Harvard Investment Magazine Spring 2004 by Harvard College Investment Magazine

SPRING 2004

HARVARDINVESTMENT

magazine

Interview with

JOHN THORNDIKE Managing Director at Merrill Lynch

Interview with

YChina ANG CHANGPO International Capital Corporation

SOCIAL COST OF BANKRUPTCY Joseph Bower and Stuart Gilson LATIN AMERICADomingo â&#x20AC;&#x2122;S MCavallo ONETARY DISORDER

Dick Grasso and the Reform of the NYSE High-Flyer: Freeport McMoRan Gold & Copper Finance for Dummies: What is Beta? The Janus Factor Firm Financial Performance following Mergers

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Last year, Janice’s research on Emily Brontë earned her top academic honors. This year, her research helped launch a new business model in biotech. At Citigroup, we can make careers happen—sometimes very quickly. That’s because, as the world’s leading financial services firm, we value talent and innovative thinking. The choices at Citigroup are only as limited as your aspirations and imagination. To find out more, go to Citigroup.com. © 2004 Citigroup Global Markets Inc. Member SIPC. CITIGROUP and the Umbrella Device are trademarks and service marks of Citicorp or its affiliates and are used and registered throughout the world. Citigroup Global Markets Inc. and Citibank are affiliated companies under the common control of Citigroup. Citibank and Citigroup Global Markets Inc. are equal opportunity employers M/F/D/V. Names and images do not reflect actual employees of Citigroup, Citigroup Global Markets Inc. or Citibank.

HARVARDINVESTMENT

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EDITOR-IN-CHIEF Michael Hauschild EXECUTIVE DIRECTOR EDITORIAL BOARD

Anna Haisi Yu Pedro Glaser Benjamin Lee Shruti Saini Kuanysh Batyrbekov David Yuan Aarti Jerath

PUBLISHING DIRECTOR Allen Chao ASSISTANT PUBLISHER Eddie Segel BUSINESS DIRECTOR Liam Martin HEAD DESIGNER Anna Yu DESIGN STAFF Diana Mitova ADVISORY BOARD John Y. Campbell Tuomo O. Vuolteenaho E DITORIAL D ESCRIPTION Harvard Investment Magazine (HIM) is a dynamic new business publication founded in 2003 to educate Harvard students about the world of finance and investment. HIM is a semi-annual journal devoted to the important and recent issues of the financial and investment world. We bring together a multitude of perspectives on the pertinent issues in corporate finance, corporate governance and investment research, serving as a platform of intellectual exchange between the professional Wall Street and the academic Harvard community. ONE-YEAR SUBSCRIPTION

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Copyright 2004 (ISSN: 1548-0038) Harvard Investment Magazine. No material appearing in this publication may be reproduced without written permission of the publisher. The opinions expressed in this magazine are those of the contributors and are not necessarily shared by the editors. All editorial rights reserved.

HIM Spring 2004

HARVARDINVESTMENT

magazine SPRING

| 2004

BANKER’S TALK 4

INTERVIEW

WITH

JOHN THORNDIKE – A LONG RACE

John Thorndike is a managing director at Merrill Lynch MICHAEL HAUSCHILD & ANNA YU

INTERVIEW

WITH

YANG CHANGPO

Yang Changpo is a managing director at China International Capital Corporation ANNA YU

S OCIAL COST

FRAUD

AND

BANKRUPTCY

The Impact of the WolrdCom bankruptcy on the Telecom Industry JOSEPH BOWER, Harvard Business School STUART GILSON, Harvard Business School

FINANCE FOR KIDS 14

A LITTLE BIT

BETA

EVERYONE

FOR

ANNA YU & MICHAEL HAUSCHILD

FIRM FINANCIAL PERFORMANCE

THE JANUS FACTOR

FOLLOWING

MERGERS

K.P. RAMASWAMY & JAMES F. WAEGELEIN edited by SHRUTI SAINI

GARY ANDERSON, Anderson & Loe Inc. edited by PEDRO GLASER

INSIDE SCOOP 26

INTERVIEW

WITH

ANNE PEREZ

Anna Perez is an investment banking anylyst at Merrill Lynch MICHAEL HAUSCHILD

INTERVIEW

WITH

MATT ESPY

Matt Espy is a hedge fund manager at Sagamore Hill DAVID YUAN & BENJAMIN LEE

RICHARD GRASSO

AND THE

REFORM

OF THE

NYSE

BENJAMIN LEE & DAVID YUAN

HIGH FLYER 34

FREEPORT MCMORAN GOLD & COPPER MICHAEL HAUSCHILD

LATIN AMERICAN E CONOMIES D ISORDER

AND

GLOBAL MONETARY

DOMINGO CAVALLO, Harvard University

VALUEDENTREPRENEURIALSPONTANEOUSINNOVATIVEADMIREDSUCCESSFULEMPOWERED

To build a great career, you need vision. And the view from the top is often, well, spectacular. The Financial Times, The Wall Street Journal, Institutional Investor, Reuters and Bloomberg – to name just a few – all find us worthy of top ranking among financial service firms. For you, this translates into opportunity. Our global dominance, innovative products and market-defining expertise offer you tremendous exposure and responsibility, and exceptional rewards. Merrill Lynch is an equal opportunity employer. Our advice about your next career move: be bullish.

INTERWIEW WITH

JOHN THORNDIKE

A LONG RACE ANNA YU MICHAEL HAUSCHILD

Tell us a little bit about yourself. What are your current responsibilities at Merrill Lynch? How did you become a managing director and what kinds of challenges did you face on your way?

I graduated from Harvard in 1964, went to Cambridge for a year, went to Law school for 3 years and was a trial lawyer in Boston for another 3. I came to Wall Street in 1971. Through a lot of hard work and some luck, I am now a Managing Director and Vice Chairman of Investment Banking at Merrill Lynch. I ran the Power Group for several years, but now, as a Vice Chairman of Investment Banking, I spend all of my time on clients.

What is the most rewarding and most frustrating aspect of your job as a senior banker at Merrill Lynch?

The most rewarding aspect is certainly dealing with the people. The people at Merrill Lynch are so talented, so creative, and have so much drive. In addition, I also very much enjoy interacting with my clients and solving problems. The most frustrating part is simply that I can’t do everything that I’d like to do because there’s not enough time during the day and critical choices have to be made about resource allocation.

You work in the Energy and Power Group. What are the major themes in M&A in this sector at the moment? What do you think of the industry consolidation in energy and power industry?

Politicians in Washington have been working on an energy bill for several years. This bill would do away with certain impediments to industry consolidation. When and if we do get an energy bill, which in my judgment is unlikely to happen before the election, it will make consolidation easier. Then I think we will see quite a lot of consolidation. We’re likely to see two

kinds of consolidation: (1) mergers of equals, which is the coming together of two companies of the same size and this will be done pretty much without any premium. The reason for the lack of premium in this kind of merger is that the power business is largely a regulated business. It’s very hard to get a return on the premium that you pay. The amount that you’re allowed to charge for electricity depends on the book value of your assets. So, if you pay a lot more than the stated value of the assets that could be a problem. (2) You will also see smaller companies being taken over by larger companies because they’re a lot easier to integrate into the acquiring company. In 2001 and 2002, national utilities had severe problems with their large debt burdens. What is the current situation? What do you think of the possibility of one of the major utilities going bankrupt and what would be the impact of that event if it is possible at all?

Yes, you’re quite right that the situation was quite serious with the California crisis a couple of years ago and then we had the whole Enron issue. Fortunately, though, the capital markets have been able to deal with the crisis – money has been funneled into the system and in many ways the crisis has been at least postponed. As far as bankruptcy is concerned, in the history of the US, we’ve only a couple of utility bankruptcies and these were, I believe, related to the nuclear power issue. In these cases, the market was able to cope. You were talking about the debt crisis being postponed. What in your opinion could bring up this crisis again? What could make the situation worse?

6 HARVARD INVESTMENT MAGAZINE

SPRING 2004

Well, I suppose that it could be behavior by the companies or it could be some sort of exogenous development in the marketplace. In terms of behavior by the companies, I think while it’s almost inconceivable, it’s nevertheless at least theoretically possible that companies could go back to their old paradigm of making a lot of investments away from their core business – expanding overseas and also in areas where the companies don't have any particular expertise. That could create the crisis all over again. Similarly, if for whatever theoretical reasons the credit markets were to dry up and capital be less available and on less reasonable terms that could create problems, with companies unable to extend the maturities on their debt. I would say that both of these theoretical possibilities are quite remote. Now, speaking of your role as Vice Chairman of Investment Banking, can you give us an example of a recent deal you worked on and what your role was?

I worked with a large utility company which had invested a major part of its capital in non-regulated businesses outside the US and unfortunately these investments did not succeed because at the end of the day the power that they generated - the commodity that they made - was not able to be sold on the market for a profitable price. Unfortunately, we had to wind up that business by essentially declaring it bankrupt. This had very severe consequences for the company’s domestic business. My colleagues and I made several appearances before the board of directors of the company. We advised them on a whole range of issues: cutting the common stock dividend, advising them on strategies with their banks and restructuring their balance sheet. And we were very active in raising

BANKER’S TALK equity and equity-linked funds. I’m pleased to say that we managed to right the situation and that the company’s stock is now more than double what it was at the low in the middle of the crisis. And there was another company, slightly smaller, that had the same kind of a phenomenon: investments outside the US which proved to be disappointing. What we had to do was again to cut the dividend and sell some noncore assets to pay down debt.

You first have to examine yourself and ask yourself serious questions about your own attitude and about what makes you tick.

What makes Merrill Lynch stand out? Why did you decide to stay at Merrill Lynch for so long?

It really gets down to the people. Merrill Lynch people are fun to work with, are very intelligent and have a high energy level. They also have a strong service ethic as our clients tend to need things right away. So, there’s a tremendous sense of urgency which everybody at Merrill Lynch shows. So, you really find the ‘let’s do it right now and let’s do it well and in a helpful way to clients’ attitude here. And I can’t imagine any other institution on earth that does that as well as Merrill Lynch does. In addition to that, we also have a huge balance sheet. It may not be as large as that of major universal banks, but it nevertheless is very large. We can lend a billion dollars to a client on a couple of days’ notice and we have done so in the past. In fact, I’ve done it for one of my clients. In a nutshell, what’s so great about working for Merrill Lynch is a combination of the agility and positive attitudes of the individuals plus the footprint of the institution and the size of the balance sheet and the reputation of Merrill Lynch. Finally, with our record earnings of $1.2 billion last quarter, we’re definitely continuing to im-

prove the business. The strength of our operating performance shows the great work that our people do on a daily basis. It’s a very exciting time to be working in investment banking and especially at Merrill Lynch. What kind of advice would you give a college student who is thinking about a career in investment banking?

You first have to examine yourself and ask yourself serious questions about your own attitude and about what makes you tick. I would say that if you’re comfortable with intense pressure and deadlines – and you probably are, since you are at Harvard; in fact, you may actually require deadlines and pressure to operate at full capacity – then you may be very happy in investment banking. The other thing you have to be comfortable with is making judgments on information which is not perhaps complete information. Oftentimes, you don’t have the luxury of running down every single detail. And yet you have to be very vigilant in getting as many details as you can in order to make the best possible decision. The other thing you have to ask yourself is how you balance work and fun. I’ve always said that investment banking is an incredibly fun business; that’s why I’ve been doing it for 33 years. But sometimes you have to take the fun when it comes. It’s fun to be working with a great team of people, it’s fun to be flying to Texas or London or Japan, but you may not be able to promise your spouse or significant other that next Thursday night you will be at the opera at 6pm because something might come up to knock your plans into a cocked hat. Most investment bankers are comfortable with those trade-offs, but some people aren’t. So, you really need to do some soul-searching on your own, ask yourself whether you’re comfortable working on this rigorous schedule. If you are, and as I said above you probably are , then you will be in for an incredibly exciting and fulfilling experience in investment banking. SPRING 2004

HARVARD INVESTMENT MAGAZINE

BA N K ER ’S TALK

Tell us about yourself. Who is Yang Changpo? I graduated from University of Texas with a PhD degree in Economics. And subsequently I joined the World Bank through its young professionals’ program. At the World Bank, I spent a few years working as a macroeconomist dealing with macroeconomic issues during which time I conducted several projects in some third world countries such as Jordan, Zimbabwe, Zambia, Egypt, etc. I also worked briefly for the Philippines and engaged in some public investment projects in India and China. In the year 1998, I left the World Bank and joined China International Capital Corporation (CICC) as a senior banker. I am now a Managing Director at the investment banking department.

YANG CHANGPO C H I N A

I N T E R N A T I O N A L

ANNA YU

HARVARD INVESTMENT MAGAZINE

C A P I T A L

C O R P O R A T I O N

What is the responsibility of a senior banker in CICC? CICC’s operational structure is similar to that of other international investment banks such as Goldman Sachs, Morgan Stanley and Merrill Lynch. Managing directors are the most senior bankers in an investment bank. Each of us covers the business of a number of industries and a number of key accounts. I am mainly in charge of businesses from telecom operators in China, a number of commercial banks and a resource company. I also share responsibility with other senior bankers over some administrative and execution issues in running the investment banking department.

I N T E R V I E W

W I T H

Y A N G

C H A N G P O

As we all know, CICC started up as a joint-venture between China Construction Bank (CCB) and Morgan Stanley. What is the relationship between CICC and CCB now? Currently, CCB is a major shareholder of CICC. CICC conducts its business on a day-to-day basis without the direct involvement of CCB at the operational level. There is no overlap on the management level. CCB’s participation in directing CICC’s operations is just like that of any other shareholder’s, i.e. through the corporate governance process. In addition to that, the chairman of the board of CICC is also the head of CCB. China injected $45 billion into two of its biggest state-run banks of which CCB is one. As the government seeks to prepare them for foreign rivalry and market listings, in what field does CICC see this foreign rivalry intensifying? And in what aspects does CICC seek to improve itself? Competition exists on two different levels: the first is the competition between foreign commercial banks and domestic Chinese banks; another one is the competition in the investment banking businesses. Foreign commercial banks are gradually penetrating into China’s financial market which is opening up more and more to international competition. Many foreign commercial banks such as HSBC, Deutsche Bank, and Citibank have already started their operative deposit and lending services

such as taking deposits, granting loans to corporations which compose their wholesale business. Over time, foreign banks will get permission to enter the retail business, i.e. business involving taking deposits and making loans to individual customers. Another sign of the intensifying competition is that foreign banks are expanding their outlets by setting up more and more local branches all over China. So we can see that the competition between foreign and domestic banks is already there. However, I am not particularly worried about Chinese banks’ ability to compete with foreign banks in commercial banking business. First of all, it is quite costly for foreign commercial banks to enter the local market. Second of all, Chinese banks have natural advantages in reaching out and serving Chinese customers — cultural identity is a favorable factor for Chinese banks. Also, the relatively lower operating cost for Chinese banks compared to their foreign counterparts adds to the difficulty of foreign commercial banks. Some of the banking operations and businesses cannot be done overnight, rather, they need to be developed over time. In a word, I think it will take time for foreign banks to build their client base, expand and strengthen their presence and establish brand names. However, the competition is certainly present, and it is definitely worth paying attention to. In terms of investment banking business, currently there exist two markets for Chinese investment banks. One is the domestic underwriting business; the other is cross-border transactions, which primarily includes the underwriting of IPO’s in overseas markets for mainland-based corporations. CICC has the advantage in operating in both markets compared to foreign investment banks. In the domestic market, our competition is mainly from other large domestic security firms, a number of which challenge CICC in domestic IPO’s, secondary offerings, fixed income businesses and advisory businesses. In cross-border transactions, we have foreign as well as domestic competitors. But the challenges are still mainly from other Chinese banks that can do both domestic and cross-border transactions, such as Bank of China International. We often work together, however we also compete with each other.

SPRING 2004 HARVARD INVESTMENT MAGAZINE 9

Are all of CICC’s customers domestic companies? Yes, this is true on the corporate finance side, where we only provide banking services to domestic firms. However, we also provide investment banking services to multinational corporations operating in China. We have been serving international institutional investors as well.

What we as investment banks need to do is to help state-owned companies to establish a sound corporate governance structure by helping the companies reorganize their business line, centralize their cash and inventory management, establish a board of directors which includes independent directors, so on and so forth. These are the preliminary works that need to be carried out before an international offering can be successfully launched. Similar restructuring efforts also happened to China Telecom, China Unicom and other large international offerings.

Has CICC ever considered expanding this focus to a larger region, say, providing investment banking services to companies in Hong Kong? We do have a wholly owned subsidiary in Hong Kong.

Talking about this “state-owned” phenomenon in China, is the Chinese government still the biggest shareholder of CICC? That’s right. Through various vehicles, they are still the largest shareholder of CICC.

CICC was the lead bookrunner of the recent China Life IPO, which was very successful. Can you tell us more about the process of bringing China Life to market, especially it being a dual listing on both the Hong Kong and New York market?

China is enjoying an amazingly fast growth and China is gaining a much greater role in the world economy, what do you see the potentials of China’s financial market in terms of IPO and M&A deals? I would say there is a certain potential and the market is still there, but some of the largest offerings have already happened, such as China Life, which I believe is the biggest offering this year in New York. In the year 2000, we also witnessed China Unicom’s 2.6 billion dollars international IPO, which is the largest offering ever from the non-Japan Asia region. Although more such international deals are coming up, I think we have already witnessed the biggest offerings of the existing Chinese market. For mergers and acquisitions businesses, the Chinese market is just starting to observe an accelerating pace in M&A activities. But in China, the equal foundation and the capital market is not yet fully developed so as to support and to require M&A activities which are still immature and infrequent. With the fast expanding economy and the ever-improving financial market, we expect to see more and more M&A deals in China in the near future, both among Chinese companies and between Chinese and foreign companies. Right now, executing an M&A deal is more difficult compared to IPO underwriting in China because of Chinese companies’ unfamiliarity with M&A advisories. Slowly but surely, Chinese companies will improve their operating structure and get acquainted with M&A advisory services.

CICC is also subject to competition from foreign banks in other types of businesses. They are limited to a number of niche services, where foreign banks can do a better job than CICC.

With the fast expanding economy and the ever-improving financial market, we expect to see more and more M&A deals in China in the near future.

Since I am not directly involved in China Life’s listing process, there is not much I can comment on. But from a distance, I do observe the process of bringing China Life to foreign markets. What is unique about Chinese companies that are listed internationally is that they need to be restructured prior to international listings, which is not very common for international corporations or companies based in the US or Europe. They are typically already well-established institutions, and thus no longer need to go through such large-scale and far-reaching restructurings that Chinese companies have to go through. This is mainly because the big Chinese companies were wholly state-owned before the listing process started. They are not wellestablished in the sense that they were not operating in a way a company would operate in a mature, developed economy such as the United States.

10 HARVARD INVESTMENT MAGAZINE SPRING 2004

BANKER’S TALK

China Construction Bank is planning on a 5 billion dollar IPO this year. Given the close ties between CCB and CICC, how does CICC see the impact of this IPO on its operations? The CCB’s going public shouldn’t have any direct impact on CICC’s operation. The injection of 5 billion dollars into CCB strengthened its balance sheet, which will in turn prepare CCB to become a much stronger bank in terms of risk management and in terms of intermediating between domestic savers and borrowers. As the largest shareholder of CICC, the publicly owned CCB becoming a stronger bank is certainly good for CICC. But I don’t see any major influence of CCB’s IPO on CICC in terms of its daily operations. Is CICC planning an IPO for itself in the near future? No. We don’t have any specific plan yet. With China opening itself up more and more to the world market, one concern that remains is the large ownership stake of the Chinese government in Chinese banks. What are the pros and cons of CICC’s relationship with the Chinese government? How do you see this relationship evolving in the future? The relationship between CICC and the Chinese government is a market-motivated and efficient one in the sense that we are based in China and our clients are major stateowned enterprises. So indirectly, we are sort of providing services to the government, which is the shareholder of those Chinese state-owned enterprises. Therefore, CICC or any professional institution needs to look after the state-owned corporations’ long-term interest and needs to provide sound professional advice to them and to the government. In addition to these, CICC is a China-based company and our job is mainly to provide services to Chinese companies. We want to do our best to act as an intermediary and we make the most effort to offer the best services to these Chinese companies. Therefore, in a way, all these factors implicitly define our relationship with the Chinese government. The relationship is not a forced one and it is not in the form of giving and obeying orders.

SPRING 2004 HARVARD INVESTMENT MAGAZINE 11

The Social Cost of Fraud and by Joseph Bower and Stuart Gilson

Bankruptcy laws, designed to preserve sound companies that have temporary problems, are increasingly being used for something fundamentally different.

Following one of the most complicated and closely watched corporate reorganizations in the history of U.S. bankruptcy law, WorldCom is now poised to emerge from Chapter 11 with a confirmed reorganization plan. A beneficiary of laws meant to preserve sound companies in temporary distress, WorldCom stands to gain undeserved advantage from its misdeeds. The firm-once greatly admired as the lowcost price setter in the hypercompetitive telecommunications industry-was in reality an elaborate work of fiction. Through fraudulent underreporting of operating expenses, the company concealed losses of more than $12 billion from public view. The costs of the deception and of cleaning up the mess have also been staggeringly high to the industry as a whole. Unable to match WorldCom's low cost structure and aggressive pricing, competitors were forced to drastically cut expenditures by sacking thousands of employees. Top managers are reported to have suffered the same fate because they couldn't match WorldCom's high reported profit margins. A crude estimate suggests that if WorldCom had priced so as to earn what it reported, the industry could have yielded an extra $40 billion in revenue and commensurate profit. And the bankruptcy itself has been litigious and costly. Professionals' fees and other administrative expenses incurred in Chapter 11 will probably be in the hundreds of millions of dollars. Additional losses – just as real but unrecorded – have resulted from the distraction and dislocation of the company's business. Ironically, some might say perversely, the new WorldCom (to be known as MCI) will come out of Chapter 11 as a formidable competitor, this time for real. Under U.S. law, the goal of bankruptcy is to protect the underlying business

12 HARVARD INVESTMENT MAGAZINE SPRING 2004

and give the company every reasonable chance to succeed once it achieves a financial settlement with its creditors. While a company is in Chapter 11, it does not have to pay (or, in most cases, even accrue) interest on its debt. It can abrogate its lease contracts or use the threat of such abrogation to obtain financial concessions from lessors. (United Airlines is said to have reduced its aircraft lease payments by 50% in this way.) Chapter 11 also gives the company access to new financing by giving new lenders priority over existing debt. WorldCom has written down $74 billion in assets and $42 billion in debt, leaving it with little interest, negligible depreciation, and a claimed operating loss carryforward of $7 billion to deduct from any future income tax bills. Its earnings will not be burdened by heavy interest or depreciation. Nor, if its claim is upheld, will it pay taxes in the near future. The merits of this long-standing approach are clear. In principle, it provides greater value for all the firm's stakeholders –not only creditors but also vendors, employees, and shareholders. Keeping a business on track, when it is fundamentally sound but suffering a temporary financial setback, ultimately improves economic resource allocation and provides more value for all of society. The system also implicitly encourages businesses to take more informed and legitimate risks – compared, say, with a system in which failed firms are automatically shut down. Indeed, for these reasons, a growing number of countries have modeled their bankruptcy laws after Chapter 11 in recent years. WorldCom's bankruptcy, however, highlights an important, potentially very large social cost of the U.S. bankruptcy system. Competing telecom firms, which have played by the accounting rules and have used more prudent financing, now find themselves–once again–at a competitive disadvantage relative to the company. Unlike WorldCom, these firms had to stay current on their debt and service their lease obligations. They did not get to write down their assets and debt, nor have they been able to reduce

Bankruptcy taxes by claiming that their profits never existed. Is this fair? Do the benefits of the system outweigh its costs? The system works well to protect assets and employees, to be sure. But are WorldCom's assets and employees really the ones that should be protected? What about those of more efficient firms? In capital-intensive industries like petrochemicals, steel, telecoms, and airlines, doesn't bankruptcy law make it harder for efficient companies to drive inefficient assets out of business? In the majority of bankruptcy cases in these industries, the top managers are gone, but old capacity returns to the market with an improved balance sheet. This can easily prolong a period of industrywide overcapacity as well as unfairly disadvantage competitors. In steel, for example, LTV returned from its first bankruptcy in 1993 stronger but inefficient, adding to the hypercompetitive conditions in the U.S. steel business and weakening Bethlehem, National, and others. Emerging from its second bankruptcy, LTV shed its legacy costs and is now one of the two lowest-cost integrated producers in the United States. Renamed ISG, it purchased Bethlehem in 2003. Maybe such outcomes make good economic sense. But when bankruptcy results from corporate fraud, the message is troubling: If your company gains competitive advantage by deliberately misrepresenting its financial condition, it will effectively go unpunished in the capital markets.

And what about the fraud? Six different investigations of tax and pricing fraud are ongoing; the cases are far from trial. Key managers who profited mightily haven't yet been brought to account. Is it fair that the managers and the company that tormented competitors with illegal accounting are brought back to compete with legal but artificial economics before their accounting statements and their legal problems are settled? Bankruptcy laws are designed to deal with a single firm's isolated problems. But giant firms like WorldCom affect the prosperity of giant competitors like AT&T and Sprint, as well as vendors, customers, and communities. It is far from obvious that a rapid emergence from bankruptcy for WorldCom represents good economic or social policy. And it is even less obvious that laws designed in simpler times, when fraud was not rampant, make good sense in every case today.

_______________________________________ Joseph Bower is the Donald K. David Professor of Business Administration and Stuart Gilson is the Steven R. Fenster Professor of Business Administration at Harvard Business School in Boston.

SPRING 2004 HARVARD INVESTMENT MAGAZINE 13

Finance 4 Kids A LITTLE BIT

BETA

FOR

EVERYONE

Michael Hauschild Anna Yu

Risk Vs. Reward When people invest, there are two things they care about: expected return on the investment and how sure you are about getting the money. Imagine you dropped by a newsstand and decide to bet your luck on todayâ&#x20AC;&#x2122;s lottery ticket. Suppose with 50% chance you can make $20 and with 50% chance you just lose your money. How much would you pay for this lottery ticket? Unless you are addicted to gambling and enjoy playing with risk, you are most likely going to pay something around $7 to $9. So, while you would expect to get $10 on average, you donâ&#x20AC;&#x2122;t like the fact that you might also lose your pocket money completely half of the time. In another word, the sadness of losing $10 outweighs the happiness of gaining $10.

You expect to earn more money out of it if there is a higher possibility that you incur a loss. We just introduced you to the most basic ideas behind how stocks are priced. When you buy a risky stock, you expect its price to

rise more than that of a safer stock because you were enduring a higher risk.

Say you paid $7 for the lottery. Before you leave, the seller tells you about another lottery that gives you $10 80% of the time, $0 10% of the time and $20 10% of the time. How much would you pay for this lottery ticket? Although you still get $10 on average, you probably will offer to buy this lottery ticket at a higher price. You feel safer because it is less likely that you will lose everything.

Do Not Put All Your Eggs in One Basket Let’s begin with an example:

You now have two types of bets to think about. One is for the up-coming Superbowl where with 50% chance you can make $20 and with 50% chance you just lose your money. Another is for the NBA finals where you face the same payoffs. Each of them costs $7. How would you spend your $14? A wise way to do this is to buy one of each. It is less likely that both games disappoint you. Betting on one of each is better than betting on the same game twice again because you are less likely to lose everything.

Finance 4 Kids

The same applies to the stock market. That’s why investors form something called a portfolio where they hold a bunch of stocks. You put your money into different stocks just as you put your eggs into several baskets. You will be completely ruined if you have all your wealth in Enron when it goes bankrupt. But you will incur a smaller loss in the same situation if you hold 10 stocks, one of which is Enron—you only lose 10% of your wealth.

How Can You Find the Best Combination of Baskets? Historically, the stock market has performed relatively well — increasing 8% on average each year. Think of this as your “secured” return for this year, because you can always make it by buying a broad market index. The market index (e.g. S&P 500) is a number calculated through a pre-specified formula to accurately reflect the performance of the 500 most important stocks. It is updated promptly with the market changes. Buying the index is equivalent to investing in the 500 stocks at the same time. However, you also have the option to make a higher return by investing more in riskier stocks or to take a safer route by weighing risky stocks less heavily. SPRING 2004

HARVARD INVESTMENT MAGAZINE

Assume you start by holding the S&P 500 “stock”. What would you do if you want to increase your expected return to more than the 8% average? You have to be prepared to endure more risk because you are asking for more return. You can buy more of a stock that provides higher average return or sell the ones that provide lower returns. But what do you look at in a stock to decide how much return and subsequently how much risk to expect?

Beta (ß) is the key to your question!

What is beta? For example, McDonald’s stock has a beta of 1.2. What does this imply?

Beta measures how much a stock moves with the market on average: but on any given day, there is no causal relationship between the

This means that when the market goes up by 1%, McDonald’s stock price on average rises 1.2%. By the same token, you also lose 1.2% in McDonald’s when the market slips by 1%.

market and a single stock. Beta is calculated through a formula. The higher the beta is, the riskier the stock is. You can look up the beta of a stock from all major financial publications like the Wall Street Journal.

Expected Return

Beta(risk)

Now you are quite ready to make your first investing decisions based on your appetite for return and your tolerance for risk!

If you take the expected return and their associated beta and put them on the same graph, you will find that most of them fall onto a straight line.

Finance for Kids In our next issue, we’ll delve deeper into the significance of beta and distinguish between two sorts of market risk: “good beta” and “bad beta”.

HARVARD INVESTMENT MAGAZINE

SPRING 2004

FIRM FINANCIAL PERFORMANCE FOLLOWING MERGERS K.P. Ramaswamy, James F. Waegelein EDITED BY SHRUTI SAINI

hether company performance improvement following merger and acquisition activity results from specific practices a company adopts is

a question that has persisted in the finance community, with prior academic studies lending ambiguous results to the causation of varied post-merger performance. This study aims to determine the factors that affect long-term post-merger financial performance through the examination of the policies and behavior strategies employed by the combined firm.

HYPOTHESES Long-term performance plans Management compensation plans affect the decisions of managers who may be inclined to forfeit the companyâ&#x20AC;&#x2122;s long-term best interests for shortterm personal gains. A salary and bonus compensation plan entices managers to act quickly to reap the profits of short-term projects without paying heed to the potential long-term consequences to the company. Long-term perfor-

SPRING 2004 HARVARD INVESTMENT MAGAZINE 17

mance plans, on the other hand, provide an

prices to increase and, consequently, the ab-

incentive for managers to enter those merger

normal return rate to decrease after the merger.

and acquisition deals that prove to be the most

The third hypothesis states that mergers an-

lucrative for the company because they man-

nounced post-1982 will endure a lower level of

date the presence of the manager during the

post-merger financial performance compared

period thus causing the decision-making hori-

to those announced pre-1983.

zon to broaden in scope and, arguably, in substance as hasty decisions with short-lived re-

Hostile Takeovers

sults are replaced by long-term beneficial poli-

Post-merger financial performance is fur-

cies. The first hypothesis is that companies

ther affected by the manner in which the two

with such long-term performance plans will ex-

firms integrated: hostile vs. friendly. A friendly

perience more positive post-merger financial

merger and acquisition entails a willingness

performance than those firms that do not have

from both companies to collaborate on joint

such plans.

future ventures. A hostile takeover implies that problems could potentially result from the ini-

Method of Payment

tial push-shove step, thereby preventing the

The signaling effect of cash vs. equity of-

combined firm from integrating smoothly after

fers contributes to the varying stock prices of

the acquisition. The fourth hypothesis thusly

the bidding firms and thus affects post-merger

states that firms who engage in friendly take-

performance. A cash offer will be preferred to

overs will be more prone to positive post-

finance a corporate acquisition when the man-

merger financial performance than those who

ager of the acquiring company, believing that

combine in a hostile manner.

his stock is undervalued, wants to prevent relinquishing ownership in his company at a de-

Industry Relatedness

pressed level. However, a manager will pursue

Two companies coming from the same in-

common stock as a method of payment if he

dustry can utilize their similar services to cut

believes his company is overvalued. He will

costs and therefore benefit greatly from syn-

opt for an equity offer, which is now more at-

ergies. On the downside, such companies

tractive at a lower cost, to use as currency to

might be required to sacrifice assets or divi-

finance the acquisition. The second hypoth-

sions to obtain regulatory approval for their

esis therefore predicts that a manager, assum-

merger. Two companies from different indus-

ing he has inside information regarding the true

tries do not generally benefit from the syner-

value of his firm, will prefer a cash offer when

gies similar companies enjoy, yet they can ex-

his firm is undervalued and an equity offer when

ploit any complimentary characteristics of their

he perceives it to be overvalued.

services and in such a manner cut costs of production. The fifth hypothesis therefore

The market for corporate control

states that the background makeup of the two

Empirical evidence shows that abnormal re-

firms, if they come from dissimilar vs. similar

turns after mergers were significant and posi-

industries, can either help or hinder post-

tive during the 70s and then, leading up to 1982

merger financial performance and is thus un-

and throughout the 1980s, the level of signifi-

clear in theory.

cant abnormal returns dropped and an exhibition of insignificant abnormal returns after merg-

Variables and Operating cash-flow measure

ers persisted. Reasons for this drop include

The dependent variable is the difference

changes to regulations and increased competi-

between the pre-merger and post-merger finan-

tion among bidders where several companies

cial performance. Performance, in this study,

went after a target firm. Such competition caused

is defined as the difference of pre-merger vs.

18 HARVARD INVESTMENT MAGAZINE SPRING 2004

post-merger ‘operating cash flow returns on market value

have more positive post-merger financial performance

of assets.’ The operating cash flows for both firms is com-

compared to firms that do not have such compensation

puted as ‘sales minus direct costs’ where direct costs in-

plans. This further supports the notion that when man-

clude ‘general and administrative expenses.’ The market

agers have a long-term stake in the company, they have

value of assets is the summation of the market capitalization

more incentive to take the strategic route and invest

of the stocks, which translates to the number of shares out-

more time, effort, energy, and money in optimal projects

standing times the stock price at the end of the fiscal year,

with positive net present values that promise to serve

and the book value of debt and the book value of the pre-

the company in the long run. Third, the variable YEAR

ferred stock. The independent variables include: a dummy

was found to be negative and significant at the 1%

variable PLAN for long-term performance plans, a dummy

level, confirming the hypothesis that post-merger firm

variable PAY for method of payment, a dummy variable

financial performance before 1983 generated higher ab-

HOST for hostile acquisitions, a dummy variable IND for

normal returns than those conceived after. Fourth, it

industry, and a dummy variable YEAR for date. Regression

was found that the variable PAY was not significant.

analysis was then administered to test performance. The

Fifth, the study found that the variable IND was negative and

Firms that announced mergers prior to 1983, compensated their managers with long-term performance plans, combined with firms from dissimilar industries, and acquired relatively smaller target firms, experienced more positive post-merger financial performance than those firms that failed to employ such tactics.

significant the

at 5%

level, thus providing evidence that firms coming from dis-

median industry-adjusted ‘operating cash flow return on

similar industries, as opposed to similar ones, experi-

market value of assets for the post-merger period of five

ence more positive post-merger financial performance.

fiscal years’ was determined by the summation of the ‘ab-

A possible explanation for this may be that firms that

normal industry adjusted return’ (denoted by alpha) and

integrate from similar industries might have the more

the return on such assets for the pre-merger period multi-

difficult task of eliminating common areas. Finally, the

plied by the slope coefficient (denoted by beta) which de-

variable HOST was found to be insignificant indicating

scribes any correlation between the pre-merger and post-

that hostile or friendly takeovers do not significantly

merger year’s cash returns, and lastly the size of the target

influence the financial performance of the combined

firm in terms of market value, again multiplied by beta. The

entity.

aim of this regression equation is to assess whether improvement exists in post-merger financial performance com-

Conclusion

pared to pre-merger performance.

To summarize, the overall picture that the full regression model describes in this study is that firms that

Results

announced mergers prior to 1983, compensated their

The results for this study are six-fold. Firstly, it was found

managers with long-term performance plans, combined

that size and year have a negative effect on returns. This

with firms from dissimilar industries, and acquired rela-

implies that larger acquisitions, in comparison to the take-

tively smaller target firms, experienced more positive

over of smaller target firms, are more troublesome to inte-

post-merger financial performance than those firms that

grate thus posing more problems for the combined firms

failed to employ such tactics. This study concludes

and thereby lowering financial performance. Second, the

that there is significant improvement in post-merger

results provide evidence to indicate that the variable PLAN

financial performance following M&A activity measured

is positive and significant at the 1% level which lends cre-

by operating cash flow returns at the end of the fiscal

dence to the fact that firms with long-term performance plans

year.

SPRING 2004 HARVARD INVESTMENT MAGAZINE 19

THE JANUS FACTOR GARY ANDERSON EDITED BY PEDRO GLASER

raders alternate between two modes. At times traders exhibit trendfollowing behavior. Relatively strong stocks are favored, while laggards are sold or ignored. At other times, the reverse is true. Traders-in-the-

aggregate turn contrarian. Profits are taken in stocks that have been strong, and proceeds are redirected into relative-strength laggards. This article presents the market as a system of capital flows reducible to the effects of traders’ Januslike behavior. As a foundation for method, two pictures are offered. First, we will look at feedback loops. Next, I will introduce a new approach to relativestrength. Then, the concepts of feedback and relative-strength will be fused to portray the market as a system of capital flows.

Feedback Loops There are two sorts of feedback—positive and negative. A common example of positive feedback is the audio screech that occurs when a microphone gets too close to a speaker. Sound from the speaker is picked up by the microphone, amplified and sent back through the speaker in a continuous loop until the limit of the amplifier is reached. Positive-feedback systems exhibit accelerating trends. A good example of negative feedback is the predator-prey relationship. An increase in the predator population tends to put pressure on the prey population. However, a fall in the number of available prey reduces the number of predators who may feed successfully, and so the predator population declines. A decline in predators, in turn, boosts the prey population, and so on. The interaction of predator and prey tends to stabilize both populations. Negativefeedback systems are stable systems, with values fluctuating within a narrow range.

Feedback in the Market When traders respond to market events, they are closing a feedback loop. The actions of individual traders collect to produce changes in the market, and those actions prompt a collective response. At times traders’ aggregate behavior is amplified through positive feedback. In the case of positive feedback during a rising market, rising prices trigger net buying on the part 20 HARVARD INVESTMENT MAGAZINE SPRING 2004

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of the aggregate trader. Net buying lifts

of opportunity loss is greatest when

offensive performance. A score above

prices, and higher prices, in turn,

the broad list advances, a stock’s

100 indicates that the target’s

generate more buying. An accelerating

offensive qualities are best measured

cumulative return during positive-

advance results. Positive feedback in a

when the market is rising.

return days exceeds the offensive

falling market, on the other hand,

benchmark.

develops when lower prices prompt

Picturing Offense and Defense

underperforms the benchmark and

traders to sell. Net selling pushes prices

To measure a stock’s offensive and

earns a score below 100.

down, and lower prices, in turn,

defensive qualities, two benchmarks are

The horizontal axis shows defensive

encourage additional net selling, and so

required, one to measure offensive

performance. A strong defensive score

on, producing an accelerating decline.

performance and the other to measure

of less than 100 places the target to

Positive feedback, when it occurs,

defensive performance. To accomplish

the left of the vertical benchmark. A

produces a trend, either up or down.

this, the average daily performance of a

weak defense generates a defensive

Traders’ aggregate behavior during

universe of stocks is separated into two

score above 100 and locates the target

these periods may be characterized as

sets of returns. The first set includes

to the right of the vertical benchmark.

‘trend-following’.

only those days when average

A target in the position marked with

At other times feedback between market

performance was either positive or flat.

an asterisk (Figure 1) has an offensive

inputs and traders’ aggregate response

That set of returns makes up the

score of 110 and a defensive score of

is negative. When negative feedback

offensive benchmark. The defensive

95. This target has outperformed the

prevails, the composite trader reacts to

benchmark is built from the balance of

benchmark both offensively and

rising prices by taking profits. That net

the daily returns, those during which

defensively.

selling puts pressure on prices.

average performance was negative.

However, falling prices encourage

Each target within the universe is

traders to hunt for bargains among

compared separately to both offensive

depressed issues. A strong bid for

and defensive benchmarks. To produce

weakened stocks pushes prices higher

an offensive score, the sum of the

again, and the cycle repeats. Price action

offensive benchmark’s daily returns

tends to be choppy or corrective.

(flat-to-rising days) over some period—

Traders’ behavior during these periods

say, 100 days—is compared to the sum

may be characterized as ‘contrarian’.

of the target’s returns for the same days

weak

offense

Figure 1

and over the same period. If the result

A New Model of Relative Strength

of that calculation is 110, then the target

Markets are risky. And risk, everyone

is ten percent stronger than the

knows, involves loss, or the possibility

benchmark on those days when

of loss. The connection we all make

benchmark returns are flat-to-rising.

between risk and loss is intuitive and

The target has an offensive score of

The Benchmark Equivalence Line (BEL)

powerful. Because the probability of

110.

Notionally,

equity loss is greatest when markets are

A similar calculation is made to

combinations of offensive and

falling, a stock’s ability to defend against

determine defensive relative strength.

defensive performance that match the

loss is most critically tested, and

The sum of the defensive benchmark’s

overall performance of the average

therefore best measured, during periods

returns on negative-return days is

stock

of general market decline.

compared to the target’s returns for the

combinations range from very weak

But rising markets are risky, too.

same days. A result of 110 in this case

offense plus very strong defense to

Regardless of how well a stock defends

indicates that the target is ten percent

the other extreme of excellent offense

against loss during falling markets, if it

weaker than the defensive benchmark.

together with very poor defense. All

does not score gains as the market rises,

Offensive and defensive performances

possible combinations of offense and

the trader is subjected to another risk,

of a target are pictured graphically in

defense that tie the universe’s average

lost opportunity. Because the probability

Figure 1. The vertical axis displays

performance comprise the Benchmark

HARVARD INVESTMENT MAGAZINE

there

are

(benchmark).

infinite

These

Equivalence Line (BEL).

How Positive Feedback Expands

relative strength improves, strong

A target with an offensive/defensive

the Universe

targets migrate toward the NW

score of, say, 110/110 has rallied ten

During periods of positive feedback,

indicating that relatively strong stocks

percent more than the offensive

traders buy into strength and sell into

are not only outpacing the benchmark

benchmark during rising periods. The

weakness. Whether the overall market

during advances but also finding

target has also fallen ten percent more

is rising or falling, capital flows from

exceptional support during weak

than the defensive benchmark during

weaker to stronger issues. As the

market periods. On the other hand,

declining periods. When offensive and

process continues, relatively strong

relatively weak targets are drained of

defensive performances are combined,

stocks become even stronger and

capital and so become relatively

overall performance of the target

relatively weak stocks become still

weaker. Weak stocks move to the SE

matches the average performance of the

weaker. The period from December 1998

and further away from the BEL.

universe. The target is simply more

through March 2000 marks a period

Positive feedback in both rising and

volatile than the benchmark. Similarly,

during which tradersâ&#x20AC;&#x2122; aggregate

falling

a score of 90/90 matches average

behavior was dominated by trend

northwesterly flow of capital and

performance, but in this case the target

following.

causes the universe to expand.

is less volatile than the benchmark. The

virtuous positive-feedback cycle that

original benchmark (100/100) at all

drove the strongest stocks to new

How Negative Feedback Contracts

volatilities comprises the BEL. The BEL

extremes of relative strength. Laggards

is shown in Figure 1 (above) and forms

the Universe

rallied, but not as well as the average

a straight line that runs diagonally

During periods of negative feedback,

stock, and so continued to drift below

through the matrix.

capital flow across the BEL is reversed.

the BEL as their relative strength

The next chart (Figure 2) pictures a

In the aggregate, traders have turned

declined. Figure 3 shows the 200-stock

universe consisting of the Standard &

from trend-following behavior to

universe in March 2000, near the end

Poorâ&#x20AC;&#x2122;s 100 plus the NASDAQ 100 as of

contrarian behavior. Traders buy only

of that expansion phase, and pictures

mid-December, 1998. The market has

once stocks are considered cheap, and

the flow of capital from weak targets SE

suffered through a sharp summer

profits, when they come, are taken

of the BEL to stronger targets NW of

decline, and confidence in the new

quickly on rallies. As a result, trends

the BEL.

are not durable, and price action is

advance is still weak. Traders are riskaverse and contrarian.

Relative

strength differences (NW-SE) are small and eclipsed by differences based on volatility (SW-NE). As a result, stocks

Traders engaged in a

markets

produces

range-locked or corrective.

Figure 3

Figure 4

Capital Flow During Positive-Feedback Periods March 13, 2000

Capital Flow During Negative-Feedback Periods November 8, 2002

hug the benchmark and arrange themselves along the BEL.

Figure 2 December 15, 1998

When feedback is positive, capital is pumped into strong targets NW of the BEL, and so the relative strength of those targets tends to improve. As

Driven by negative feedback, capital flows out of stronger issues NW of the BEL and into weaker stocks to the SE.

HARVARD INVESTMENT MAGAZINE

Stocks that have

rewarded.

been strong lose

In either case, confidence in the trend leads to trend-

relative strength and

following behavior. The controlling dynamic is positive

fall back toward the

feedback. Relatively strong stocks outperform weaker

BEL. On the other

issues, and the universe expands.

hand, stocks with a

The dynamic is quite different once traders lose

recent history of

confidence in the trend. Risk-averse and contrarian,

weakness, pumped

traders respond negatively to price changes. Buying is

by an infusion of

focused on oversold “bargains”, and profits are taken

capital, migrate in a

in stocks that have rallied. Trends are short-lived and

northwesterly

unreliable, and profits are elusive. Stocks with a recent

direction toward the

history of relative strength fall back toward the BEL

BEL

while laggards improve, and the universe contracts.

relative

strength improves. Negative-feedback periods produce a southeasterly flow of capital and cause the universe to contract. Figure 4 shows the universe

November 2002, near the end of a long contraction phase, and pictures the flow of

capital

under

negative-feedback

The Spread

A proper read-

The spread in performance between relatively strong and relatively weak targets offers a running picture of

ing of capital

expansion and contraction. The Spread is calculated as the difference in forward performance of relatively strong

flows can lead

vs. relatively weak targets. One may choose to compare the average forward performance of all targets NW of

to consistent

the BEL with that of all targets SE of the BEL. To make the comparison, all targets NW of the BEL on day d are

trading

identified, as well as all targets SE of the BEL. Then the average performance for each set of stocks on the

success.

conditions.

following day (d+1) is calculated, and the difference between the two averages is determined. The resulting number is the daily performance spread between all strong and all weak targets. Daily spreads are cumulated

Confidence

to create The Spread.

The current of capital

The Spread discloses the direction of capital flow within

alternates back and forth in a cycle repeated over and over

a universe of targets and offers a new and precise

as the universe of stocks expands then contracts. But

definition of ‘momentum’. Traders may use The Spread

what is it that prompts traders, as if with one mind, to push

not only to identify profitable trending periods but to

stocks to relative-strength extremes before pulling them

avoid difficult markets as well. Indeed, these indications

back toward the benchmark? It is confidence in the trend.

are consistent enough to support reliable trading rules.

When traders, for whatever reasons, become confident of

Those rules are listed below:

a bullish trend, they defer profits and chase strong stocks

1.When The Spread is rising, and relative-strength

into new high ground. Stocks that do not participate in

leaders are advancing, buy the strongest stocks and

the trend are ignored or sold. Trends accelerate, and profits,

groups;

for those trading with the trend, come easily. When traders

2.When The Spread is rising, and relative-strength

are confident of a bearish trend, on the other hand, the

laggards are declining, sell or sell short the weakest

weakest stocks are liquidated or shorted aggressively, and

stocks and groups;

proceeds are held in cash or shifted to stronger stocks

3.After a decline, if The Spread is falling and relative-

that defend well in a falling market. Trends are durable,

strength laggards are advancing, buy the weakest stocks

albeit negative, and traders willing to sell into the trend are

and groups.

24 HARVARD INVESTMENT MAGAZINE SPRING 2004

Testing The Spread

maximum draw-down of 39%.

A protocol was devised to back-test the efficacy of The

Set-size was increased incrementally by ten-percent until

Spread. To isolate the effect of The Spread, simultaneous

the relatively strong half of all stocks were positioned

long-short trades were assumed in order to neutralize

on one side of trades and the relatively weak half on the

the impact of market direction. The sole pre-condition

other (“50%”). Each set tested scored a higher net gain

for trades was the immediate direction of The Spread.

and a smaller maximum draw-down than the 200-stock

Figure 5 summarizes five separate computer back-tests

average.

of a market-neutral strategy based on the direction of

The best overall performance came from the set of

The Spread. The method employed is simple, direct and

stocks (10%) nearest the two relative-strength extremes

free of any attempt to optimize outcomes. The Spread is

of the universe. Generalizing, the most profitable

used to determine whether the universe of 200 stocks is

opportunities consistently come from targets furthest

expanding or contracting. If The Spread rises (universe

from the BEL.

expands), long positions are selected from relatively strong stocks and short positions are selected from

Postscript

relatively weak stocks. Positions are reversed when The

Markets make sense. Price series are not chaotic, but

Spread falls (universe contracts). The net percentage

are carried along on currents of underlying capital flow.

change for the following day (close to close) resulting

As we have seen, those currents may be observed

from long and short positions is cumulated. No leverage

through their effect on price. Moreover, a proper reading

is assumed. No allowance is made for commissions or

of capital flows can lead to consistent trading success.

other costs. As with any back-test, results are theoretical

Skeptics hold that operations based only on observed

and are intended only as a demonstration of the validity

price changes cannot succeed. Markets are moved by

and power of the methods developed in this paper.

news, they argue, and since, by definition, news cannot

The back-test was made assuming stock-sets of varying

be predicted (or it would not be news), price movement

size. “10%” tags the overall performance that results

cannot be anticipated. It is a short step to conclude

from trading only the strongest and the weakest ten

that price data are not linked and that price series follow

percent of the universe. That set posted a gain of 404%

a random walk.

with a maximum draw-down of 14%. Over the same period

What they fail to take into account that price activity is

(4.3 years), the 200-stock average gained 69%, with a

also news. As we have noted, traders respond to news of price change, just as they respond to other sorts of news. By their collective response

Figure 5

traders forge causal links between past price data and current price movement. Price data

Market-Neutral Results vs. 200-Stock Average

are linked because traders link them. Granted,

markets

are

the

free

and

spontaneous creation of buyers and sellers motivated only by insular self-interest. Yet the whole of their activities assumes a shape and flow beyond the intent of any individual trader. Out of the chaos of daily trading, something new, orderly and recognizably human emerges. At bottom it is hope and fear, measured by the rhythms of expansion and contraction in a process as relentless and as natural as breathing or the beating of a heart.

SPRING 2004 HARVARD INVESTMENT MAGAZINE 25

INTERVIEW WITH

ANNE PEREZ

MICHAEL HAUSCHILD

ell us about yourself. How did you start at Merrill Lynch?

I was an economics concentrator at Amherst College and interned at Merrill in the Financial Institutions Group my junior year. Coming in, I didn’t know exactly what to expect and I didn’t know much about corporate finance, but I met a lot of great people at Merrill as I learned about investment banking and the life of an analyst. After my internship, I got an offer to work full-time in the Financial Institutions Group. Students thinking about an internship in investment banking shouldn’t be too worried as you aren’t expected to know everything when you start. The learning curve is extremely steep. During the 10-week program, you acquire so many new skills and you work with so many brilliant people. It’s really a fascinating learning environment with people from many different backgrounds.

C INSIDE SCOOP

an you give us an example of a recent deal you worked on and what your role was?

I recently worked on the IPO of an auto-insurance company, which was a spin-off from American Financial. It was the first real transaction where I had a lot more responsibility and was entrusted to deal closely with the client. I think there’s no better way to learn about a company than to hear the CEO talk about his plans for the strategy and growth of the company. The stock is up over 100% since the IPO and we actually worked on an add-on offering in November (delete in November). I got to work on the same project, which was very exciting for me because I already knew these people and the company.

HARVARD INVESTMENT MAGAZINE

SPRING 2004

INSIDE SCOOP

During the 2-year analyst program, you will find that in the beginning you work more on pitches while later you will have more deals and so more client contact. Through pitching, you learn more on a broad level about an industry, about how we go about contacting clients and about how we’re positioned to serve the client. But the best way to learn is of course to work with the client; learn it through the people who are there every day. It’s really exciting to work alongside the founder of a company or run financial models with the CFO and exchange ideas in order to serve the company in the best possible way.

errill is known for giving a lot of responsibility to its first-year analysts. What is it like to work closely with senior bankers and clients coming straight out of college? It’s amazing to see how far someone can come after 2 years. You hear people say that no day is the same in investment banking and it’s really true. You find yourself simultaneously working on a couple of different projects. When you start out, you’re more like a sponge; you go to meetings, listen and learn. As time goes on, you become more confident in your abilities and you get more responsibility as you learn and improve your skills. For example, I recently worked on a project in which we developed an operating model for a bank. I was the one running the models and the CFO would discuss with me what

would happen in the model if we changed certain assumptions. To have that kind of responsibility and to be confident that you can do it is really something that helps you to grow. It’s true that people have high expectations and expect you to be right 100% of the time, but if you’re up for the challenge, it’s the best way to learn. Moreover, working on a project with a small team is a very rewarding experience. There are few other industries where you can get this kind of responsibility and exposure to such meaningful projects at such a young age. It is certainly a challenge, but that is what makes it so exciting.

ith the stock market hitting levels not seen in more than 2 years, investment banking activity such as M&A and IPO’s has clearly picked up. How does that affect your work as an analyst? How do you expect 2004 to be different from the 2001-2002 period, if at all? When I first came in 2 years ago, a lot of the work was pitching. The few deals I worked on were mostly debt financings. Despite a lower transaction volume back then, it was a very good environment to learn about banking – any period is in fact. Pitching in and of itself is very important. In presenting an idea to a client, even if no deal is done immediately, you build a relationship and find out what options the client is considering for the future and how you can help with these plans. In terms of the market, M&A activity has definitely picked up toward the second half of 2003 and early 2004, as recent deals in the banking sector have demonstrated. The effect of this is that more pitches turn into real deals, and from an analyst’s perspective, I spend more time working with clients, engaged in transactions, building financial models and going on roadshows.

SPRING 2004

HARVARD INVESTMENT MAGAZINE

INSIDE SCOOP

No day is the same in investment

hat do people do after completing the analyst program at

Merrill?

banking and

In general, there are several options analysts completing the 2-year program have. Some stay on as third-year analysts, some go to other Merrill offices abroad, a lot of people go to work in a hedge fund or in private equity, some go to business school and there are a few that do something completely different. The doors are wide open for you—I am really amazed at the marketability of this two-year position.

it’s really true.

o you have any advice for undergraduates who are thinking about investment banking as a possible career path? If you’re curious about the financial services industry, about getting underneath how a company manages itself and how an industry works, then investment banking is really the place to be. It is such a great learning experience to work on live deals with some of the smartest people in finance. You gain a broad understanding of corporate finance and of the companies in your industry. As a candidate, you need to be motivated and have a good work ethic. Try to keep an open mind and good attitude. You want to learn as much about finance as you can and if you show the people you work with your enthusiasm they will be all the more excited to teach you.

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SPRING 2004

INSIDE SCOOP

MATT ESPY

HEDGING HIS BETS

Matt Espy, Class of 2003, was the President of the Harvard Investment AssociaW

tion (HIA) from 2001-2002. An Applied Mathematics and Economics concentrator, Matt now works for Sagamore Hill Capital Management, a multi-strategy, market neutral hedge fund that provides investors with risk adjusted returns through quantitative analysis of securities. Below is an interview with the former HIA President, as he shares with us his experiences preparing for and working in the field of finance.

David Yuan Benjamin Lee

HAT

YOUR

ROLE

Y O U TELL U S W H A T A

S A G A M O R E H ILL ,

AND

CAN

T Y P I C A L D A Y IS LIKE F O R Y O U ?

The title of my desk is Capital Structure Arbitrage, and there are two of us working together. The idea behind capital structural arbitrage is that we would look at the different securities within the capital structure of a company, for example, different bonds, stocks, options etc…. We would compare the values of the securities and buy certain securities while selling others. Basically, we’re taking advantage of the fact that certain securities prices are out of whack even though they are from within the same company. My day at Sagamore Hill usually begins at 8 in the morning and ends at 6. Since we concentrate mostly on bonds, I would come in to my office and read the list of bond prices that investment bank brokers sent me. I would see how the bond prices have moved since the day before, and evaluate the relative prices to determine whether there’s an opportunity for trade. For example, the brokers may send out a run for all of Georgia Pacific’s bonds, and I will compare the relative prices between, for instance, Bond A and Bond B. Since there are different brokers sending out prices from different markets, the price of a bond may be slightly different here from there, so keeping in mind the positions we already have for the different companies we are looking at, we wait for the prices to make sense and then take on a position, whether it’s buying one bond or selling the other. Hence, I spend a lot of time looking at markets. Besides that, my job also involves extensive research and looking into the fundamentals of a company to answer questions such as “Do we expect the company to go bankrupt?” and “Do we believe that the bonds will pay off?”

COMING

A N

U N D E R G R A D U A T E, DID

YOU

THINK

Y O U W O U L D W O R K IN F I N A N C E ?

I was interested in finance, but when I first got to Harvard, I didn’t know much about it besides the fact that Goldman Sachs is a leading firm in the field. I’ve got to credit the Harvard Investment Association (HIA) for teaching me a lot about finance. Before that, I didn’t know a lot about the field, but through HIA, I learned a lot about investment and finance, and I realized that finance is an industry that only cares about whether you produce, so that regardless of your age or your background, as long as you are willing to produce, you’ll have a lot of opportunities. SPRING 2004 HARVARD INVESTMENT MAGAZINE 29

CA N

Y O U SHARE

WITH U S

YOUR PERSONAL

E X P E R I E N C E S IN C O L L E G E IN P R E P A R I N G F O R A

C A R E E R IN F I N A N C E ?

HIA was a big thing. Beyond that, I subscribed to some investment journals, read various finance related books and took some of the finance classes that Harvard offered. I also did internships in the finance industry. In the summer before my senior year, I worked for Lehman Brother’s London branch in the Sales and Trading side. In the summer before that, I worked at a hedge fund in New York and before that, for a trust in Atlanta.

H A T IS T H E M O S T E X C I T I N G T H I N G T H A T

Y O U ’V E D O N E W O R K I N G IN A

AN D

H E D G E F U N D?

W H A T IS T H E L E A S T E X C I T I N G ?

The most exciting thing is to see that a trade that you completed made money, and it’s a great feeling to claim that, “Look, it’s my work, my research and I did that,” and to know that you are the one who made it happen. Besides that, working on the new idea of a trade and looking at the starting of that has also been a lot of fun for me. As for the least exciting part of my job, to be honest, it’s been great. Everyday, I spend a couple of hours looking at the positions that we’ve been working on and updating the prices. Just updating the prices in itself isn’t that exciting, but what it allows me to do is to familiarize myself with how the bonds are moving, and to see what other stuff we should be looking at. While it isn’t the most glamorous job, I still think that it has been beneficial for me.

H A T D O Y O U T H I N K A R E S O M E K E Y QUALITIES T O

RUNNING A

S U C C E S S F U L H E D G E F U N D?

One of the most important qualities is to be willing to take risks. At times, it’ll appear as if the market isn’t doing something you want, but in order to be successful, you’ll want to pursue the same strategy anyway. Another key feature is to be innovative. Sometimes, you’ll be faced with an opportunity that has not been pursued or may not work, in which case you will need to devise new and often unconventional approaches because as soon as the market finds out about the idea, the excess return disappears just like you learned in school. So I would say that being innovative and risk-taking are the most important qualities.

T R A D I T I O N A L L Y, IN

INVESTMENT

ACQUIRE T H E

COLLEGE GRADUATES OFTEN W O R K BANKING

FOR

FEW

YEARSTO

“I N V E S T M E N T B A N K I N G S KILL S E T ”

B E F O R E B R A N C H I N G O U T I N T O T H E D I F F E R E N T FIELDS LIKE H E D G E F U N D S , V E N T U R E C A P I T A L A N D E T C . H O W E V E R, Y O U W E N T S T R A I G H T I N T O W O R K I N G A T

30 HARVARD INVESTMENT MAGAZINE SPRING 2004

H E D G E F U N D.

WH A T

C O N V I N C E D Y O U T O D O S O?

Investment banks are great in terms of providing training and a more structured environment. I work for a hedge fund right out of college not because I feel that the investment banking skills and knowledge are not needed, but because the investment banking environment is a little too structured that it can become restrictive for me. After all, the investment banks would assign you to one group and you would do that and then assign you to another division and you would do something else. While this structured environment is good for training, the ability to have more freedom and decide on what I want to do is the reason why I went into a hedge fund, where I also assume more responsibility.

F INALLY,

WHAT

UNDERGRADUATES

ADVICE

WOULD

INTERESTED

YOU IN

GIVE

PURSUING

FOR A

C A R E E R IN T H E I N V E S T M E N T F I E L D ?

If you’re really interested in finance, read as much as you can outside of class. Get an idea of the different areas of finance, and read the Wall Street Journal. Learn from the people who have already been in the industry and know what’s going on, and learn from what they have to say. Don’t be overwhelmed. You’re clearly not going to be able to understand everything that’s going on in the business, but pick up as much as you can from wherever you can. This way, when you start working, you can move forward and produce as much as possible while learning even more about the field. You’ll also find that you are running while someone who was stepping back and waiting in college is still learning the basics.

DICK GRASSO

AND

The Reform Of the New York Stock Exchange Benjamin Lee

David Yuan

n 1968, few could have imagined that Richard Grasso, a clerk working on the floors of the New York Stock Exchange with a wage of $80 per week, would one day ascend to the role of CEO and Chairman of the NYSE. Recent SEC corporate governance reforms forced the revelation of his top-secret, extravagant $187.5 million in deferred compensation and retirement benefits, which was followed by weeks of blistering criticism from traders, pension fund managers, politicians, and even members of his own board of directors. Since then, he has decided to forgo $48 million, leaving a still enormous $139.5 million compensation package. On September 17, 2003, Richard Grasso was forced to resign after losing a vote of Thank you. I am blessed. confidence, 13-7. While Richard Grasso’s astronomical pay package is debatable and controversial in itself, the issue also raises several fundamental questions: Who is Richard Grasso, and what did he accomplish to justify his through the ceiling pay package, if he deserved such rewards at all? More importantly, is this incident an indication of problems within the structure of the NYSE regulating body, and that pressing reforms should be made?

The NYSE and Richard Grasso Established in 1792, the New York Stock Exchange is the largest securities exchange in the United States. The exchange itself does not buy, sell, own, or set prices of the stocks traded within; rather, the prices are determined by public supply and demand. With over 2,800 companies enjoying over $15 trillion in capital, the NYSE is headed by a board of directors consisting of a chairman, an executive vice chairman, a president as well as 10 public representatives and 10 Exchange members. In addition to its role of regulating member activities and overseeing the exchange, the board also approves applicants as new NYSE dealers and sets policies for the exchange. Richard Grasso, meanwhile, is the first Chairman and CEO to come from inside the exchange. Brought up in lower-middle class Queens, New York, by his mother after his father left his family, he started working at the exchange as a floor clerk in 1968, after failing to graduate from Pace University and a brief stay in the US army. Richard Grasso’s popular and personable qualities eventually led to his designation as the NYSE President and CEO, then vice-chairman and finally chairman in 1995, making him the first person to ever be elected to all these positions in the exchange’s long history. In his 8-year tenure as Chairman of the NYSE, Mr. Grasso has been credited with innovative technological reform of the exchange, allowing the 211-year-old institution to compete with its new electronic rivals, such as the NASDAQ exchange. Under his leadership, the NYSE now spends 62% of its annual $800 million budget on new products and new technology. The impact of such investments is apparent on the trading floor, where traders now process orders with computerized tablets rather than running back and forth between booths with pink, yellow, and white forms. Clients now get real time prices with immediate executions. This technology has also allowed the NYSE to deal with the surge of volume from 300 million shares per day

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during the early 1990’s to over 1.4 billion shares per day today. With the current technology, the NYSE can handle 10 times that amount. However, the NYSE is still far from being as efficient as it can be. The NYSE uses a specialist system that involves much manpower, since all trades must be conducted through the specialists. While this system has its advantages, allowing, for instance, the execution of trades at prices inside the quoted spread, it is still less efficient than a fully computerized trading system, such as that of the Nasdaq. “In the long run, the NYSE has to move to an electronic limit order book. They have to accomplish that, otherwise they are going to lose ground. Exchanges that are not fully electronic will eventually die,” comments Professor Tuomo Vuolteenaho, Assistant Professor of Economics at Harvard. Professor Vuolteenaho adds that such a transition would be “very difficult for the CEO because a lot of the profits come from the fact that not just anybody can participate in this current system.” Aside from the technological changes, Richard Grasso has been recognized for his able leadership during times of crisis. He was much commended for his ability to reopen the NYSE trading floors 6 days after September 11th, restoring investor confidence in the functioning of financial markets and demonstrating to the world the resilience of the U.S. economic system against catastrophe. Also, he responded to the wave of corporate scandals, beginning with Enron and WorldCom, by creating a system of stricter guidelines for listed companies. Listed companies must have independent directors as the board majority, conduct compulsory internal au32 HARVARD INVESTMENT MAGAZINE SPRING 2004

dits, and have shareholder vote on stock option plans. Under Mr. Grasso, the NYSE also responded differently to the “technology bubble” in the 1990’s. Whereas Nasdaq became really involved with companies in the technology sector, the NYSE, because of its relatively stringent listing requirements, stayed away from the most speculative companies. In hindsight, many of these stocks were overvalued, and the NYSE is now receiving a considerable amount of business from Nasdaq. As Professor Vuolteenaho notes, the NYSE has pursued “the correct long-term strategy of not listing stocks that are completely speculative.” In an era of dishonesty in the financial markets, Mr. Grasso is seen as the defender of the NYSE’s system of honor that was difficult to maintain in a time period that required increasingly large amounts of resources to perform the designated functions of the exchange. The NYSE, after all, entailed a system of elite traders who were exclusively entitled to see all orders as part of their requirement to maintain fair and orderly markets. He became a classic proof that hard work and dedication lead to success, and served on a number of worthy boards, including that of the New York City Police. However, this image as an American hero all changed when news of his compensation erupted on August 27th, 2003.

Doubts on the compensation: Despite Mr. Grasso’s innumerable contributions to the NYSE as Chairman, strong doubts have been cast upon the equity of his compensation and the procedures for determining such compensation.

Dick Grasso’s Compensation

somewhat ironic role considering the enormous pay package. According to Professor Brian Hall, Professor of Business Administration at the Harvard School of Business, Mr. Grasso’s pay package was a result of “atrocious corporate governance.” Professor Hall also adds that while the NYSE is technically a not-for-profit organization, it also has considerable influence in the financial system. Hence, the compensation for the CEO of the NYSE cannot be fully compared with that given to executives of other non-profit organizations such as the Red Cross; but on the other hand, to pay the head of the NYSE the amount given to the CEO of a company like Goldman Sachs would also be absurd. “What is remarkable here,” Professor Hall concludes, “is that this happened to a group that is in charge of fixing the corporate governance structures of its members.” Is Richard Grasso’s resignation, then, the the NYSE’s response to appease public outcry? “No question about it,” Professor Vuolteenhao remarks, “It’s a political scandal. There were problems in setting the compensation, and that it came out at the end in such a large number. It’s much easier for people to swallow a figure of $20 million per year than to learn about the compensation over several years all together in such a lump sum.”

1995 -2002

From Mr. Grasso’s compensation trend since his appointment to the CEO position, we can see that while his base salary remained at a steady $1.4 million throughout the years, his bonuses rapidly inflated his compensation total to over $25 million during the peak in 2001, a time when the stock market was in full retreat. This, when compared to the roughly $2.4 million compensation received by NASDAQ CEO Hardwick Simmons and AMEX CEO Salvatore Sodano each in 2002, seems astronomical.. Richard Grasso, however, justified his stance by arguing that the pay package was a deferred compensation for his years of service in the NYSE, and that a large part of it was his bonus accumulated over the years. He was reported to have said “Thank you. I’m blessed” after he was informed of each compensation decision. When criticisms and public outrage continued, Mr. Grasso responded by commenting that a financial institution should not focus its energies on the CEO’s compensation. The NYSE’s board committee structure, however, casts doubts on Mr. Grasso’s defenses as well as the integrity of the compensation process. SEC filings show that a majority of the NYSE’s compensation committee from 1998 to 2003 composed of representatives from companies directly regulated by the NYSE and more importantly, by Mr. Grasso. Furthermore, until the SEC corporate governance reforms of 2003, Mr. Grasso personally recommended all committee assignments, and he had handpicked members of the compensation committee that set his play. This questionable process in determining the committee and the Chairman’s compensation is particularly embarrassing for the exchange, as the NYSE enforces corporate-governance standards for its 2800 listed companies, and is even empowered by federal law to be a frontline regulator of the securities industry, a

The Ongoing Case for the NYSE and Richard Grasso Since Richard Grasso’s resignation, the Big Board has named John Reed, a former CEO of Citigroup, Inc., as the interim Chairman. In December of 2003, the SEC approved the split of the positions of chairman and CEO. Professor Vuolteenaho called this “a step in the right direction.” However, the SEC considers this as the first of a series of policy reforms. In the long run, the SEC has discussed further bolstering the independence of the NYSE’s self-regulatory branch, perhaps even leading to the formal separation of the regulatory arm from its business operations. At the same time, the New York state attorney general Eliot Spitzer and the SEC have opened up investigations into whether any rules or laws were broken in the compensation process. Investigators are examining whether Mr. Grasso exchanged favors to directors in return for the enormous compensation package. So far, SEC officials have not found evidence of malfeasance. Professor Vuolteenaho warns, “It’s a danger now that in light of these scandals, everybody’s names get equally tarred by the newspaper coverage.” He emphasizes the need to distinguish Richard Grasso from the Enron and mutual fund executives who have clearly committed fraudulent acts. “These are very different situations – not all scandals are created equal.”

SPRING 2004 HARVARD INVESTMENT MAGAZINE 33

In this section, we feature companies and stocks th shown considerable improvements in their operating have outperformed their peers in their respective in

HIGH FLYER HIGH FLYER Michael Hauschild

The Company

reeport McMoRan Gold & Copper (NYSE: FCX) is the world’s sixth-largest copper and seventh-largest gold miner. It operates the Grasberg complex in Indonesia, the largest single gold mine and second largest copper mine. The copper/gold split of the company’s revenues is about 60/40, giving Freeport the exceptional appeal of an economic recovery play (copper) and a safe haven (gold). Freeport is one the most profitable companies in the industry with enviable operating margins of 30-35% in recent years. The company has the lowest cost structure in the mining sector and its Grasberg complex has one of the highest ore grades- two very important factors in the commodity business. Freeport’s three main mining operations include majority-owned subsidiary PT Freeport Indonesia (91% stake) and the wholly owned subsidiaries Atlantic Copper and Eastern Mining. PT Freeport is the largest and most important revenue and earnings driver with its Grasberg complex in Indonesia, the largest copper and second-largest gold mine in the world.

Financial Performance reeport has been strengthening its balance sheet and enhancing its financial flexibility by paying back debt, redeeming convertibles early and converting preferred shares into common stock. The outlook for the company’s free cash flow in the next 34 years is better than ever. In 2003, Freeport massively reduced its debt by taking advantage of low interest rates to refinance and pay back debt and by redeeming preferreds. This will have a very positive effect on free cash flow allowing the company to increase dividends and buy back shares to benefit shareholders. Freeport started paying an annual dividend of $0.36 to its common shareholders in 2003 for the first time since 1998. The company later boosted this dividend to more than double ($0.80) as cash flow remained tremendously strong due to higher gold and copper prices. Freeport is expected to hit its free cash flow ‘sweet spot’ in 2004 and 2005 as lower debt payments coincide with higher gold and copper revenues. Shareholders stand to benefit from the large amounts of cash coming into the company and the resulting dividend increases and share buybacks.

34 HARVARD INVESTMENT MAGAZINE SPRING 2004

Operating Performance

he owner of the prestigious Grasberg complex has made every effort to improve its already efficient and cost-effective operations in the Indonesian mine – the largest gold and second largest copper mine in the world. The lowest cost structure in the industry give Freeport spectacular operating margins of 40% compared to Phelps Dodge’s 5%. Phelps Dodge is Freeport’s closest competitor and has seen its shares rise in lock-step, but less steeply as Freeport’s. Freeport partnered with several of its primary equipment and contract service suppliers in Indonesia in an effort to reduce cost further, improve conditions of roads in Indonesia, and increase equipment availability, resulting in increased output to meet the company’s aggressive production targets and in reduced operating and capital costs. The company’s metallurgists, geologists and engineers continue to work hard on the concentrating process in order to increase already impressive metal recovery rates

Stock Performance reeport’s stock was the first to rally in the metals and mining sector in early 2003. While the entire sector saw sizeable gains in 2003, shares of FCX have outperformed their industry by as much as 40%. After breaking above its 5-year resistance level around $20-21, Freeport’s shares went from strength to strength and never looked back. The stock rallied in almost a straight-line fashion to fresh 10-year highs of $46 at its peak. Shares have almost tripled from their lows around $16 in early 2003, making Freeport the strongest performer in the metals group (competitors Phelps Dodge + 155%, Inco + 122% and Newmont Mining +102%).

Copper and Gold market

opper is one of the most cyclically sensitive metals, i.e. in an economic recovery, copper is a great place to be - as early as possible. Copper prices have been rising in 2003 on hopes of an economic recovery that started in March of 2003. Analysts expect higher copper prices in the early part of 2004 extending recent gains as economic activity

hat have done particularly well in the past 6 to 12 months. These companies have g activity and/or their share price performance. High Flyers are typically firms that dustry and deserve to be lauded for this achievement.

around the world picks up momentum. Lower inventories and very strong demand from China continue to support copper prices in the medium and long term. Gold has been one of the most heavily debated metals in the past two years. Historically seen as an anti-cyclical investment, gold used to rise when stocks fell and vice versa. In the stock market downturn that began in 2000, this pattern was still valid equities fell and gold rose - but in the most recent stock market upturn, gold has continued on its upward trajectory. The main drivers are the weak dollar, geopolitical uncertainty and reduced central bank selling of gold. In a low-interest rate environment, central banks - which also have to earn a certain return on investment - can better justify holding a noninterest bearing asset such as gold. In addition, the strong depreciation in the US dollar in 2003 has also made investing in gold very attractive as gold prices are quoted in dollars. This means that with the dollar falling foreign investors and central banks can buy gold more cheaply without being subject to the day-to-day fluctuations of a direct currency investment. With gold prices surpassing the critical $400mark that Wayne Murdy, CEO of Newmont Mining, correctly predicted, Freeport’s revenues will see a boost in the coming quarters. From a technical perspective, both copper and gold have recently established new highs and still offer more upside than downside. Since costs are relatively stable in the commodity business, higher copper and gold prices will have a positive effect on Freeport’s earnings. Due to its low cost structure, Freeport is heavily geared toward metals prices, i.e. a 1% rise in gold or copper prices leads to a greater than 1% rise in earnings.

the stock decline 12% for the week - even though shares quickly regained their strength after the news calmed down. Events like this one are excellent buying opportunities as Freeport itself is usually unaffected. Its Grasberg mine is located on top of a mountain 2,000 miles from Indonesia’s capital Jakarta. After the bombing of the Marriott hotel in Jakarta on August 5th 2003, Freeport’s stock only declined 1.5%, in line with the market that day, and rose to new highs in the days following the attack. This is a clear indication that Indonesian headline risk is diminishing for Freeport. Don’t be confused, Freeport is a US company based in New Orleans and its shares are listed on the NYSE under the ticker FCX, but its largest operation, Grasberg, is located in Indonesia. Moreover, lower than expected copper and gold prices could have a negative impact on Freeport’s share price. In the short term, with the stock trading at new 10-year highs, investors could take some money off the table.

Conclusion reeport McMoRan Gold & Copper truly deserves to be a High Flyer. Its impeccable operating performance, its opportunistic use of low interest rates to strengthen its balance sheet and the stock’s excellent performance in 2003 make the company a great example of how improving fundamentals can boost the stock price. Just like the stock has rallied since April 2003 – hitting new highs almost every week – the fundamentals for the company as well as the gold and copper market have improved continuously.

One Year Chart of Freeport’s Stock Performance

Risks

he risk to investing in Freeport comes in several forms. Most importantly, the political risk is obviously higher in Indonesia than in the US or Europe. Negative Indonesian news flow, though mostly unrelated to Freeport, can lead to irrational selling pressure. For example, the Kuta Beach bombing last year had SPRING 2004 HARVARD INVESTMENT MAGAZINE 35

LATIN AMERICAN ECONOMIES AND GLOBAL MONETARY DISORDER

Why “Pesofication” or “De-dollarization” is a Bad Idea Domingo Cavallo is Robert Kennedy Visiting Professor in Latin American Studies, Department of Economics, Harvard University. In Argentina he was Minister of Finance (1991-1996 and 2001) and Minister of Foreign Affairs (1989-1991). In 1997 he created his own political party Acción por la República- and was elected National Congressman (1997-2001). He also served as National Congressman from 1987 to 1989 and as Chairman of the Central Bank of Argentina in 1982. Mr. Cavallo holds a Ph.D. from Harvard University and a doctorate in Economics from Cordoba National University.

The economy is becoming increasingly global as a consequence of declining transportation and communication costs. Since the creation of the GATT, later transformed into the WTO, a Global Commercial Order has been emerging. In previous episodes of globalization, international monetary institutions like the Gold Standard and the Bretton Woods’ System provided also a Global Monetary Order. But that is not the case nowadays. Outside Europe, monetary institutions and policy decisions continue to be predominantly national with almost no global coordination.

Domingo F. Cavallo Edited by Kuanysh Batyrbekov

HARVARD INVESTMENT MAGAZINE

Global Monetary Disorder Each country is assumed to have a national currency and it is advised to grant independence to its Central Bank to pursue price stability. So, there are almost as many so-called “independent monetary policies” as national economies and the exchange rates fluctuate widely as a consequence of those different policies interacting with real cross-border shocks affecting national economies. Globalization of financial markets and the increasing facilities for cross border capital mobility offer savers of a particular national economy the opportunity of investing abroad whenever their savings are in danger of being eroded by inflation, taxation or any kind of confiscation. That is why the fluctuations of exchange rates have a much larger impact on emerging than on mature economies making their financial systems more vulnerable to external shocks. In contrast with the order imposed in the past by the Gold Standard and the Bretton Woods’

System, I call the current situation a “Global Monetary Disorder”. There is strong intellectual support for the idea that trade negotiations to establish global trade institutions will strengthen growth potential in all the engaged national economies. But that is not the case for the organization of a truly international monetary system. This is unfortunate for emerging economies because monetary institutions are at least as important as trade institutions to facilitate investment decisions in a Global Economy context. I will argue that for the Latin American economies, inadequacy of national monetary institutions and absence of an international monetary system capable of providing an anchor for national institutions may be a more important impediment for growth than the existing restrictions to foreign trade. Latin American economies have tried to overcome these obstacles through total or partial dollarization, but nowadays the mood in Washington is that they should de-dollarize their economies. This is the point I will argue against in this presentation. Instead I suggest that emerging economies should enlarge the monetary choices of their people by facilitating the use of the Euro together with the Dollar.

Growth, Investment and Productivity Growth comes from investment and increased factor productivity. For sure, investment projects will start to be evaluated if there is demand for the goods and services that the increased capacity is able to produce. Eliminating distortions through deregulation and trade liberalization at the national level and engaging in fruitful international trade negotiations is for sure a good strategy for emerging economies to create investment opportunities. The competition created by deregulation and trade liberalization reassures that the investment opportunities that are created will call for the most productive technologies and will push up factor productivity. But once the investment opportunities are created, investment will only be decided and implemented if there is capital available. And capital originates in savings. The first step for an emerging economy to make capital available to investors is to create the institutions that will

mobilize domestic savings as to accumulate capital within the national economy. Once foreign savers see that the nationals of a particular country are investing their savings in their economy, they will start considering taking cross border risk and invest in that country.

Monetary institutions The monetary institutions that different countries have adopted relate to their past experience. Countries with a long history of price stability and responsible monetary policy have fully convertible national fiat currencies managed by independent monetary authorities and floating exchange rates. This is the case of the United States of America, The United Kingdom, Japan, Canada, Australia, Singapore and most European Union nations before the creation of the Euro. Countries that in the past suffered inflationary processes encounter difficulties to build monetary institutions that will be trusted. To overcome these difficulties these countries have tried different institutional arrangements. The participation in an expanded monetary area is the best example. Countries like Italy, Spain, Greece and Portugal could remove the inflationary expectations from interest rates by joining the Euro and started to get the benefits of a trustable currency and stable monetary institutions. Eastern European nations will have the possibility of using this mechanism to find an anchor for their still unstable national monies.

Monetary institutions in Latin America Not having the possibility of joining a monetary union, most Latin American economies very often have used the US dollar as an anchor for their domestic monetary regimes. The use of the dollar as a crucial ingredient of national monetary institutions in Latin American economies adopted different forms. Most of the Latin American economies have, at least for some period of time, adopted a weak peg to the US dollar. Chile did it in the early 80’s, Mexico in the early 90’s and Brazil in the mid 90’s.There are nations that have fully dollarized their economies. This is the case of Panama, El

SPRING 2004 HARVARD INVESTMENT MAGAZINE 37

Countries that in the past suffered

Salvador and Ecuador. Some countries have let their currencies to compete with the US dollar. This is the case of Peru and Uruguay, countries where most of the time deposits and longer term contracts are written in dollars. Finally there are countries that have not only made contracts in dollars legally enforceable but in addition have adopted a strong peg through a currency board arrangement for the national currency. This is the case of Argentina.

inflationary processes

encounter

difficulties

build monetary institutions that will be trusted.

The opinion of the International Financial Institutions The opinion of International Financial Institutions and the economic profession on the merits and pitfalls of these monetary arrangements has been changing. Since the Mexican and Brazilian crises they have definitively disregarded the weak pegs and have advised the countries to move toward flexible exchange rates and organize independent Central Banks capable of conducting inflation-targeting as national monetary policy. After the crisis in Argentina, the same institutions and economists are starting to disregard strong pegs as well as partial and full dollarization. Although they have not been very specific on it, they have been pushing the new monetary alchemy: “Pesofication” or “de-dollarization”. In my opinion they are making a wrong reading of the Argentinean crisis. They overlook the responsibility that the changes in monetary institutions had in making the crisis deeper and more intractable. What they do not realize is how important the dollar is in each one of these emerging economies as an anchor for their monetary institutions and as a protector for the property rights of savers. De-dollarization or Pesofication is a bad idea Forcing changes in monetary institutions to facilitate desired adjustments in relative prices is a bad idea because it leaves the economy without reassurances of legal protection for savings and destroys the mechanisms that allow mobilizing domestic savings as to provide financing for domestic investment. The advice to transform dollar contracts into peso contracts at the exchange rate prior to the

38 HARVARD INVESTMENT MAGAZINE SPRING 2004

floatation tries to prevent the insolvency of debtors in dollars that follows a large devaluation. But as a consequence of the forced dedollarization, the creditors, including the depositors in the banks, suddenly find that the currency composition of their portfolios is not the desired one. Their attempt to rebuild the desired DollarPeso composition sharply increases the demand for dollars provoking a much larger devaluation of the Peso. In addition, most of the creditors will sue the debtors and the Estate to get back their dollars. This adds uncertainty to the end results, including the budgetary impact of the Pesofication. The case of Argentina 2002 shows clearly that the attempt to set the “right prices” by changing the monetary institutions of the 90’s have aggravated the recession and destroyed the “property rights” of savers. No emerging economy should be advised to follow that strategy if it wants to preserve the possibility of renewing growth through investment and productivity increase. Argentina itself will have to work hard and soon to rebuild its monetary institutions as to reassure savers that their financial wealth will be protected from arbitrary changes in the rules of the game. Rather than banning the use of dollars for domestic financial intermediation and trying to force the savings in pesos, the new rules of the game should enlarge the monetary choices of argentines. Facilitating the use of the Euro will give the Argentinean Central Bank the possibility of having not only the Dollar but also the Euro as an institutional monetary anchor. The Peso will also be available for medium and long term contracts if financial indexation is permitted. If the Central Bank manages monetary policy in such a way that overtime argentines are convinced that the Peso provides as good protection to their savings as the Dollar and the Euro, they will probably end up using Pesos most of the time. By then Argentina will have the monetary system that prevails in economies with a long history of price stability. If instead Argentines are obliged to save in Pesos and from time to time monetary policy is used, like in the past, to wipe out debts, the country will continue missing the monetary and financial institutions that nourish economic growth.

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