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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

Northern Trust: Outsourcing Accelerates Through Pandemic as Investment Managers Seek to Improve Margins, Enhance Business Resilience, and Future-Proof Operations

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Northern Trust: Outsourcing Accelerates Through Pandemic as Investment Managers Seek to Improve Margins, Enhance Business Resilience, and Future-Proof Operations 1

White Paper Sees Increase in Managers Outsourcing Middle and Front Office Functions to Achieve Optimal Business Structures

According to a white paper published today by Northern Trust (Nasdaq: NTRS), investment managers of all sizes and strategies have been prompted to undertake a comprehensive review of their operating models as a result of the Covid-19 pandemic which has accelerated existing trends that are compounding cost pressures. This has led increasing numbers of managers to outsource in-house dealing and other functions, such as foreign exchange and transition management, hitherto seen as core.

While cost savings remain a core driver, and indeed are one outcome of outsourcing, costs are no longer the only focus. Far from being solely a defensive reaction to increased pressure on margins, the white paper (‘From Niche to Norm’) describes outsourcing as part of the target operating model, or moving toward the ‘Optimal State’ for many investment managers, and  explains how the focus “has expanded to the variety of other potential benefits offered – enhanced capabilities, improved governance and operational resilience.”

Gary Paulin, global head of Integrated Trading Solutions at Northern Trust Capital Markets said: “The pandemic has challenged a range of operational assumptions. Working from home has, for example, questioned the need for a portfolio manager to be in close proximity with the dealing desk. Previously considered essential, the pandemic has effectively forced firms to ‘outsource‘ their trading desks to remote working setups and the effectiveness of this process has disproved the requirement for proximity, in turn, easing the path to third-party outsourcing. Many investment managers are actively considering outsourcing to a hyper-scale, expert provider as a potential, cost efficient solution – one that maintains service quality and, hopefully, improves it whilst adding resiliency.”

Northern Trust’s white paper compares outsourced trading to software-as-a-service stating: “instead of carrying the cost and complexity of running an in-house solution, firms move to an outsourced one, free up capital to invest in strategic growth and move costs from a fixed to a variable basis in line with the direction of travel for revenues.” 

Guy Gibson, global head of Institutional Brokerage at Northern Trust Capital Markets said: “The opportunity to deploy capital to build new fund structures, develop new offerings, focus on distribution and enhance in-house research has been taken up by several of our clients to the benefit of their investment approach, and to the benefit of their investors.  Additionally, in the last two months alone, many firms have recognized that outsourcing to a well-capitalized, global platform has enabled them to take advantage of cost-contained growth opportunities in new markets.”

A further development, which has echoes of the journey the technology industry has already undertaken, is the move towards ‘whole office’ solutions, which represent the next potential wave in outsourcing.

According to Paulin; “recently we have observed a growing number of managers wanting to outsource to a single, hyper-scale professional service provider who can do everything, everywhere. This aligns with Northern Trust’s strategy to deliver platform solutions for the whole office, serving our clients’ needs across the entire investment lifecycle.”

The white paper can be downloaded here.

Integrated Trading Solutions is Northern Trust’s outsourced trading capability that combines worldwide locations and trading expertise in equities and fixed income and derivatives with access to global markets, high-quality liquidity and an integrated middle and back office service as well as other services, such as FX. It helps asset owners and asset managers to meaningfully lower costs, reduce risk, manage regulatory compliance and enhance transparency and operational efficiency.

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How are investors traversing the UK’s transition out of lockdown?

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How are investors traversing the UK’s transition out of lockdown? 2

By Giles Coghlan, Chief Currency Analyst, HYCM

Just when we thought we had overcome the initial health challenges posed by COVID-19, the UK Government has once again introduced lockdown measures in certain regions to curb a rise in new cases. This is happening at a time when the government is trying to bring about the country’s post-pandemic recovery and prevent a prolonged economic downturn.

This is the reality of the “new normal” – a constant battle to both contain the spread of the virus but also avoid extended economic stagnation.

Of course, no matter how many policies are introduced to spur on investment, traders and investors are likely to act with caution for the foreseeable future. There are simply too many unknowns to content with at the moment.

To try and measure investor sentiment towards different asset classes at present, HYCM recently commissioned research to uncover which assets investors are planning to invest in over the coming 12 months. After surveying over 900 UK-based investors, our figures show just how COVID-19 has affected different investor portfolios. I have analysed the key findings below.

Cash retreat

At present, it seems that by far the most common asset class for investors is cash savings, with 78% of investors identifying as having some form of savings in a bank account. Other popular assets were stocks and shares (48%) and property (38%). While not surprising, when viewed in the context of investor’s future plans for investment, it becomes evident that security, above all else, is what investors are currently seeking.

A third of those surveyed (32%) said that they intended to put more of their wealth into their savings account, the most common strategy by far among those surveyed. This was followed by stocks and shares (21%), property (17%), and fixed interest securities (17%).

When asked about what impact COVID-19 has had on their portfolios throughout 2020, 43% stated that their portfolio had decreased in value as a consequence of the pandemic. This has evidently had an effect on investors’ mindsets, with 73% stating that they were not planning on making any major investment decisions for the rest of the year.

Looking at the road ahead

So, it seems that many investors are adopting a wait-and-see approach; hoping that the promise of a V-shaped recovery comes to fruition. The issue, however, is that this exact type of hesitancy when it comes to investing may well slow the pace of economic recovery. Financial markets need stimulus in order to help facilitate a post-pandemic economic resurgence, but if said financial stimulation only arrives once the recovery has already begun, the economy risks extended stagnation.

It seems, then, that there are two possible set outcomes on the path ahead. The first is a steady decline in COVID-19 cases, then an economic downturn as the markets correct themselves, followed by a return to relative economic stability. The second potential outcome is a second spike of COVID-19 cases which incurs a second nationwide lockdown – delaying an economic revival for the foreseeable future. At present, the former of these two scenarios is seemingly playing out with economic growth and GDP steadily increasing; but recent COVID-19 case upticks show that it’s still too soon to be certain of either scenario.

A cautious approach, therefore, will evidently remain the most common investment strategy looking ahead. But investors must remember that, even in the most uncertain times, there are always opportunities for returns on investment. Merely transforming a varied portfolio into cash savings risks a long-term decline in value.

High Risk Investment Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. For more information please refer to HYCM’s Risk Disclosure.

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Hatton Gardens 5 top tips for investing in Diamonds

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Hatton Gardens 5 top tips for investing in Diamonds 3

By Ben Stinson, Head of eCommerce at Diamonds Factory

Investing in diamonds can be extremely rewarding, but only if you know what to look for. For investors who lack experience, finding your diamond in the rough can be quite daunting.

For even the most beginner of diamond investors, the essentials are fairly obvious. For instance, you need to ask yourself will the diamond hold its value over time? What’s the overall condition of the stone and the jewellery? Is there history behind the item in question?

Although common sense plays a big part in investing, people often need insider tips and tricks to go from beginner to expert. Tony French, the in-house Diamond Consultant, at Diamonds Factory shares his professional knowledge on the 5 most important things to look for when investing in diamonds.

1: Using cut, weight and colour to determine value

Firstly, consider the shape, colour, and weight of your diamond, as this can play a pivotal role in guaranteeing growth in the value of your item. Granted, investing trends change with time, but a round cut of your diamond will almost always be the most sought after. The cut of your diamond is incredibly important, as it can influence the sparkle and therefore, the overall value. It’s a similar story for the intensity of some colours, such as Pink, Red, Blue, Green etc. Concerning weight, the heavier (bigger) stones will generally increase in value by a bigger percentage. Collectively these factors also contribute to the supply and demand aspect, which will determine their high price, and will ensure your item is re-sellable.

2: Provenance

Looking for significant value? Well, aim to own jewellery or diamonds that come from an important public figure. If you’re lucky enough to own a piece that has significant history, or was owned by a celebrity or person of interest, it’s an absolute must to have concrete evidence of this. Immediately, this proof will increase an item’s overall value, and there’s a good chance the stardom of your item might drum up interest amongst diehard fans, increasing the value even further…

Equally, it’s possible to proactively bring provenance to unique diamonds of yours. For instance, you can offer to loan bespoke, or unusual pieces for film, theatre, or TV performances – then it can be advertised as worn by xyz.

3: Find the source

Ben Stinson

Ben Stinson

Establishing your diamond’s source is one of the most important things you can do when investing in diamonds. If you’re starting out, try to purchase diamonds that have NOT been owned by too many people, as the overall value of the diamond will reflect multiple ownership. Alternatively, I’d always recommend buying from suppliers like ourselves or other suppliers and retailers, who buy directly from the people who have had them certified.

Primarily, this will allow you to have a greater degree of transparency, which is crucial when buying such a valuable item. Next, you should immediately see an increase in value of your diamonds, as identifying a source will allow traceability and therefore, market context.

4: Certification

Linked closely with my previous point, is the requirement to ensure that your diamonds are certified by a credible lab, and you have the evidence to prove so (a written document with specific grading details about your diamonds) – this will remove any doubts of impropriety.

It’s essential to remember that not all labs are the same, and many labs are better than others. Both the AGS (American Gem Society) and GIA (Gemological Institute of America) have great reputations and are world renowned. I’d recommend doing your own research into the labs, and when you’ve found the pieces that you’d like to invest in, then make an informed decision based upon your findings. Ultimately, proving certification will make your stones easier to insure, and deep down, you can have peace of mind knowing you have got what you have paid for.

Don’t forget to keep this paperwork in a safe location as well – you’d be surprised how many people we’ve met who have lost, or forget where they’ve placed it.

5:  Patience is a virtue…

If the market is strong, it might be tempting to look for an immediate sale once you’ve purchased a high value item. However, I suggest holding onto your diamonds for some time before even thinking about selling. More often than not, an item is more likely to increase in value over a few years than a few days – try and wait a little longer!

Equally, I would encourage having your diamonds, or jewellery professionally valued regularly. If you don’t have the knowledge to make a rough judgement on how much your pieces are worth, a consultant or expert can provide both a valuation, and contextualise that amount in the wider market. From there, you should be empowered with the knowledge to decide whether to keep or sell.

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