Financial Analyst Journal

Sullivan, Rodney N.; Arnott, Robert D.

doi: 10.2469/faj.v62.n1.2780pmid: N/A

This report details a successful 2005 for the FAJ as it celebrated its 60th anniversary with a conference of industry leaders—Reflections and Insights—and a year-long series of Reflections articles.

Siegel, Jeremy J.; Schwartz, Jeremy D.

doi: 10.2469/faj.v62.n1.4055pmid: N/A

The S&P 500 Index is continually updated, with approximately 20 companies added each year and an equal number dropped. In the study reported here, the returns to all 500 of the original S&P 500 companies and returns to the continually updated index were calculated from March 1957 through 2003. Contrary to earlier research, this study found that the buy-and-hold returns of the 500 original companies have been higher than the returns to the continually updated S&P 500 and with lower risk. Furthermore, the original companies in 9 of the 10 industry sectors outperformed the new companies added to the index.

Antia, Murad J.; Meyer, Richard L.

doi: 10.2469/faj.v62.n1.4056pmid: N/A

Reducing the marginal tax rate on dividend income was not the optimal modification of the tax code. The U.S. corporate tax code continues to favor debt over equity because corporate interest payments are tax deductible whereas dividend payments are not. The recommendation in this article is that dividend payments be deductible at the corporate level and fully taxable to investors at their marginal income tax rates. The benefits should be a decline in debt financing and bankruptcy risk, substantial increases in dividend payouts, fewer stock option grants to managers, a decline in the equity risk premium, and higher stock valuations.

ap Gwilym, Owain; Seaton, James; Suddason, Karina; Thomas, Stephen

doi: 10.2469/faj.v62.n1.4057pmid: N/A

Recent evidence for the U.S. market has shown that, contrary to popular wisdom, the greater the proportion of earnings paid out as dividends, the greater the subsequent real earnings growth. This study extends previous work by examining whether a similar relationship exists in 11 international markets and by considering the role the payout ratio plays in explaining future real dividend growth and returns. Higher payout ratios do indeed lead to higher real earnings growth—but not to higher real dividend growth. This information has limited use, however, for predicting future returns.

Altman, Edward I.; Rijken, Herbert A.

doi: 10.2469/faj.v62.n1.4058pmid: N/A

The role and performance of credit-rating agencies are currently under debate. Several surveys conducted in the United States reveal that most investors believe rating agencies are too slow in adjusting their ratings to changes in corporate creditworthiness. It is well known that agencies achieve rating stability by their through-the-cycle methodology. This study provides quantitative insight into this methodology from an investor's point-in-time perspective and quantifies the effects of the methodology on three, somewhat conflicting, objectives: rating stability, rating timeliness, and performance in predicting defaults. The results can guide the search for an optimal balance among these three objectives.

Shaffer, Sherrill

doi: 10.2469/faj.v62.n1.4059pmid: N/A

An important problem for portfolio managers is how to adjust the valuation of equity for the risk that the company may fail. Traditional adjustments seem ad hoc, and previous research on the topic has ignored the irreversible nature of failure. Here, a standard equity valuation model is extended to include a parsimonious but rigorous correction for a stationary annual probability of failure. Although the correction is nonlinear, it can be reduced to an equivalent function that enters the valuation equation in the traditional additive way. Empirical benchmarking suggests that, even without assuming risk-averse investors, this approach comes closer to predicting observed equity premiums than the traditional approach.

Kwag, Seung-Woog; Shrieves, Ronald E.

doi: 10.2469/faj.v62.n1.4060pmid: N/A

Whatever the source or explanation of bias in forecasts of company earnings, if such bias persists, it is potentially discoverable and exploitable by investors. This research addresses (1) whether characterizing forecasts as if they were a homogeneous group with respect to bias is accurate or useful and (2) whether a long-term record of forecast errors contains information useful in predicting subsequent errors. We found that earnings forecasts are heterogeneous with respect to direction and degree of bias. We also found evidence of extremes in optimism and pessimism and that extreme errors tend to persist in the same direction, which suggests certain potentially profitable trading strategies.

Chen, Peng; Ibbotson, Roger G.; Milevsky, Moshe A.; Zhu, Kevin X.

doi: 10.2469/faj.v62.n1.4061pmid: N/A

Financial planners and advisors increasingly recognize that human capital must be taken into account when building optimal portfolios for individual investors. But human capital is not simply another pre-endowed asset class; it contains a unique mortality risk in the form of the loss of future income and wages in the event of the wage earner's death. Life insurance hedges this mortality risk, so human capital affects both optimal asset allocation and demand for life insurance. Yet, historically, asset allocation and life insurance decisions have been analyzed separately. This article develops a unified framework based on human capital that enables individual investors to make these decisions jointly.