Double Digit Dilemma - Assignment Example

Reading Header: CASE TITLE: “DOUBLE DIGITS DILEMMA – WHEN NUMBERS ADD UP TO A BIG REACTION.” Your institution: Your name: Course name: Course instructor: March 31, 2010 Brief abstract or summary This paper deals with case study by Fiona Buffini and is titled as the “Double Digit Dilemma” and actually handles a case where the numbers add up to a big reaction in the stock market evident by the sudden shift in market share prices due to actions by wealthy investors in line with the information that they receive from the management either by mistake or planned. It deals with a case of Coca Cola Amatil Bottlers manager, Terry Davis; announced profit growth of the firm for the half was going to be 10 percent instead of a predicted double digit growth, while in a Macquarie Bank Investment Conference. The firm was expecting a fifth year of double digit profits growth, while on the other hand analysis was predicted a 14 % growth in earnings in the same period. The market reaction was so swift that the 120 fund mangers who were listening to Terry Davis watched the stock price fall, while at same time the company issued an Australian Stock Exchange statement whereas the managers began emailing traders using their blackberries. During that day, the share price of the bottler firm fell by more than 14% and closed down at 7.2%. This strength of the sell-off surprised the Coca Cola Amitil that that he decided to issue a clarification statement in an attempt to downplay the reaction by stating that, “Ypu need to manage the business and the share price will take care of itself, and at times of market overreact, it’s the nature of the stock markets” (The economist newspaper, 1996). Preamble/introduction Question 1 The distinction between a 10% and a double digit growth rates, when number itself is a double digit is that when mangers present growth prediction as a double digit figure, investors would be expecting a wide range of possible expectations ranging from 10% itself to as high growth as 30% or even above 50%, which is highly positive and desirable for investors who are expecting great earnings. Hence the main difference is that 10% is specific and lacks incentive towards investors while stating as a double digit figure is speculative on the part of investors and hence provides incentives to maximize on it as there is still room for improvement. The implications that this information signal portray to investors as in the case of Coca-Cola Amatil boss Terry Davis is that when he announced growth for the period to be 10%, investors become demotivated as it portrayed a sense of lack of improvement. The analysts had previous predicted that the growth would be 14% but then the target has not been attained hence this was a negative incentive for investors as evidenced by the fact that the share price dropped drastically by 14% and closed at 7.2%. This would not have happened should Terry Davis have announced it to be a double digit figure which would have left investors guessing what the actual percentage would actually be. Also direct marketer Salmat was heavily punished with a 10% reversal in its share price for saying that its full-year profit would be at the lower end guidance. Question 2 I do think that by expressing the expected earnings growth rate to be “about 10%” instead of a “a double digit figure “ by the Chief Executive Officers of companies should not deserve a 7% drop in the share price. This is because the growth rate is not really very far from there prediction by the CEO and also the prediction is made after results had been analyzed. The huge unexpected reaction of the market as far as Coca-Cola Amatil is concerned was a surprise as expressed by the Co-managing director Peter Mattick, since the company had issued the same statement the previous year, yet there was no such reactions. This calls for managers to evaluate their information contents and the kind of signals they portray to investors in the market while anticipating their reactions depending on the market dynamics/climate at the moment without having to rely on past reactions to the same information signals. It is thought that these reactions happened with Coca-Cola Amatil because of the presence of market perceptions and the market was overheated and everyone got a bit scared. Most investors were thinking that they had a great run; hence it was their time to take a bit of profit and run, even though most firms were traveling pretty well with low debt, solid profit and cash in hand. Mattick also says that while managers cannot guess the market for a second time, investors and analysts are most of the times focused on the short term profits/gains hence they end up overreacting to certain small predictions. He continues to advice that in business, investors should learn to take a three- to five-year view of things, though at times the market seems to want to take a shorter-term view. Also other corporations that have issued recent downgrades say the resulting share swings are distracting to management and company boards, while an anonymous manager says that it has no positive incentives to managers who work hard and rewarded with share swings by the shareholders because certain short-term wordings and predictions Question 3 In my view concerning market reaction to the direct marketer Salamat prediction about the expected earnings which was so swift and punishing, given that there was no such reactions to the same guidance that was issued in the previous year is that the managers should not rely on the past market behavior since dynamics of stock markets change with time. During the period under the case study, there have been a lot of market perceptions and the market was highly overheated with every investor being scared. Everybody wanted to reap profits and run even though businesses who well geared with low debts and adequate cash in hand. Direct marketer Salmat, while at the Macquarie Bank conference had said that the company’s full-year profit was going to be at the lower end guidance. He was promptly punished with a 10% reversal in the company’s share prices. Another reason that resulted in heavy punishment of Salamat was because the investors and analysts are often focused on short-term business performance while managers often focus on long term performance hence agency crisis easily arise when actual results fall short of the target predictions. These swings distract managements and boards in the prediction (Shiller, 2006). Question 4 I agree with the statements of the Suncorp chairman John Story who says that all corporations want to be valued correctly and that this applies on an equal measure to upgrades. He postulates that should one get an upgrade and the market overreacts, one would get expectations out in the marketplace, and should that fails to be satisfied, it might have a very adverse effect too on the company performance. It’s also true that executives would be willing to forgo economic value in order to meet a short-term earnings target as found out by a recent study of 400 United States executives. This is because of the severe market reactions. The study confirmed that 78 percent of top executives would be willing to avoid a positive net present value project should it mean missing a quarter’s consensus earnings (Mishkin, 2007). An example is that of David Shirer, who is a spokesperson of PaperlinX. His company’s stock fell by 15% after it slashed its full-year profit forecast just after saying that it had no update to make. He says that, “there’s an awful lot of volatility....we have to manage the business on a long-term basis and the market is pricing everything on a very short-term basis.” Another example is that a spokesman of Great Southern Plantations, known as David Ikin, who says that the 17% share price fall that his company experienced after it missed an unofficial sales target despite having reported record profits was disappointing. He postulates that, “In this market, anything that’s given as a forecast becomes locked in the minds of investors, and it punishes you beyond reason when you fall short” (Stretton, 1999). Final example is that of a Macquarie Graduate School of Management finance professor, Tyrone Carlin, who says that he would be surprised if there would be no empirical research on earnings management in Australia going on. He continues to say that, “I don’t think it’s specific to this point in the market or business cycle, it’s something that goes on all the time.” “If you’ve got executives who have a lot of wealth riding on the share price ....or if you’re worried about shoring up the value of your options or you’re on an earnings-linked bonus scheme, I can understand why people might be tempted to do this,” Carlin says, ‘I can’t see any real merit in placebo numbers. We should be given the real thing – investors don’t need sugar coating of the story” (Mladjenovic, 2006). Branching out to existing literature In the United States, for a share to be listed in the NASDAQ it must be priced at $1 or more. This is normally delisted if its price falls below that level and it becomes OTC (over the counter stock). Also a stock is required to retain the price of more than $1 or more for 10 trading consecutive trading days during every month. In spite of this many companies in the U.S. try to keep their share price low, partly because of the round lot trading. Round lot trading is the practice of selling share in multiples rather than singly. A corporation will normally adjust its stock price for various shares while maintaining the price of other shares. Random walk is used by economists and financial theorists as a model behavior of asset prices, and in particular shares prices on the financial markets, commodity markets and currency exchange rates. The presumption in this practice is that investors act rationally and with no bias. At any time they estimate the asset value base on the future expectations. It is notable that all the existing information affects the price of the asset and it only changes when new information comes out. New information will normally be random and the influence on the price will also be random (Copeland, et al, 2005). Studies have shown that prices are not always on the random walks. There are low correlation existing in the short run and slightly stronger correlations over the long run. The strength and sign depend of various factors. Research has shown that some of the biggest price deviations result from temporal and seasonal patterns. Particularly, returns in January exceeded significantly in other months. Monday stock price are lower than on any other day. These effects have been noted for many years by observers but they have not been able to any satisfactory explanation. Historical data movement is used in technical analysis to extract information on future price. Some economists argue that these patterns are more accidental than result of irrational or inefficient behavior of investors. Also there is a possibility that the large amount of data used by researchers could be the cause of fluctuations. Behavioral finance is another area of study which has come to try to shade some light on this scenario of stock price. Emotional biases and attribute to non-randomness to investors cognitive are some of the behavioral factors that could affect the price of assets in the stock market. When observed over long periods of time, the share price is proportional to the earnings and dividends of the company. On the other hand over short periods, the relationships between dividends and share prices are unmatched especially for small and young companies. Stock prices change daily according to the market operations. Sellers and buyers make the prices to change and the prices change result from supply and demand. All this activities between the buyer and the sellers, demand and supply decide to what extent is the value of each share (Brealey, 2007). If more people are willing to buy the share than to sell it, the price will go down. Even when one has only one share he or she owns the company. Therefore, the price indicates the feel of an investor of what the share is worth. Stock prices can be stable for several months of change wildly which is called volatility. Hundred of variables drive the stock prices but earnings are the most important. Earnings are described as profit of the company after deductions and taxes have been removed in order to attain the net profits. Other factors affecting stock market The listed share prices in stock market keep fluctuating constantly going up and down due several factors that happen from business units to individuals through to a complicated economic systems and environment. This is because all economic activities do not operate in a vacuum since the business world is inter-connected and boundless, hence the slightest of tremors are able to detonate earthquakes, too much rain may also decrease or increase rates of interests. Stock markets react uncharacteristically and promptly to rumors of negative political climate, alterations in business regulatory environment, El Nino vagaries, and also rates of interest vary according to the general economic performance. Therefore the share prices of stocks in market are affected either negatively or positively by various factors that occur within and without the economic frame/system. The domestic factors involving those originated from within the country while those that impact the investment and business from outside the business environment are categorized as global/external factors. Thus, one should first ascertain both the internal and the external factors before making decisions that concern selling or buying of shares. This would enable investor to determine the kind of factors influencing the market hence would be able toe establish good timing for selling or buying the shares. Share prices are normally higher, traditionally, when economy of a country is performing well and stronger and they are normally lower when the nation’s economy encounters poor economic performance due to varied shocks. Stock market trends are determined to a great extent by the interest rates as they play major roles in the same upward market normally regarded as bull market is characterized by low rates of interests while a bears market which is a downward trend market, is associated with interest rates which are very high. Demand for capital, on the other hand determines the interest rates, which normally pushes them up thus indicating that the economy is performing well or thriving and that the stock share prices have also risen i.e. are expensive. Low demand for capital depicts low interest; hence liquidity on the other hand would build up in the economy, while share prices are driven down. Profits/ earnings of corporations are often of much issue in investment of shares with companies which are performing well in their operational activities are often likely to attract a lot of rich investors, thus resulting in shares being demanded highly. Whereas firms doing poorly in business would have their investors tending to sell their shares in the market hence this would result in extra shares flooding the stock market thus pushing prices down, since too much of a commodity in market results in price decline. Factors of perception also contribute to fluctuation of share prices for instance, the fact that south Africa is categorized as an economy that is developing would, hence means that general perceptions towards economies developing will also impact on share prices of the local industries. Conclusion Prices are able to fall as they rise quickly, whichever way the wind blows, hence confounding the best industry plans while rescuing firms from brinks of disaster is no overemphasized. These great unknowns/random forces are able to integrate with daily supply and demand laws, including the business cyclical nature in order to shape the valleys and peaks of markets dynamically shifting. Investors and mangers might not be able to make predictions on these forces, but through analysis and understanding, one would be better informed/equipped to encounter/weather the lows while waiting for the fortune tide to turn, since the above are only the factors that influence movement of share prices on the exchange market. References Brealey R., 2007, Principles of corporate finance, 2nd Ed., Tata McGraw-Hill: ISBN0070635803, 9780070635807 Copeland T. E., et al, 2005, Valuation: measuring and managing the value of companies: volume 294 of Wiley finance series, 4th Ed., John Wiley and Sons: ISBN0471702188, 9780471702184 Mladjenovic P., 2006, STOCK INVESTING FOR DUMMIES, Wiley India Pvt. Ltd: ISBN8126507772, 9788126507771 Mishkin F. S., 2007, the economics of money, banking, and financial markets 8th Ed., Pearson Addison Wesley: ISBN0321422813, 9780321422811 Stretton H., 1999, Economics: a new introduction, 2nd Ed., Pluto Press: ISBN0745315364, 9780745315362 Shiller R. J., 2006, Irrational Exuberance, 2nd Ed., Currency/ Doubleday: ISBN0767923634, 9780767923637 The economist newspaper, 1996, The Economist, Vol. 340, Issues 7973-7976, The Economist Newspaper Ltd., University of Michigan Read More