Divergence of opinion in the presence of restrictions on short selling has implications for mergers and for value additivity.
A stock’s equilibrium price will be just adequate to attract the mar- ginal investor. Furthermore, marginal investors will generally be those who are most optimistic about a particular stock’s outlook. Recognizing the marginal investor’s role opens the possibility (indeed probability) that the marginal investors may be different for different securities.
It is well known that different investors use different methods for eval- uating investment opportunities.45 Also, different methods frequently lead to quite different portfolios. For instance, managers are often classified by
“style” into “value” managers and “growth” managers. Investors with different styles buy different securities, with growth investors often being the marginal investors for growth stocks and value oriented investors for
“value” stocks (those with low price-to-earnings ratios, or low price-to- book ratios). Stocks can be described as having clientele groups, that is, groups who view them as being worthy of inclusion in their portfolios.
Conglomerates
The implications for mergers of divergence of opinion theory can be understood with the aid of a simple example using the data shown in Exhibit 14.3. It is assumed that there are two types of investors, those
45As shown in Madelon DeVoe Talley, The Passionate Investors (New York: Crown Publishers, 1987); John Train, Dance of the Money Bees, A Professional Speaks Frankly on Investing (New York: Harper & Row, 1974); and John Train, The Mon- ey Masters, Nine Great Investors: Their Winning Strategies and How You Can Ap- ply Them (New York: Harper & Row, 1980), for example.
EXHIBIT 14.3 Conglomerate Price Determination
Growth Drugs Value Brands Diversified Industries Growth Investors $100 ($240) $50 ($120) $150 ($360) Value Investors $50 ($120) $100 ($240) $150 ($360) Market Price $100 $100 $150
who are willing to extrapolate a history of growth forward several years (growth investors), and those who base decisions on estimates of value with no allowance for growth (value investors). Imagine there are just two securities, Growth Drugs and Value Brands. Growth Drugs appeals to the value investors who forecast a future value of $240 for it versus a forecast of only $120 for Value Brands. After discounting, the growth investors are willing to pay $100 now for a share of Growth Drugs and
$50 for a share of Value Brands. Likewise, the value investors estimate that Growth Drugs will be worth only $120 in the future, while Value Brands will be worth $240. After discounting, they are willing to pay only $100 for Value Brands and $50 for Growth Investors.
If the two companies are separate, Growth Drugs will sell for $100.
All of the value-oriented investors will offer their stock for sale when the price rises above $50. Then competition among the growth investors will bid the price up to $100. In equilibrium all of the Growth Drugs stock is held by the growth investors. The value-oriented investors regard the stock as overvalued. Notice that although they view the stock as overvalued, they do not regard it as a good potential short sale since they believe that it will rise in price to $120. To sell short at $100 and to buy back at $120 (a higher price) is not a profitable trade for the inves- tor who does not get prompt use of the proceeds.
Likewise, Value Brands would sell for $100. The growth-oriented investors view it as a stodgy company not expected to experience fur- ther growth, and will sell if offered more than the $50. The value-ori- ented investors will offer more (since from their view point it has a comparative advantage for inclusion in their portfolios) and competing among themselves will bid the price up to $100. Thus, both Growth Drugs and Value Brands would sell for $100 per share.
How much should a merged company sell for where each share rep- resents a claim to the cash flow of one share each of Growth Drugs and Value Brands? Textbook theory suggests the merged company should sell for $200, the sum of the values of the parts.
However, inspection of Exhibit 14.3 above shows there are no investors who would be willing to pay $200 a share for the new com- pany. The growth investors would view the merged company as a claim on Growth Drugs, worth $100 because of its growth prospects, and a claim on Value Brands, which their valuation methods estimates to be worth only $50 because of its poor growth prospects. Thus, they would view the merged company as worth $150 per share, with most of this attributable to Growth Drugs.
The value-oriented investors view the merged company as being worth $150 also; $100 for the well-established Value Brands unit plus
$50 for Growth Drugs (their valuation methodology gives little weight
to the growth history of the drug unit, perhaps because they have seen too many failures to maintain historical growth rates).
Thus, there are no investors who will pay more than $150 for the merged company. The supply/demand analysis shows that the merged company would be worth only $150, even though theories assuming perfect information among all investors predict that value additivity will hold and the total price will be $200. A simple implication is that it will not be in the interests of the two firms to merge.
Suppose the merged firm was already in existence. There would be an immediate profit from breaking it up. The stock would be trading at $150 while the component parts could each be sold for $100. The stockholders would be tempted to break the company up for an instant profit. If the management did not make the proposal, an outside entrepreneur would be tempted to buy control and then sell the parts separately. In some cases he might desire one unit, and realize he could acquire the desired unit by pur- chasing the whole and then selling the unit he did not desire to others (who presumably would pay more for it because their valuation methods indi- cated it to be worth more). For instance, someone who desired the Value Brands operation might realize he could purchase the combined units and then sell the Growth Drugs unit to someone optimistic about its prospects.
How do firms ever come to be in different industries? Many con- glomerates exist because they make possible real cash flow improve- ments. There is a very large industrial organization literature on when combined firms may be more economical.46 In some cases, there are economies from combining different operations. Sometimes these may disappear after the operations are large enough to be self-sustaining, creating a situation where a break up is value enhancing. For instance, much hard rock mineral exploration is conducted without being certain what if anything will be found. There are also economies to maintaining expertise in mine design. Thus, many mining companies find themselves mining a variety of minerals. However, since gold mining seems to appeal to a different group of investors than other forms of mining, it may later develop that splitting the firm up is optimal.
Successful research and development may give a company a strong position in an industry outside of its primary industry, or outside of the type of industry that appeals to its primary investors. Often in a new industry a firm will find that it must manufacture the machines it needs for producing its products. Exploiting a new invention may require both producing the machines and then using them to produce a product.
Thus a firm may find itself in both the highly cyclical machinery busi-
46See for instance David J. Ravenscraft and F. M. Scherer, Mergers, Sell-Offs, and Economic Efficiency (Washington, D.C.: Brookings, 1987).
ness as well as in the more stable business of producing a product for consumers. After the business is established, there may be fewer econo- mies from having both machinery and consumer products produced by the same firm and a split up may be feasible.
A common production process may cause a firm to produce several different products or a common marketing arrangement may cause it to produce its own products. These different lines of business may later become candidates for divestitures as conditions change and there are no longer major economies from having production done by one firm.
In other cases, there are clientele groups for mergers. For instance, in the 1960s there were many investors who believed that conglomer- ates improved the management of the firms they acquired. Other inves- tors used analytic methods that used a price-earnings ratio based on historical growth rates in earnings per share. These investors did not distinguish between growth arising from mergers with firms with lower price-earnings ratios, and growth arising from being in a true high growth industry. The investors who applied the acquirer’s high price- earnings ratio to the post-merger earnings (without realizing the new company probably was not as fast growing and should have a lower price-earnings ratio) constituted the price-setting optimistic investors.
Thus, a strategy of continued mergers was wealth creating (for the orig- inal stockholders). Later, when the environment changed or the stream of mergers stopped, being a conglomerate turned into a disadvantage.
Then there was money to be made from breaking the firms up.
In particular, many financial management textbooks describe how a takeover of a firm with a low price-earnings ratio by a high growth, high price-earnings ratio conglomerate will raise the earnings per share of the conglomerate (as well as assets per share). Several years of such mergers will leave a statistical series that looks as if the conglomerate is growing rapidly (which in turn can be used to prove the superiority of its manage- ment). The illusion of growing profits is increased by financing with con- vertible securities and warrants, which do not hurt current earnings. This appears to have happened in the 1960s with conglomerates.47
The above illustrates how divergence of opinion can cause a stream of cash flows to be worth more in parts than the whole is worth. This contrasts with the predictions of the mainstream value additivity theory that the whole equals the sum of the parts. Since the predictions of divergence of opinion theory differ from mainstream value additivity theory, it is interesting to look for empirical evidence on the theories.
47Uwe E. Reinhardt, Mergers and Consolidations: A Corporate-Finance Approach (Morristown, NJ: General Learning Press, 1972), pp. 22–25.
Closed-End Funds and Spin-Offs
To test value additivity, it is necessary to find cases where prices of assets are available as a package and for the components separately. One case is closed-end funds and another is where divisions of firms are spun-off.
A closed-end fund is an investment company that holds stock in other companies, but does not offer continuously to redeem its shares at net-asset prices (unlike a mutual fund). The prices of closed-end funds are set in the competitive markets in which they trade, as are the prices of the stocks of the companies they hold. Usually, closed-end funds sell at a sub- stantial discount to their net asset values,48 a fact Brickley and Schallheim call “an interesting anomaly.”49 A graph of the discounts from 1933 to 1982 shows only two periods with negative discounts.50 Similar puzzling discounts were found for dual-purpose funds.51 Richards et al. found closed-end bond fund discounts of 12.3% (December 1979).52
Malkiel proposed several possible explanations for these discounts but decides that none are adequate, and eventually concluded the mar- ket was inefficient here.53 Thompson showed that profitable trading strategies existed.54
The closed-end fund discount is contrary to the value additivity the- ory but is predicted by the divergence of opinion theory. An investor
48See Thomas J. Herzfield, The Investor’s Guide to Closed-End Funds (New York, NY: McGraw-Hill, 1980); and Rex Thompson, “The Information Content of Dis- counts and Premiums on Closed-End Fund Shares,” Journal of Financial Economics (June 1978), pp. 151–187.
49James A. Brickley and James S. Schallheim, “Lifting the Lid on Closed-End Invest- ment Companies: A Case of Abnormal Returns,” Journal of Financial and Quanti- tative Analysis (March 1985), p. 107.
50William F. Sharpe, Investments (Englewood Cliffs, N. J.: Prentice Hall, 1981). p. 592.
51See Robert H. Litzenberger and Howard B. Sosin, “The Theory of Recapitaliza- tions and the Evidence of Dual Purpose Funds,” Journal of Finance (December 1977), pp. 1433–55, and Robert H. Litzenberger and Howard B. Sosin, “The Per- formance and Potential of Dual Purpose Funds,” Journal of Portfolio Management (Spring 1978), pp. 49–56.
52R. Malcolm Richards, Donald R. Fraser, John C. Groth, “The Attractions of Closed- end Bond Funds,” Journal of Portfolio Management (Winter 1982), pp. 56–61.
53Burton G. Malkiel, “The Valuation of Closed-End Investment-Company Shares,”
Journal of Finance (June 1977), pp. 847–859. For other attempts, see Kenneth J.
Boudreaux, “Discounts and Premiums on Closed-End Mutual Funds: A Study in Valuation,”Journal of Finance (May 1973), pp. 515–522; and Rodney L. Roenfeldt and Donald L. Tuttle, “An Examination of the Discounts and Premiums of Closed- End Investment Companies,” Journal of Business Research (Fall 1973), pp. 129–
140.
54Rex Thompson, “The Information Content of Discounts and Premiums on Closed- End Fund Shares,” Journal of Financial Economics (June 1978), pp. 151–187.
will find that a portfolio of stocks selected by someone other than the investor himself will contain some stocks he would not have chosen himself, either because they did not meet his own unique needs, or because he was less optimistic about them than the portfolio managers for the closed-end fund were. The closed-end fund discount has long been recognized as an anomaly. No alternative explanation able to explain the magnitude of the discount has been offered, although some are plausible and could explain part of the discounts.
Another opportunity for testing the implications of value additivity is to observe what happens when a firm spins-off a subsidiary. Pure value additivity predicts that if the cash flows are not changed by the spin-off then the market value of the separate units will equal the prebreakup value. However, studies have shown that spin-offs create wealth, with the stockholders being wealthier after the spin-off than before.55
At first glance the wealth increases do not appear to be large since the total increase in wealth is small in percentage terms (7% according to Hite and Owers). However, as Hite and Owers put it (the size factor referred to is the percentage of the value of the firm spun-off):
The reevaluations seem quite large in relation to the fraction spun- off. For the overall sample, the median size factor is 0.066 of the combined firm value, and the revaluation of 0.070 during the event period is of the same order of magnitude. Similarly, the point esti- mate for the small group is roughly the same as the size factor.
Even for the large group, the revaluation is about a half the frac- tion spun-off. That spin-offs per se could generate gains roughly equal to the value of the divested unit is to suggest that the market
55Kenneth J. Boudreaux, “Divestiture and Share Price,” Journal of Financial and Quan- titative Analysis (November 1975), pp. 619–626; Gailen L. Hite and James E. Owers,
“Security Price Reactions Around Corporate Spin-Off Announcements,” Journal of Fi- nancial Economics (December 1983), pp. 409–436; Oppenheimer (quoted in Ronald J.
Kudla and Thomas H. McInish, Corporate Spin-offs: Strategy for the 1980’s (Westport, CT, 1984), pp. 46–50; Ronald J. Kudla and Thomas H. McInish, “Valuation Conse- quences of Corporate Spin-Offs,” Review of Business and Economic Research (Winter 1983), pp. 71–77; Ronald J. Kudla and Thomas H. McInish, “Divergence of Opinion and Corporate Spin-Offs,” Quarterly Review of Economics and Business (Summer 1988), pp. 20–29; Katherine Schipper and Abbie Smith, “Effects of Recontracting on Shareholder Wealth: The Case of Voluntary Spin-Offs,” Journal of Financial Econom- ics(December 1983), pp. 437–469; James A. Miles and James D. Rosenfeld, “The Effect of Voluntary Spin-offs Announcements on Shareholder Wealth,” Journal of Finance (December 1983), pp. 1597–1606; and James D. Rosenfeld, “Additional Evidence on the Relation Between Divestiture Announcements and Shareholder Wealth,” Journal of Finance (December 1984), pp. 1437–48, to name a few.
value of the parent’s equity is hardly diminished even though assets are distributed to the subsidiary. The gains seem quite large, to be explained by the savings from using separate specialized contracts in which the parent and subsidiary have comparative advantages.56 Schipper and Smith report similar values for the overall gains.57
The literature discusses several possible explanations for the gains from spin-offs. Both Hite and Owers and Schipper and Smith consider the possi- bility that the spin-off reduces the assets backing the firms’ bonds and transfers wealth from bondholders to equity holders, but find no evidence of bondholders being made worse off.58 Some spin-offs are done to facili- tate mergers but most are not, and those for other reasons report compara- ble gains. Regulatory factors explain some spin-offs, but Hite and Owers report that the legal/regulatory inspired spin-offs actually had negative excess returns over the whole preevent period, but positive returns around the announcement date that were similar to those for all spin-offs.59 Schip- per and Smith report higher returns for regulatory related spin-offs.
Separating operations in different industries might permit better and more specialized management or incentive compensation plans for man- agers related to stock prices. Ravenscraft and Scherer, drawing on both interviews and statistical studies, present evidence that profitability gains in the spun-off units frequently do occur with spin-offs.60 Both Hite and Owers and Schipper and Smith discuss this possibility at length, with Schipper and Smith concluding that it explains the wealth gains with spin-offs. Hite and Owers (in the quote above) question whether it can explain the magnitude of the effect.
While there clearly can be disadvantages to a single management try- ing to manage several different businesses, most of these managerial spe- cialization economies could be obtained by a separate management team for each unit. If anything, if the operation remained a subsidiary, the concentration of ownership in the parent would appear to permit more efficient monitoring than could be done by numerous uninformed stock- holders. Evidence suggests that stock in small firms is valued at less than
56Hite and Owers, “Security Price Reactions Around Corporate Spin-Off Announce- ments,” p. 430.
57Schipper and Smith, “Effects of Recontracting on Shareholder Wealth: The Case of Voluntary Spin-Offs.”
58As discussed by Dan Galai and Ronald W. Masulis, “The Option Pricing Model and the Risk Factor of Stock,” Journal of Financial Economics (January/March 1976), pp. 53–82.
59Hite and Owers, “Security Price Reactions Around Corporate Spin-Off Announce- ments,” p. 432.
60Ravenscraft and Scherer, Mergers, Sell-Offs, and Economic Efficiency.
that of large firms.61 A spin-off typically creates a much smaller firm, one that is usually traded over the counter where transactions costs and liquidity are less. Thus, the gains from improved contracting and man- agement (as Hite and Owers noted) appear unable to fully explain how assets can be spun-off without perceptible effects on the parent’s stock price (the result Hite and Owers report for small spin-offs).
Very closely related to complete spin-offs are equity carve-outs in which only part of a subsidiary’s stock is sold to the public. Schipper and Smith have shown that announcement of carve-outs are accompanied by an average increase in the parent’s stock price of just under 2%, a strong contrast with the typical price lowering effect of announcing a stock sale.62 Although at first glance a 2% stock price gain appears small, it is large rel- ative to the value of the subsidiary interest being sold, which was reported to have a median value of 8% of the parent’s value. This wealth increase represents either a belief that the carve-out was actually going to raise the value of the parent’s interest in the subsidiary by an appreciable amount or a belief that the equity interest sold would be sold for about 25% (2%
gain divided by 8%) more than its value as part of the parent firm. The lat- ter interpretation implies an appreciable violation of value additivity.
Predicting Firms for Which Spin-Offs and Divestitures Are Likely
Given there are often stock price increases (as shown above) when spin-offs or carve-outs are announced, it would be useful for investors to be able to predict the types of firms for which these are most likely. Spin-offs are pre- sumably most likely when the parts will be worth more than the whole, as discussed above. One distinguishing characteristic of firms that do spin-offs is a firm with operations in widely differing industries. There are not likely to be any appreciable synergies from combining operations in different industries, and thus there are no lost economies of scale from breaking the firm up or diseconomies from dissolving integrated operations.
Schipper and Smith examine the industries of spun-off operations and document that in only 21 out of 93 spin-offs is the parent in the same broadly defined industry.63 They interpret this as supporting their
61For instance, Donald B. Keim, “Size Related Anomalies and Stock Return Season- ality: Further Empirical Evidence,” Journal of Financial Economics (June 1983), pp.
13–32.
62Katherine Schipper and Abbie Smith, “A Comparison of Equity Carve-Outs and Seasoned Equity Offerings,” Journal of Financial Economics (January/February 1986), pp. 153–186.
63Schipper and Smith, “Effects of Recontracting on Shareholder Wealth: The Case of Voluntary Spin-Offs,” p. 462.