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Financially constrained firms are more susceptible to a stock price crash – but why?

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Financially constrained firms are more susceptible to a stock price crash – but why?

This article is written by Guanming He, Professor of Accounting at Durham University Business School, and is based upon his research paper ‘Financial Constraints and Future Stock Price Crash Risk’, co-authored by a PhD student, Helen Ren.

 There are a wide range of factors that can cause a public company’s stock price to crash. These can be uncontrollable, external factors such as government sanctions, which we have recently seen employed by Donald Trump on Russian oligarchs (causing Russia’s main share index to crash by 11%),or internal factors, for example, Facebook’s stock price crashing by 16% as a result of a recent data breaching scandal.

These recent examples are proof that even the world’s largest, most stable and well-known companies can be suspect to a stock price crash. The possibility of such crashes occurring naturally causes uneasiness across all firms, regardless of their standing or success.

Although these stock price crashes can have huge ramifications for a firm, it is arguably the company’s investors that stand to be the parties most affected. As a firm’s stock value drops dramatically, shareholders can see their investments also plummet in worth. This likely causes incumbent investors to consider pulling their investments and deters other potential investors. It is no wonder then that those at the head of public companies look to do everything possible to prevent such situations from occurring.

However, even firms that experience the opposite of a stock price crash – a prolonged period of excessive stock price rises – can also be incredibly susceptible to a stock price crash in the long term, in which the stock’s metaphorical bubble ‘bursts’. Therefore, it is important for firms to find balance between increasing their stock prices and preventing a crash because of these rises. This is a tricky balance to achieve, and some firms find it a lot harder than others.

In my recent study, conducted alongside my PhD student, Helen Ren, we researched the impact that financial constraints have on the potential risk of a firm’s stock price crashing. For this, we defined firms experiencing financial constraints as those who were facing difficulty in funding their desired investments and used a large sample of U.S. listed firms across a 20-year period from 1995-2016.

Our research revealed that financially constrained firms were indeed much more likely to be at risk of a stock price crash. But why is this? My research explored a number of contributing factors.

Higher Default Risk

Firms experiencing financial constraints are highly unlikely to have any extra available cash to fund their desired investments. This is likely to lead to firms exploring new means of raising money to fund these investments such as short-term financial assistance, most likely in the form of loans.

Although these loans may be helpful in the short-term, such financially constrained firms may then find themselves hard-pressed to continue to meet the legal covenants to repay loans or resulting debts due in the long-term. This induces a higher default risk for a firm, meaning that the likelihood of them paying back all their debt regularly and on time is slim.As a result, corporate failure becomes a much higher possibility – which destines a firm for a stock price crash.

Bad News Hoarding

Bad news for a firm easily has the potential to damage reputation, drastically increase the costs of issuing equity and debt, and could be a significant contributing factor to a stock price crash. Financially constrained firms are significantly more likely to be affected by such bad news compared to firms who have spare funds to deal with the consequences of a knock to reputation.

Therefore, it is no wonder that managers at the helm of financially constrained firms look to hoard and bury bad news in the hope of avoiding its negative impact, at least until they’ve secured vital external funds. However, the choice to withhold bad news from shareholders, customers, suppliers and employees is not a wise one from a long-term perspective.

With a firm’s external environment changing unforeseeably and uncontrollably, and the limited control a firm has over their own internal environment, the ability for a firm to not only anticipate but also consistently withhold bad news only stretches so far.At some point, the amount of withheld bad news will reach a threshold. Once this threshold is crossed, bad news will become completely uncontainable and when revealed all at once, can result in causing a sudden, dramatic price drop – known as a stock price crash.

Coincidentally, as bad news is hoarded a firm is likely to experience a prolonged period of rising and inflating of its stock price. As the stock price becomes increasingly overvalued, the risk of a crash increases also.

Though financially constrained firms are much more susceptible to a stock price crash, there are some tactics that managers can use, other than gaining extra external funds, to help alleviate this risk, and resulting corporate failure. These include:

Minimising Tax

One way for a firm to gain extra funds without having to source out new investors can be by looking at ways to minimise their tax payments legally and ethically, of course. The extra funds made available by minimising tax payments will alleviate the firm’s financial constraints, lower its default risk and create more money for potential investments. However, in some instances the attempt to minimise corporate taxes could be regarded as unethical and as a result generate some bad news for the organisation, therefore this tactic should be treated with caution.

Building Up Strong Corporate Governance

Weak corporate governance can easily lead to various management issues, such as a divided workforce more concerned with personal job prospects and reputation than company reputation, or managers being offered compensation to act unethically for short-term gains. Such management issues increase the potential for bad news, which as highlighted earlier will inevitably cause damage to a financially constrained firm’s long-term stock performance.

Strong and united corporate governance can be built by introducing thorough monitoring of management practices and by increasing managers’ accountability to their employees, customers, suppliers and investors. One way to strengthen corporate governance is by granting the firm’s external directors with more stocks or stock options to incentivise them to better monitor firm management. A strong corporate governance will reduce bad news hoarding and thereby lower the risk of a future stock price crash.

Increasing Credit Rating

Having a low credit rating makes it difficult for a firm to gain access to external funds such as loans for investments and induces a shorter distance to default for the firm. It is therefore important that a firm looks at ways to increase its credit rating, such as increasing information transparency by disclosing more value-relevant corporate information to the public. This will make it a lot easier for a firm to obtain external funds through loans, thus making the firm less prone to a default and a stock price crash.

Firms confronted with financial constraints may use the above tactics to alleviate the potential of a stock price crash, attract more external funds, thereby sustaining and expanding their business for long-term benefits.

Guanming He

Guanming He is an associate professor in accounting at the Durham University Business School. His research areas focus on financial reporting and disclosures, insider trading, financial analysts, and risk management, and has had his research published in various prestigious international journals such as The Financial Review, The Review of Accounting Studies, and The International Journal of Accounting.

Investing

What is the procedure for proving a missing or lost Will?

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Intermediaries will be key to Investment Houses navigating the Covid19 crisis

By Alexa Payet, Partner at Bolt Burdon and listed specialist in the Certainty

Contentious Probate Hub & Area

Initial steps

When an individual dies it is necessary to search their paperwork to establish whether they made a Will and gather information regarding their estate. This is important because the personal representatives of the estate have a legal duty to distribute the estate correctly and could be held financially responsible for any mistakes made through any breach of duty.

Where a Will cannot be found but is believed to exist there are a number of steps that can be taken to help confirm its existence, including (but not limited to) the following:

  • making enquiries of the deceased’s family and friends;
  • making enquiries with the deceased’s professional advisors;
  • instructing The National Will Register to undertake a Certainty Will Search.

Presumption of revocation

Where the original Will is known to have been in the testator’s possession before their death and cannot be located afterwards, there is a rebuttable presumption that the Will was destroyed by the testator with the intention of revoking it. If an order for the proof of a copy is to be obtained then this presumption must be rebutted.

Procedure for proving a copy Will

The procedure for proving a copy Will is set out in Rule 54 of the Non-Contentious Probate Rules 1987 (‘NCPR’).

The application is made to the Probate Registry at which the application for the grant will be made and the order can be made by a district judge or registrar.

The application must be supported by evidence in the form of an affidavit (although during the global pandemic the rules have been amended by the Non-Contentious Probate (Amendment) Rules 2020, SI 2020/1059, to provide for the use of witness statements as an alternative to affidavits).

The evidence must set out the grounds of the application and any available evidence that the applicant can adduce as to the Will’s existence after the death of the testator or, where there is no such evidence, the facts on which the applicant relies to rebut the presumption that the Will was destroyed by the testator during his/her life.

The applicant must ensure that the Court has the best available evidence of what happened to the testator’s Will in order that effect may be given to his/her testamentary wishes.

It is important to understand that the applicant does not need to demonstrate that the Will has been lost (it is the fact of its loss which gives rise to the presumption of revocation). Instead, the applicant must establish, by evidence, that the Will was not in fact revoked.

What is a Certainty Will Search and why is it necessary?

A Certainty Will Search searches for Wills that have been registered on The National Will Register (circa 8.7 million Will registrations in the system) and for Wills that have not yet been registered in geographically targeted areas where the deceased used to live and/or work. A Certainty Will Search is extremely important as it will be necessary to notify the probate registry of any persons who would be prejudiced by the grant if the copy Will is proved. If no such person exists then the registrar is more likely to grant the application. Alternatively, if such a person does exist then you should seek to obtain their written consent to the application. The written consents can then be lodged with (or following) your application.

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Investing

Oil prices rise as investors look to higher demand seen in second half

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Oil prices rise as investors look to higher demand seen in second half 1

By Shadia Nasralla

LONDON (Reuters) – Oil prices climbed on Tuesday as optimism that government stimulus will eventually lift global economic growth and oil demand trumped concerns that renewed COVID-19 pandemic lockdowns globally are cooling fuel consumption.

Brent crude futures for March rose 72 cents to $55.47 a barrel by 1152 GMT after slipping 35 cents in the previous session.

“The perception that any retracement will be quick as confidence in economic and oil demand recovery is unlikely to fade away,” said PVM analysts in a note.

U.S. West Texas Intermediate crude was at $52.65 a barrel, up 29 cents. There was no settlement on Monday as U.S. markets were closed for a public holiday. Front-month February WTI futures expire on Wednesday.

Investors are upbeat about demand in China, the world’s top crude oil importer, after data released on Monday showed its refinery output rose 3% to a new record in 2020.

China also avoided an economic contraction last year.

Investors are watching out for U.S. oil inventory data from the industry association API, due on Wednesday, the same day U.S. President-elect Biden’s inauguration speech will likely give details on the country’s $1.9 trillion aid package.

The International Energy Agency cut its outlook for oil demand in 2021, but pointed to a recovery in demand in the second half of the year to an annual average of 96.6 million barrels per day.

“Border closures, social distancing measures and shutdowns…will continue to constrain fuel demand until vaccines are more widely distributed, most likely only by the second half of the year,” it said in its monthly report.

(Additional reporting by Florence Tan, editing by Louise Heavens)

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Investing

Can Thematic Investing provide investors with growth opportunities in uncertain times?

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The impact of COVID-19 on the investment market

New whitepaper from CAMRADATA explores

CAMRADATA’s latest whitepaper on Thematic Investing, considers the role this type of investing can play in asset management and explores trends that can permeate society and traverse sectors. The whitepaper includes insights from guests who attended a virtual roundtable on Thematic Investing hosted by CAMRADATA in November, including representatives from CPR Asset Management, Sarasin & Partners, Impact Investing Institute, PwC, Quilter Cheviot, Scottish Widows and Stonehage Fleming.

Sean Thompson, Managing Director, CAMRADATA said, “In these seminal times, thematic investing has the potential to shape how the future unfolds. Yet running a successful thematic fund is no easy feat – it is a bit like navigating unchartered waters trying to identify the trends and the long-term opportunities.

“Trends such as AI and biotechnology are still in their relative early days, for example, and global economies are undergoing dramatic changes. But mapping out certain trends, identifying potential sustainable returns through a unifying thread that spans multiple sectors, could help future-proof investments. “Our roundtable guests considered current key themes, which themes worked well, and which have not and how thematic investors could identify trends with the potential to offer future growth.”

The guests named themes they currently like which included artificial intelligence, China, climate change, clean energy, automation, evolving consumption, ageing, digitalisation, water, waste management, biodiversity, and board diversity.

After discussing themes that have worked or not, the guests looked at total allocation to themed funds, and whether clients might be blinded by themes to the overall risk exposure in their portfolios.

Key takeaway points were:

  • Themes have a habit of coming and going. One guest recognised that automation and robotics, for example, were cyclical, which means that investors will have to think carefully about entry-points.
  • It was agreed that the commodities ‘super cycle’ of the 2000s came about with the economic development of China. Many commodities-based products found their way into mainstream investing, but this is unlikely to happen again.
  • One guest was surprised by some of the themes that interested their customers; with their research showing that Board Diversity was almost the lowest-ranking concern among the ESG choices they listed.
  • There was correlation between environmental impact and social benefits to investing. The theme that concerns the Impact Investing Institute, which is less than two years old, is improved measurement of such relationships.
  • In terms of successful themes, one clear winner due to COVID had been digitalisation.
  • One theme that has not done so well is the Ageing theme focused on older people travelling and enjoying experiences abroad later in life.
  • One guest said their firm used themes for ideas generation, not as a shortcut for portfolio construction. They said themes lead to good ideas, but they then spend at least three months researching a stock, so that the best themes are represented by the best investments.
  • The final point was that there are sensitivities for any global investor in allocating to themes, even the biggest one of all, Climate Change.
  • But on a positive note, one guest added if all stakeholders can resolve their differences on definitions such as impact and ethical investing, then more capital will be readily transferred into opportunities.

The whitepaper also features two articles from the sponsors offering valuable additional insight. These are:

  • CPR Asset Management: ‘Central Banks: leading the path towards Impact Investing’
  • Sarasin & Partners: ‘Theme or fad? How to invest for the long term’

To download the Thematic Investing whitepaper, click here

For more information on CAMRADATA visit www.camradata.com

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