Letter number 21 of December 2006


News : Dow Jones versus Eurostoxx

Why has the Dow Jones index risen above its historical high of 2000, while the Euro Stoxx 50 still has a long way to go, as illustrated by the relative performances of these two indices since 1991 (rebased at 100):

There are two possible explanations.  Either US groups have been faring a lot better than European groups since 2000 or the instrument used to measure performance (the Dow Jones or the Euro Stoxx 50) is skewed, like a scale that always tells you that you weigh around five pounds more than you really do!

It is in fact quite easy to spot the explanation behind the different figures.  It’s the composition of the Dow Jones and the calculation methods it uses rather than anything else.  The performance of two indices which are both composed of a wide range of firms - the S&P 500 and the Euro Stoxx 600 (euro zone) - shows that both the US and the European stock markets have yet to achieve their historical highs of 2000:

The S&P 500 still has to rise by 10% and the Euro Stoxx 600 by 18% if they are to beat their records set in 2000. 
The Euro Stoxx 50 is strongly correlated to the European market as a whole, as represented by a major index like the Euro Stoxx 600:

On the other hand, the performance of the Dow Jones, especially since 2000, is generally disconnected from the performance of the US market, represented by a major index like the S&P 500:
The explanation for this disconnection between the two US indices since 2000 is the small share of technology, media and telecoms (TMT) stocks on the Dow Jones and the larger share of industry stocks, which obviously withstood the bursting of the TMT bubble a lot better than TMT stocks did.
The reason why the Dow Jones is less representative than the Euro Stoxx 50 is because the market capitalisations of the companies listed on the Euro Stoxx 50 account for 38% of the euro zone market cap, compared with 26% for the companies listed on the Dow Jones as a percentage of the US market cap.
There is a logical explanation for this.  Because the US stock market is twice the size of all of the stock markets in the euro zone put together (in terms of market capitalisation), an index containing only 30 firms in the USA compared with 50 for the Euro Stoxx 50, is likely to be less representative of its market than the Euro Stoxx 50 is of its market. 
In addition, the specific way in which the Dow Jones is constructed helps to make it less representative.  Also, among the 30 largest US market caps, only 18 are included on the Dow Jones index.  The large market capitalisations that are missing include Bank of America (5th largest market cap), Berkshire Hathaway (13th), Cisco (14th), Chevron (15th), Google (16th), Wells Fargo (19th), Conoco Phillips (24th), Pepsi-Cola (25th), Oracle (26th), Wachovia (28th), Amgen (29th) and Genentech (30th).
On the other hand, it does include 3M (54th), McDonalds (61st), Dupont de Nemours (70th), Caterpillar (81st), Honeywell (89th), Alcoa (132nd) and General Motors (172nd).
The only big market caps missing from the Euro Stoxx 50 are EDF (4th biggest in terms of market cap but very small free float) Mittal Steel (27th), Banca Intesa (35th), GDF (42th), KBC Groupe (44th), BMW (48th), Inbev (49th) and Volkswagen (50th).
Finally and most importantly, the weighting of the stocks included on the Dow Jones index is totally disconnected from financial reality as they are not weighted on the basis of market capitalisations and free float (as is the case of European indices), but on the basis of stock prices.  In other words, the weighting of General Motors, with its share trading at $35, is similar (2.3%) to that of General Electric (2.3%) which is also trading at $35, while the car maker has a market capitalisation of 18 times that of General Electric ($20bn compared with $365bn), the second largest market cap in the world.

Pfizer, which accounts for the second smallest share of the Dow Jones (1.8%) is the 9th largest US market capitalisation.  IBM, which accounts for the largest share of the Dow Jones (6.1%) is the 17th largest US market capitalisation.  If the Dow Jones were to include the Berkshire Hathaway stock, Warren Buffet’s company and 13th largest US market capitalisation, currently trading at around $100,000, it would account for 98.5% of the index! We can thus conclude, without much risk of being wrong, that the Dow Jones should change the way in which it calculates the index or the Omaha firm should carry out a massive split (1) if it hopes to join the Dow Jones index one day!
(1) For more on splits, see the glossary on www.vernimmen.com.

Statistics : P/E ratios

For 2007, the European weighted average P/E ratio is 14. Maximum is 23.3 for Software companies and minimum are financials (banks and insurance) which are currently traded on the basis of 11 times 2007 net income and energy shares on a P/E ratio of 10.

Research : The small world of the coporate elite

The effectiveness of boards of directors, a determining factor in the performance of a system of corporate governance, is a major topic for research in financial literature.
In an article published in 1989, Andrei Schleifer and Robert Vishny wrote: “A crucial function of the board of directors of a listed firm is to monitor the management team and to replace it when necessary”.  An effective corporate governance structure should reward the efforts of management properly and fairly and at the same time, provide shareholders with the possibility of sanctioning management in the event of poor results or disreputable behaviour.
While this is all well and good in theory, measuring the effectiveness of control exercised by a board of directors is in practice a real challenge. As Michael Weisbach (1) put it: “Unfortunately, most of the daily work of the board of directors is invisible”. Consequently, financial researchers try to work out how effective boards are by analysing the link between the characteristics of a board and some of the results and decisions of the firm in question.  A myriad of factors have been looked at, from the size of the board, its composition, the frequency of meetings, the separation of the function of chairman from that of CEO, the percentage of shares held by directors, etc.  A few basic conclusions have been arrived at following studies carried out in several countries the most important of which is that the greater the independence enjoyed by the board, the more effective it will be.  However, the independence of boards has generally only been measured in terms of the number of independent directors as a percentage of the total number of directors, even though the definition of an independent director (a director who is neither a present or past employee and who has no commercial relationships with the firm) remains vague. 
B. Nguyen-Dang, who was awarded the 2006 European Finance Association prize for research for his thesis (2), looked at relationships that are perhaps informal, but very close, between CEOs and directors, that have given rise to a sociological phenomenon known as the "small world of the corporate elite". 
In many countries, the corporate elite, which includes the executives and directors of many large firms, are all on very chummy terms.  They've all been to the same business schools and universities, come from the same social milieu, and have formed lasting relationships that are kept up through well-organised social circles.  This prompted the sociologist C. Wright Mills to comment that members of the corporate elite “seem to know each other well, to work naturally together, and to belong to many of the same organisations”. Financial research had not however factored in this sociological observation, which could potentially be the real determinant of the independence and the effectiveness of a board of directors. 
Accordingly, B. Nguyen-Dang posits that when an executive has a relationship with directors, perhaps an informal one but a close relationship nevertheless, it is more difficult for the board to exercise control or to take difficult decisions vis-à-vis this executive.  Additionally, it is easier for executives to control their boards, manipulate voting, discourage unhappy directors from expressing their views, quash draft resolutions even before they can be put on the agenda, and ensure that those directors with whom they have a close relationship will always vote the way they want them to.  The independence and effective operating of such a board will obviously be reduced. 
B. Nguyen-Dang suggests a few methods for measuring the small world of the corporate elite, and tests the assumptions on a sample of the largest listed French companies between 1994 and 2001. Even though this “small world” phenomenon exists in many countries, France is ideal ground for testing it, as the French corporate elite is widely perceived as an impenetrable network built on long-standing friendships, often formed at the highly selective French Grandes Ecoles or in the civil service. 
B. Nguyen-Dang’s findings show that contrary to received opinion, board control over executives is effective in France.  Poorly performing managers will regularly be shown the door.  However, social networks reduce this effectiveness.  Executives who are part of highly selective social circles within the business elite tend to underperform their peers.  When a CEO and some of the directors are members of the same social circles, the CEO enjoys double protection.  Firstly, such CEOs are less likely to be fired if the company is performing poorly, and are more likely to find other jobs which are at least as good as their previous ones.  B. Nguyen-Dang’s research confirms previously published findings that executive turnover decreases as the number of directorships they hold in other companies increases.  It is more likely that an executive holding several directorships will be asked to sit on even more boards following a good performance.  State involvement and the political cycle also seem to influence the effectiveness of a board of directors.  Executive turnover is less sensitive to performance in state run companies, but incumbent executives are generally replaced every time there’s a change in government. 
(1) Weisbach Michael, 1988, Outside directors and CEO turnover, Journal of Financial Economics 20, 431-460.
(2)  Nguyen-Dang Bang, 2006, Corporate Elite’s Small world and effectiveness of boards of directors, EFE 2006 Paper, http://ssrn.com/abstract=864184

Q&A : A small quizz (Part I)

1. The Dow Jones has got back to its historic highs of 2000 but the EuroStoxx 50 has not yet managed to do so because:
- US firms are doing better than European firms
- The Dow Jones does not reflect fluctuations in its market capitalisation as accurately as the EuroStoxx 50 does
- The Dow Jones does not include any technology, media and telecom (TMT) firms
2. SEPA stands for:
- System for European Payment Advances
- Société Européenne Par Action
- Single Euro Payments Area
3. The net debt to EBITDA ratio at the start of an LBO is:
- Always below 5x
- Always above 6x
- Varies depending on the sector
4. The margin required by banks on the Tranche A of a senior debt in an LBO is generally:
- Between 175 and 225 basis points
- Above 250 basis points
- Below 150 basis points
5. To qualify for listing on the London Stock Exchange, a firm must:
- Be headquartered in the UK
- Have a share capital of at least €1,000,000
- Have financial records going back two years
6. When adjusting capital employed to equity, a firm's net debt on its seasonal activity corresponds to:
- Net debt on December 31
- Net debt on June 30
- Average net debt over the year
7. The Naulot report concerns:
- The European takeover directive
- The banning of shares with double voting rights in Belgium
- The role of independent experts in France
8. Under IAS, fungible stocks can be valued:
- Using the LIFO method
- Using the FIFO method
- Using the identified purchase cost method
9. In Islamic finance:
- In theory, interest at a fixed rate cannot be charged on a bank loan
- In theory, the interest rate on a bank loan must be fixed
- In theory, the duration of a bank loan should not exceed 7 years
10. In the consolidated financial statements of a listed German company:
- Goodwill must be booked as a fixed asset and depreciated over a maximum of 40 years
- Goodwill must be booked as a fixed asset and written down if necessary
- Goodwill is systematically set off against shareholders’ equity
11. The value of a put option rises:
- If the exercise price is low
- If the volatility of the underlying asset is low
- If interest rates are low
12. What percentage of bank loans do banks in Europe sell on, directly or indirectly, to institutional investors:
- Less than 20%
- Around 40%
- Over 60%
13. PSR stands for:
- Personal Savings Rates
- Preferential Subordinated Rates
- Preferential Subscription Right
14. Company A, with a P/E ratio of 12 acquires Company B on the basis of a P/E ratio of 25.  The acquisition is fully financed using debt at 3% after tax:
- This acquisition will have no impact on Company A’s EPS
- This acquisition will be accretive to Company A's EPS
- This acquisition will dilute Company A's EPS
16. A firm carrying debts with an overvalued share price can create value for its existing shareholders:
- By buying up its own shares at market price
- By carrying out a capital increase
- By buying up its own shares at a premium to the market price