The folks in the treasurer’s office who earn their keep playing the active management game spend their time chasing past winners and diversifying across managers. Why diversify? Because, as noted, managers’ performance can be highly unstable. The workers in the treasurer’s office will be evaluated relative to their counterparts at other sponsors. Therefore, it will pay for these people to diversify across styles. If they avoid value funds, and value funds do well in a particular year, their judgment will be called into question. Therefore, better to use the services of a manager who uses the value style. A similar remark applies to other styles: growth, small cap, emerging funds, and so forth.
Regret and Responsibility
There are interesting differences between institutional money managers and mutual fund managers. Mutual fund managers provide superior returns to investors, but offer no hand-holding. However, the folks in the treasurer’s office choose money managers in accordance with their own comfort levels. They need effective hand-holding in order to feel comfortable. An important element of this comfort is exposure to regret.
Meir Statman and I (Shefrin and Statman 1986) discuss the roles of regret and responsibility in the money management industry. Regret, as previously noted, is the psychological pain associated with realizing after the fact that the wrong decision was made (see chapter 3). The magnitude of regret affects the degree to which the person who made the decision feels responsible.
The treasurer’s office directs pension assets by transferring the responsibility for investment decisions to money managers. If things go well, employees can pride themselves on having selected top performers. However, if things do not go well, they can mitigate the criticism directed at them by blaming the managers. People look for ways to minimize their exposure to regret. One way is to behave conventionally. Sponsors now routinely diversify across active money managers, even when superior index fund alternatives are available. Sponsors can also make active managers the scapegoat when returns are poor. This also serves to enhance the level of comfort by mitigating possible future regret.
Of course, the pain of regret may also play a role in learning, analogous to the pain experienced by touching a hot stove. The latter experience helps us learn to avoid touching hot objects. However, shifting regret to money managers inhibits learning about the most effective ways of managing the sponsor’s assets.
Money managers may not completely understand this part of the game. They too have personal needs for pride and are averse to regret. Consequently, they may take steps to reduce the blame directed at them. For example, many managers engage in “window dressing,” hiding the identity of poor investment choices from sponsors by selling them before the end of the reporting period.
Gary Brinson, Randolph Hood, and Gilbert Beebower (1986) analyzed the performances of ninety-one large U.S. pension plans over the period 1974–1983, comparing the performances of these plans to that of strategic asset allocation. Two important numbers came out of that study. The first number was 1.1 percent. That is, the average fund underperformed a strategic asset allocation approach by 1.1 percent.
What does this tell us? Roughly speaking, it suggests that the value paid for scapegoating services is about 1.1 percent. After all, sponsors are perfectly able to use passive management. But they don’t, and on average 1.1 percent is what they give up. Of course, that assumes sponsors know how much they are giving up. Another possibility is that because of heuristic-driven bias they do not. Instead, sponsors believe that the active managers they hire are likely to outperform strategic asset allocation. This might happen because of a combination of the hot hands phenomenon, stemming from representativeness, and the usual overconfidence.
The second number that came out of the Brinson-Hood-Beebower study was 93.6 percent, which is the R-squared from a regression of pension plan returns on the returns to strategic asset allocation. This second number is often described by saying that strategic asset allocation is “90 percent of the game.”12 But that description is misleading at best, in that it is suggestive of relative performance. The R-squared says nothing about relative performance.
Consider a hypothetical situation in which active pension fund managers always earn returns that are double those of strategic asset allocation. This is what would happen if pension fund managers simply bought the market portfolio on 50 percent margin. In this hypothetical situation, the R-squared for a regression of pension fund returns on strategic asset allocation is 100 percent.
Does this say that strategic asset allocation is “100 percent of the game”? To say so is to admit that little potential value is generated by tactical asset allocation. Yet Statman (1999) points out that over the period 1980–1997, the marginal gain to effective tactical asset allocation would have been 800 basis points. The point is that “93.6 percent” tells us the degree to which pension fund returns move in the same direction as the returns to strategic asset allocation. But that figure says nothing about relative performance.
Summary
The institutional money management industry has a split personality. One half is highly concentrated and stable, consisting of large banks and insurance companies offering generic products. The other half is unstable, consisting of a large number of money managers offering active money management and specialized services. In many ways this segment is like the market for restaurants and beauty salons, with customers always in search of new favorites and the latest hot spots.
A combination of private interests and behavioral phenomena provide the basis for the existence of this active segment. Both frame dependence and heuristic-driven bias play major roles.
Frame dependence occurs as the sponsor divides responsibility for its portfolio across several active money managers. These managers are evaluated relative to benchmarks. The division of the portfolio gives rise to a mental accounting structure with particular reference points. This leads sponsors to react more strongly to outcomes that fall below a reference point than to outcomes that lie above it. Mental accounting also leads to the view that diversification means having variety across styles rather than maximizing expected returns subject to a fixed return variance.
An important aspect of active money management is scapegoating, or shifting regret to, the manager when returns are poor. Given the fact that active managers underperform strategic asset allocation, the amount of underperformance may serve to measure the value of scapegoating.
Scapegoating is one explanation for why sponsors select active money managers. Another is that sponsors are overconfident, believing the active managers they hire are likely to outperform strategic asset allocation. This might happen in conjunction with a hot hands phenomenon stemming from representativeness.
Part V The Interface Between Corporate Finance and Investment
Chapter 16 Corporate Takeovers and the Winner’s Curse
Corporate executives suffer from “Lake Wobegon syndrome”: Lake Wobegon is the mythical rural Minnesota community where all children are above average.1 Lake Wobegon syndrome pertains to hubris, overconfidence about ability. In chapter 4, I mentioned that most people rate themselves as above-average drivers. In this chapter, I discuss how overconfidence affects corporate decisions, mostly associated with mergers and acquisition.
There is general evidence that corporate executives exhibit hubris—they are impressed with their own abilities. Since July 1996, the Financial Executives Institute and Duke University have been jointly surveying corporate executives on a quarterly basis. During the first two years of the survey, executives of companies whose stocks are publicly traded have consistently indicated that their companies were undervalued.2
Corporate decisions offer ample examples of heuristic-driven bias and frame dependence. This chapter offers several examples: excessive optimism, the illusion of control, gambler’s fallacy, and loss aversion. Hubris, however, is the primary bias involved in corporate takeovers because it leads to the phenomenon of winner’s curse, where the acquiring firm overpa
ys for the target. Richard Roll (1983) coined the term hubris hypothesis for this effect.
This chapter discusses the following:
• the role of hubris in the decision by American Telephone and Telegraph (AT&T) to take over computer maker NCR
• how after the takeover, loss aversion led AT&T to throw good money after bad
• what the general literature has to say about the winner’s curse in corporate takeovers
Case Study: AT&T’s Bid for NCR
Let’s begin with some history. Once upon a time AT&T thought it would be the premier computer company in the world. Its research arm, Bell Laboratories, had produced truly revolutionary break-throughs such as the transistor and UNIX, a major operating system. The switching technology that forms the backbone of a telephone network is essentially a computer. Therefore, AT&T had every reason to see itself as the leading computer firm.
But for seven years in the 1950s, AT&T fought an antitrust suit brought by the U.S. Justice Department. When it ended in 1956, AT&T signed a consent decree agreeing not to market its computers outside its own company. This agreement stayed in force until 1984, when a landmark agreement took effect that broke up AT&T’s monopoly in the telephone business and created seven independent regional phone companies.
No longer bound by the 1956 agreement, AT&T entered the computer market with a line of medium-range machines that used its UNIX operating system. But AT&T ran into a series of difficulties. It could not produce its machines fast enough to meet consumer demand, or cheaply enough to be especially profitable. In 1986, just two years later, its computer division was generating losses at the rate of $1 billion annually. By the end of the 1980s AT&T was widely recognized as a failure in the computer business, having lost between $2 and $3 billion.
On December 2, 1990, AT&T announced its intention to acquire NCR, at the time the fifth-largest computer maker in the United States. What was AT&T’s rationale in choosing NCR?
AT&T’s chairman at the time was Robert E. Allen. In Allen’s view, corporations, led by banking and retailing, were increasingly coming to rely on permanently connected networks of computers to transact business instantaneously. So from his perspective, AT&T would supply the networking capability and NCR would provide the transaction technology. Allen put it as follows: “It’s a natural marriage between our communication services and network skills and their transaction service operations all over the world.”3
The Behavioral Basis for Winner’s Curse
Analysts greeted the announcement with skepticism, viewing the proposed merger as a high-stakes gamble. They pointed out that virtually every merger between technology companies in recent years had failed. At the time, the largest technology takeover was Burroughs Inc.’s 1986 $4.8 billion acquisition of Sperry Univac. The entity resulting from that merger was Unisys. Unisys was the product of a hostile takeover and produced a string of losses.
A situation very similar to the AT&T/NCR case was IBM’s purchase of Rolm. This deal was designed to produce the same marriage of computers (IBM) and telecommunications (Rolm) that AT&T was pursuing with NCR. When the IBM/Rolm combination failed to create value, IBM sold Rolm to Siemens, the German technology firm, and wrote off its losses.
Robert Kavner was AT&T’s top computer executive and the architect of its hostile takeover attempt of NCR. During a news conference that December, Richard Shaffer, a technology analyst and principal of the firm Technologic Partners, put the following issue before Kavner: “It sounds like hyperbole, but no one I know can think of a single example of where a large high-technology merger has been really successful. And it’s hard to see how AT&T’s play for NCR would be any different.”4 Shaffer then asked Kavner if he could name any high-technology merger, even a friendly one, that had been successful. Apparently embarrassed by the question, Kavner mumbled that he could not.
Why did AT&T executives believe that they could succeed where others had failed? When dealing with similar questions that were posed to Kavner, Robert Allen did acknowledge that “it’s going to be tough” not to repeat history. But he argued that the NCR deal offered AT&T unique opportunities to increase its core telecommunications business and enter the emerging market for networked cooperative computing, meaning computers linked by telephone lines.
Consider the behavioral biases here. Were AT&T’s executives overconfident? Might they have been unduly optimistic? Did hubris lead them to believe that they could succeed when all others had failed? I suggest that the answer to each of these questions is yes.
There may have been other behavioral biases at work as well. Allen commented on the risk attached to his strategy, stating: “This is not a safe world. And we’re not looking for safety. Taking the easy, less-risky way is not satisfactory because it won’t make us successful.”5
Think about this statement in light of AT&T’s losses in its computer operations. Do you recognize any patterns that have been discussed in earlier chapters? What about loss aversion—taking risks that are unlikely to pay off, especially after having incurred a loss?
Did AT&T suffer from the illusion of control, believing that it was more in control of the situation than, say, IBM had been in dealing with Rolm? Was AT&T influenced by its experience in previous deals? For example, in January 1988 it had agreed to purchase up to 20 percent of workstation manufacturer Sun Microsystems. One year later, AT&T took a 49 percent stake in AG Communication Systems, a joint venture with GTE Corp. that makes telephone switching equipment. In March 1989, AT&T acquired Paradyne Corp., a manufacturer of data communications equipment, for about $250 million. Twelve months after that it entered the consumer credit card business with the AT&T Universal card, available through either Visa or MasterCard. Some of these deals had shown early promise. However, none were comparable in magnitude to the NCR acquisition.
The Fine Act of Overpaying
Discussions between AT&T and NCR actually began on November 7, 1990. At that time, NCR shares were trading at $48. In private discussions, AT&T had offered to pay $85 per share in a stock swap, a premium of 77 percent. When the NCR board rejected this offer, AT&T announced that it planned to acquire NCR shares in a takeover attempt, and increased its bid to $90, an 88 percent premium.
During the previous week, NCR shares had closed at $56.75. How did the market react the day of AT&T’s announcement? Well, the price of NCR shares jumped dramatically, surging by $26.50 to $82.25. NCR stock was the second most actively traded issue on the New York Stock Exchange that day. Not surprisingly, the most active issue was AT&T. But unlike NCR, whose stock rose, the price of AT&T shares fell by 2⅛ to $30.
How did the combined market value of the two stocks change as a result of the announcement by AT&T? This is an important issue, in that it reflects investors’ collective assessment of the merits of the merger. On the previous Friday, the market value of AT&T’s 1.1 billion shares was $35.33 billion, and the market value of NCR’s 64.5 million shares was $3.66 billion. The combined value, $39 billion, actually declined slightly to $38.3 billion on the day of the announcement!6
Was Robert Allen doing the shareholders of AT&T a favor? Not on December 2, 1990. What about the shareholders of NCR? It might certainly seem so. Given the small change in combined value, the effect of the announcement was to transfer $1.65 billion from the shareholders of AT&T to the shareholders of NCR.
However, keep in mind that the NCR board had rejected an offer of $85 a share. What were they thinking? Were they still anchored on NCR’s 52-week high, which was $104.25? If so, were they reluctant to sell below this reference point? Or were they committing gambler’s fallacy by anticipating a reversal? It is worth keeping this point in mind as we trace through the negotiations that ensued over the following months.
In December 1990 the NCR board rejected AT&T’s bid of $90 a share, but it expressed a willingness to talk if AT&T would agree to a price of $125 a share. This offer corresponded to a premium of 120 percent, relative to the price of NCR shares just prior to AT&T
’s announcement. Apparently, AT&T thought the price was too high, and instead of accepting the counteroffer it began a proxy battle to take control of NCR’s board. Two days after its $90 offer was rejected, AT&T asked NCR shareholders to hold a special meeting to remove the board.
The proxy battle took place during the first four months of 1991. During the public relations campaign Charles Exley, chairman of NCR, reminded investors that history had shown that such takeovers turned out to be “calamities!” Exley pointed out the difficulties of bringing disparate corporate cultures together, and he stressed the indirect costs associated with having the attention of top-level executives distracted by the merger instead of being focused on the core competencies of the firms. But because technological developments continue to occur, “the competition has a field day at your expense,” he was quoted as saying.7
On March 28, the day of the shareholders’ meeting, AT&T and NCR announced that for tax reasons they had agreed to a stock swap in which AT&T would pay the equivalent of $110 a share.8 In September 1991, the two companies filed merger papers in Maryland, where NCR had been incorporated, thereby concluding a $7.48 billion dollar deal.
The Chickens Come Home to Roost
AT&T implemented the takeover by having its own computer division absorbed by NCR. In this regard, it focused attention on promoting NCR’s high-powered 3000 series of computers. AT&T merged marketing groups, announced phased plans to discontinue a variety of product lines, such as minicomputers and client/server systems, and terminated previous arrangements with firms such as Intel and Sun Microsystems.9 At the time, the overall cost of this streamlining was estimated at $1.5 billion.
Beyond Greed and Fear Page 29