and angel quality – results of LOGIT regression of
base dataset (AQ13) split by industries ................................................ 136

Table 25: Price-to-book ratio and angel quality – results of univariate tests of
base dataset (AQ13) split by industries ................................................ 137

Table 26: Price-to-book ratio and angel quality – results of LOGIT regression
of base dataset (AQ13) split by industries ............................................ 138

Table 27: Price-to-earnings ratio and angel quality – results of univariate tests
of base dataset (AQ13) split by industries ............................................ 140

Table 28: Price-to-earnings ratio and angel quality – results of LOGIT
regression of base dataset (AQ13) split by industries ........................... 141

Table 29: Standardized unexpected earnings ratio and angel quality – results
of univariate tests of base dataset (AQ13) split by industries ............... 143

Table 30: Standardized unexpected earnings ratio and angel quality – results
of LOGIT regression of base dataset (AQ13) split by industries ......... 144

Table 31: Cumulative abnormal return and angel quality – results of
univariate tests of base dataset (AQ13) split by industries ................... 146