Sharekhan - Stock Updates

Cipla
Cluster: Cannonball
Recommendation: Buy
Price target: Rs375
Current market price: Rs342

Robust growth

Result highlights

• Cipla's Q1FY2006 revenue was Rs662.8 crore as compared to Rs533.4 crore in Q1FY2005 (an increase of 24.2%) primarily because of the increase in exports.
• The operating profit grew by 40.4% over Q1FY2005 and stood at Rs149.9 crore. This was due to increasing operational efficiency as the total expenditure increased by only 20.2% compared to a 24.2% increase in the net sales. 
• The profit before tax rose by 37.5% year on year (yoy) at a slower pace than the growth in the operating profit. The slowdown was due to the decrease in the other income that decreased to Rs8.36 crore as against Rs11.9 crore in Q1FY2005.
• The profit after tax (PAT) increased by 40.6% over Q1FY2005 to Rs111.4 crore. This was helped by a decrease of 166 basis points in the effective tax rate, which stood at 22.3%.
• At the current market price of Rs342, the stock is trading at 22 x FY2006E earnings.

Genus Overseas Electronics  
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs150
Current market price: Rs115

Profit meter on a roll

Result highlights

• Genus Overseas Electronics' net sales for Q1FY2006 increased by 24.7% year on year (yoy) to Rs41.52 crore on the back of a strong order backlog of Rs100 crore.
• Its operating profit margin (OPM) for the quarter declined by 50 basis points as the other expenditure increased by 68% yoy. The increase was primarily because of an advertising campaign launched in April 2005 to promote Genus' products like inverters and settop boxes.
• The operating profits for the quarter stood at Rs3.86 crore, up 18.5% yoy. 
• The company's interest expenses for the quarter declined by 9% and depreciation increased BY 10.8%; consequently the profit before tax (PBT) for the quarter stood at Rs2.54 crore, registering a growth of 33.8%.
• The net profit for the quarter stood at Rs2.1 crore as against Rs1.52 crore in Q1FY2005, marking an increase of 38.3% yoy.
• The order inflow during the quarter maintained a strong momentum with Rs65 crore worth of order inflow.

Indian Petrochemicals Corporation
Cluster: Apple Green
Recommendation: Book profit
Current market price: Rs189

Book profit

Result highlights

• Indian Petrochemicals Corporation Ltd's (IPCL) net sales for Q1FY2006 were higher by 9.6% compared to that in the corresponding quarter last year. However, the volume growth for the quarter was limited to 2%.
• The operating profit for the quarter grew by 27.5% as the operating profit margin (OPM) expanded by 300 basis points.
• IPCL's profit before tax grew by 62.6% for Q1FY2006 to Rs317 crore, aided by higher other income and lower interest cost.
• The net profit for the quarter was at Rs225 crore, up by 83% due to the lower tax rate.
• The volume growth for the quarter was at just 2%. The cracker margins for ethylene-based derivatives have also shown a steep decline. Hence we recommend investors to book profit on the stock.

Maruti Udyog

 
Cluster: Apple Green
Recommendation: Buy
Price target: Rs636
Current market price: Rs465

Strong growth continues

Result highlights

• Maruti Udyog Ltd (MUL) registered a 5.9% year-on-year (y-o-y) growth in Q1FY2006, despite a decline in the volumes by 1.4% year on year (yoy). 
• The contribution margin expanded by 60 basis points yoy to 21.7%, while the operating profit margin (OPM) remained flat at 12.4%. 
• The net profit registered a strong growth of 32.5% yoy to Rs226.5 crore. 
• MUL's Q1FY2006 results are in line with our estimates. At the current market price of Rs465 the stock is discounting its FY2006E earnings by 12.1 times. We reiterate our Buy call on MUL with a price target of Rs636. 

Sintex Industries 
Cluster: Apple Green
Recommendation: Buy
Price target: Rs650
Current market price: Rs595

Powering ahead

Result highlights

• Sintex Industries Ltd's (SIL) revenues grew by a robust 44.7% in Q1FY2006 to Rs146.7 crore on the back of the strong performance of both the Textile and Plastic divisions. 
• The Plastic division reported a year-on-year (y-o-y) revenue growth of 39.2% in the quarter to Rs100.5 crore. The margins improved sequentially by 310 basis points to 10.5%. 
• The Textile division's performance was good with a 52.4% growth in the revenue to Rs47.3 crore. A higher offtake by Canclini (a joint venture) led to the better performance of the division. 
• The operating profit margin (OPM) was maintained at 17.2% in the quarter compared to the same period last year. However the OPM was down by 70 basis points on a sequential basis primarily on account of the lower realisation in Canclini's business. 
• The profit after tax (PAT) growth was robust at 144.5% in the quarter to Rs14.5 crore, partly driven by the strong performance in both the businesses and partly due to the deferred tax write back of Rs3.5 crore in the quarter.
• The earnings for the quarter stood at Rs7.8 per share, in line with our estimates.
• SIL's board has approved a proposal of sub-division of one equity share of Rs10 paid-up into 5 equity shares of Rs2 paid-up.
• SIL trades at an enterprise value (EV)/earnings before depreciation, interest, tax and amortisation (EBDITA) of 7.1 x FY2007E and price/earnings ratio (PER) of 12.8 x FY2007E. We maintain our Buy call with a price target of Rs650 with an investment horizon of 12 months.

State Bank of India  
Cluster: Apple Green
Recommendation: Buy
Price target: Rs950
Current market price: Rs801

Results ahead of expectations

Result highlights

• State Bank of India (SBI) reported a strong growth of 19.9% in its net interest income (NII) for Q1FY2006.
• The growth in the NII came on the back of a 32.5% growth in advances year on year (yoy). The deposits grew by 13% yoy.
• SBI's core operating profit grew by a strong 22% yoy as the expenses were under control.
• The net profit grew by a slower 15.6% yoy to Rs1,222.8 crore for the quarter as the provision for the amortisation of the premium on investments lying in the Held-till-maturity (HTM) portfolio shot up significantly.
• At the current market price of Rs800.8 the stock is quoting at 1.1x its FY2007E consolidated book value. We maintain our Buy rating on the stock with a revised price target of Rs950.

Union Bank of India  
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs150
Current market price: Rs128

Bank on track

Result highlights

• The net interest income of Union Bank of India (UBI) grew by 14.6% year on year (yoy) in Q1FY2006.
• The advances were up by 28.2% while the deposits grew by 18.7% yoy.
• The operating profit of the bank was down 10.2% yoy.
• The net profit increased by 14.3% yoy. 
• At the current market price of Rs128, the stock is discounting its FY2006E earnings by 8.2 times and FY2006E adjusted book value by 1.3 times. We reiterate our Buy call on UBI with a price target of Rs150

Sharekhan - Jaiprakash Associates

Jaiprakash Associates 
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs291
Current market price: Rs246

Price target revised

Result highlights

• Jaiprakash Associates Ltd's (JAL) net revenues grew by 12% year on year (yoy) in Q1FY2006 to Rs817 crore.
• Its cement revenues grew by 25% driven by a volume growth of 23% and a realisation growth of 2% during the quarter.
• The construction revenues grew by 5.6% yoy to Rs548 crore driven by a strong order backlog of Rs6,800 crore as on June 30, 2005.
• The operating profit margin (OPM) rose by 100 basis points to 19% during the quarter. The growth was driven by the strong volume growth in the cement business and savings in power costs.
• The profit before tax (PBT) increased to Rs96 crore, up 19% quarter on quarter (qoq), while the profit after tax (PAT) increased to Rs54 crore. The PAT saw a marginal growth of 4% primarily because of a higher tax outgo.
• During the quarter the company sold off its 36.6% stake in Jaiprakash Hydro Power Ltd (JHPL) and realised a profit of Rs360 crore.

Networth Stock Broking - Faze Three

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Motilal Oswal - Ashok Leyland

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Indiainfoline - Triton Valves

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Motilal Oswal - Tata Tea

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Motilal Oswal - Vardhaman Textiles

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Motilal Oswal - Vijaya Bank

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Hindu Businessline Recommendations

BUY     >> Andhra Sugars, SAIL
SELL    >> I-Flex Solutions, Cosmo Films, KPIT Cummins
                    Corporation Bank
HOLD   >> L&T, Taj GVK

Satyam & Geometric - Sharekhan

Satyam Computer Services  
Cluster: Apple Green
Recommendation: Buy
Price target: Rs 570
Current market price: Rs 533

Numbers ahead of expectations

Result highlights

• Satyam Computer Services' Q1FY2006 results were better than our expectations.
• The company's top line surged by 8.5% quarter on quarter (qoq) on the back of a good volume growth of 8.7%.
• The operating profit grew by 2.5% qoq. 
• The operating profit margin (OPM) fell by 140 basis points in line with our expectations. The company expects its margins to improve in the coming quarters. 
• The net profit declined by 3.7% qoq. 
• The company plans to acquire Singapore-based data warehousing (DW) and business intelligence (BI) solution provider KDP soon. 
• It has marginally revised upwards its guidance for FY2006. 
• At the current market price the stock is quoting at 14.9x FY2007E earnings. 
• We maintain our Buy call on the stock and upgrade it to the Apple Green cluster.

Geometric Software Solutions Company 

Cluster: Emerging Star
Recommendation: Buy
Price target: Rs 630
Current market price: Rs 545

Price target revised upwards

Result highlights

• Overall Geometric Software's Q1FY2006 numbers are slightly below our expectations.
• The company's top line fell by 2.6% on a quarter-on-quarter (q-o-q) basis. The top line numbers are marginally below our expectations. 
• The decline in the top line resulted in a higher-than-expected fall in the operating profit margin (OPM). 
• The operating profit fell by 36.1% quarter on quarter (qoq). 
• A higher other income helped the company in controlling the fall in its net profit, which decreased by just 3.7% qoq.
• At the current market price of Rs545 the stock is quoting at 10.4x FY2007E earnings. 
• We maintain our Buy call on the stock with a revised price target of Rs630

Riding the Ciprofloxacin wave..

The prices of Ciprofloxacin bulk drug are on a continuous rise on the back of shortage of raw materials. In the domestic market, prices have moved up more than 100% from Rs.900/Kg in January to more than Rs.1950/Kg now. The trend is not expected break for 6-8 months from now.

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Networth Stock Broking - Assam Co.

Networth Stock Broking Recommends

BUY     >> Assam Company

Target >> 450

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Motilal Oswal - Shree Cement

Motilal Oswal Recommends

BUY - Shree Cement

Target 430

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IDFC IPO - Equitymaster

Equitymaster recommends SUBSCRIBE on IDFC IPO

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Motilal Oswal - Geometric Software

Motilal Recommends BUY

Target - 610

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Equitymaster - Geometric Software

BUY - Target - 750

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Kotakstreet - Andhra Sugar

Andhra Sugar Report

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Archives

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Motilal Oswal - Reliance Energy

Reliance Energy - Motilal Oswal Report

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Motilal Oswal - Indo Gulf Fertilizer

Motilal Oswal - Indo Gulf Fertilizer

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Sharekhan - ICI & Deepak Fertilizers

ICI India 
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs330
Current market price: Rs285

Strong numbers for quarter

Result highlights

• ICI India reported a strong revenue growth of 25% for Q1FY2006 to Rs215.4 crore year on year (yoy). The growth was achieved on the back of a good growth in the businesses of both paints and chemicals.
• The paint business grew at 24.5% yoy to Rs155 crore owing to an optimised product mix in favour of premium brands, thereby vindicating our assumption of a 25% growth in the business for FY2006.
• The chemical business grew by 25% yoy to Rs89.7 crore, as its new polymer adhesive plant became operational in Q4FY2005 and textile chemicals (surfactants) reported a good growth.
• The company's operating profit grew by 52.4% as the operating profit margin (OPM) expanded by 180 basis points yoy.
• The profit after tax but before exceptional items went up by 37.7% yoy to Rs16.6 crore. 
• At the current market price of Rs285 the stock is quoting at an enterprise value (EV)/earnings before interest, depreciation, tax and amortisation (EBIDTA) of 4.4x its FY2007E EBIDTA. We maintain our Buy call on the stock with a price target of Rs330 based on our sum-of-parts valuations.

Deepak Fertilisers & Petrochemicals Corporation 
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs126
Current market price: Rs71

Strong quarterly numbers

Result highlights

• Deepak Fertilisers and Petrochemicals Corporation (DFPCL) reported a strong revenue growth for Q1FY2006 at 23.5% year on year (yoy) to Rs138.3 crore on the back of a strong growth in the ammonium nitrate business.
• The ammonium nitrate business grew by 138% yoy on the back of a 93% year-on-year (y-o-y) growth in the volumes and the balance from the growth in realisations. DFPCL has shown intentions of expanding its capacity for ammonium nitrate looking at the supply shortage.
• The operating profit grew by 49.5% as the operating profit margin (OPM) expanded by 480 basis points yoy.
• The profit after tax went up by 72.2% yoy to Rs22.7 crore as the effective tax rate for the quarter was lower.
• DFPCL's expansion plans are well on track with the isopropyl alcohol (IPA) plant expected to go on stream by the end of FY2006.

FMCG sector to grow over 50 pc by 2010

From Hindu Business Line

Fast Moving Consumer Goods (FMCG) sector will witness more than 50 per cent growth in rural and semi-urban India by 2010, according to an analysis carried out by the Associated Chambers of Commerce and Industry of India (Assocham).

In totality, it is projected to grow at a CAGR (compounded annual growth rate) of 10 per cent and increase its market size to Rs 100,000 crore from the present level of Rs 48,000 crore.

The growing penchant of rural and semi-urban folks for FMCG products will be mainly responsible for this development, as manufacturers will have to deepen their concentration for higher sales volumes.

In the rural and semi-urban areas, FMCG market penetration is currently less than 1 per cent in general as against its total growth rate of about 6.2 per cent, the President of Assocham, Mr Mahendra K. Sanghi, said while releasing the analysis.

The analysis is based on the feedback obtained from various district industry centres all over the country on the future demand-supply situation of FMCG products.

Mr Sanghi said the Indian rural market with its vast size and demand base offered a huge opportunity that FMCG companies cannot afford to ignore. With 128 million households, the rural population is nearly three times the urban.

Though the rural and semi-urban demand of FMCG products will grow, it will put a severe pressure on the margins of manufacturers of FMCG products due to cut-throat competition, finds the analysis. Companies in the sector to benefit will include known names such as Nirma, HLL, Dabur, ITC, Godrej, Britannia, Coca-Cola, Pepsi, among others.

The chamber is of the view that the rural market may be alluring but it is not without problems such as low per capita disposable incomes and large number of daily wage earners.

Some of the other problems associated with rural markets are acute dependence on the vagaries of the monsoon, seasonal consumption linked to harvests, festivals and special occasions, poor roads and power problems.

The other difficulty that FMCG companies are likely to face is that of logistics. India's 627,000 villages are spread over 3.2 million sq km. Delivering products to the 750 million Indians living in rural areas will be a tough task.

Growth visibility to keep valuations intact

Power Sector

The sector continued to remain market performer with all the segment of the industry i.e. generation, transmission and distribution continued the consistent growth. The performance of power equipment companies remained better than the generation companies.

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Networth Stock Broking - Saksoft

Saksoft - BUY - Target - 207

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Sharekhan - OMAX

Cluster: Apple Green
Recommendation: Buy
Price target: Rs178
Current market price: Rs128

(O)MAXimum returns

• Omax Auto is a leading manufacturer of sheet metal, machined and tubular components, and precision components. The company supplies its products to auto majors like Hero Honda Motors, Maruti Udyog, TVS Motor Company, Eicher Motors etc as their chief vendor.
• Omax has strategically re-structured its business model by diversifying its both domestic client base and product portfolio as well as by focusing on exports.
• The company's globally competitive manufacturing facilities will maintain its leadership status in the domestic market, apart from positioning itself strongly in the export market.
• Omax is aggressively scaling up its capacity to capitalise on the domestic and global outsourcing opportunities in the country.
• The company's top line and bottom line are expected to grow at a compounded annual growth rate (CAGR) of 23.5% and 26.1% respectively during FY2005-07E.

Motilal Oswal - Tata Consultancy Services

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IDFC IPO Analysis

Background :

• Infrastructure Development Finance Company (IDFC) was incorporated as a public limited company in the year 1997. IDFC works closely with GOI and other state governments in formulating policies for participation of private sectors in infrastructure development.
• IDFC offers non-fund-based products such as guarantees, debt syndication & advisory services on project and financial structuring. The company's main focus is on energy, telecommunication and transportation projects. Sector wise distribution as on FY 2005 on the above stated areas are 36%. 26% and 25% respectively.
• In order to attract private sector investment in infrastructure projects to supplement public investment, a subsidiary, IDFC Asset Management Company was formed in the year 2002.
• GOI and IDBI holds 40% shares, other domestic players like SBI, ICICI and others hold 20% of the shares and foreign holdings accounted for 40% of the share capital.

Objects of the Issue :

• To augment the capital base to meet future capital requirements arising out of growth in business and other general corporate purpose.
• Enhance its brand name and provide liquidity to its existing shareholders and employees.
• Meet Issue related expenses.

Strengths :

• Total Income and profit after tax has been growing at a CAGR of 23% and 21% respectively from FY2001 to FY2005. Growth prospectus is bright as all the indicators show that reform momentum, opportunities for growth and financing opportunities in infrastructure sector continues to grow robustly.
• Similarly net approval and outstanding disbursements increased at a CAGR of 20% and 48% respectively from FY2001 to FY2005.
• IDFC is in advantageous position over the banks, as the company does not have to maintain a CRR and SLR. Operating expenses to asset ratio is 1:5.
• Experienced professionals manage IDFC. As GOI holds 35% of its share capital, the company has the access to the policy makers and thus will be ahead of competitors.
• At the end of FY 2005, the gross NPA as a percentage of total loan assets and net NPA as a percentage of total loan assets were 0.7% and 0%, respectively. Company's long-term borrowings have been rated as AAA by CRISIL and LAAA by ICRA.

Weakness :

• IDFC is benefited from certain tax incentives on account of favorable treatment to infrastructure related activities. Any change in tax structure will adversely affect the profitability of the company.
• About 87% of the total exposure is towards three sectors (i.e. energy, telecom, transport) and top 10 borrowers accounted for 28% of the aggregate exposures. Either negative trend in any of these sectors or financial difficulties of the borrowers will have an impact on the company.
• The infrastructure financing industry is becoming more competitive. The company faces stiff competition from public and private sector commercial banks and other financial institutions. Many of the competitors have better resources than IDFC.

Valuations :

• Income from Infrastructure operation for FY 2005 has increased by 28% to Rs.6818 million, where as treasury income has declined by 62% to Rs.368 million.
• PAT for FY 2005 has increased by 17% to Rs.3040.23 million. NAV as on 31st March 2005 was Rs.18.89. RONW for FY 2005 was 16.10% as against 15.28% in FY 2004.
• At the price band in the range of Rs.29 to Rs.34, the issue is priced at 1.5 times and 1.8 times its pre-issue book value of Rs.18.89. On FY 2005 unconsolidated EPS (on post-issue equity), P/E works out to 10.7 to 12.6.

Kyoto Protocol

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Motilal Oswal - HDFC Bank

Motilal Oswal >>

Neutral on HDFC Bank

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Hindu Businessline Recommendations

Buy   >>  Infosys, Macmillan, Aegis Logistics
Hold >>   NDTV, Centurion Bank, Bank of Punjab,
               Thomas Cook

Show me the money - Economist

Mysterious happenings in America's international financial accounts

AT THE start of this year, when the American dollar stood at $1.36 to the euro, most economists expected it to stay weak or to become still more feeble. Instead it has since risen by 14% against Europe's single currency, hitting a 14-month high of $1.19 this week. Another puzzle: contrary to dire predictions that America's vast current-account deficit would plunge the country ever deeper into debt to foreigners, recent figures show that foreign debt has actually fallen, relative to GDP, in the past few years. Does this mean that the current-account deficit isn't a problem after all, and that the dollar will keep on climbing? No, it doesn't.

Last year, America had a current-account deficit of $668 billion. In effect, it had to borrow this amount from the rest of the world. However, the new numbers, published last week by the government's Bureau of Economic Analysis, show that America's net external liabilities rose by only $170 billion in 2004, to $2.5 trillion. The mystery goes deeper. Since the end of 2001, America's cumulative current-account deficit has amounted to $1.7 trillion, yet America's net external liabilities have increased by only $200 billion, and have fallen as a percentage of GDP (see chart). What's going on?

The explanation is that the value of foreign assets and liabilities changes with exchange rates and share prices. The rally in global stockmarkets in 2004 boosted the value of America's external assets by more than the value of its liabilities because Americans own more shares abroad than foreigners own in the United States. In addition, foreign stockmarkets outperformed Wall Street last year.

Even more important over the past three years has been the impact of a cheaper dollar. About 70% of America's assets abroad are denominated in foreign currencies, so when the greenback falls, their dollar value rises. Meanwhile, as the home of the world's main reserve currency, America has the advantage that virtually all of its foreign liabilities are in dollars, so that the currency's depreciation does not increase their value. Thus a fall in the dollar boosts America's net wealth.

It may be tempting to conclude that America can comfortably continue to run huge deficits and let a falling dollar erode the real value of its external debt. But foreign investors are not stupid: if they expected a persistent decline in the dollar, they would demand a higher yield on American assets to compensate them for their expected loss. This would increase the current-account deficit.

If the dollar hangs on to its gains, then the end-2005 figures for America's net foreign indebtedness could prove truly shocking. Brad Setser, of Roubini Global Economics, a research firm, estimates that at current exchange rates the capital loss on America's foreign assets could amount to $350 billion this year. Add that to his forecast for the current-account deficit of $820 billion, and it seems that America's net foreign liabilities could leap by $1.2 trillion, to $3.7 trillion by the end of 2005. Of course, a further drop in the dollar and a fall in American share prices could trim those liabilities again in 2006. But that is hardly a reason to buy dollars.

IDFC IPO Analysis

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Carbon Credits

Carbon Credits ?

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Motilal Oswal - Infosys

Motilal Oswal - Infosys - BUY

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Motilal Oswal - Aurobhindo Pharma

Motilal Oswal recommends a SELL on Aurobhindo Pharma

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Hindu Businessline Recommendations

Buy   >>  Rallis India
Sell    >> IL&FS Investment Managers
Hold  >> Titan Industries, Cranes Software,
                Chemfab Alkalis

IL&FS - Update

IL&FS - Oversubscribed 24 times in Retail Category

Duncans Industries - Motilal Oswal

STRONG BUY

Duncan is story without merits. Its fertilizer plant has already started operations.

G P Goenka likely to call press conference shortly to announce the restructuring plans. As per all analyst, G P is likely to sell assets worth Rs 240 crs to meet up the debt of the company in a phased manner.

It has been also projected the fertilizer unit will do business of over Rs 800 crs in the current fiscal and tea around Rs 200 crs and EBITA on the same shall be not less than Rs 90 crs on an Equity of Rs 53 crs. Another Rs 60 crs is projected on account of interest saving on debt restructuring.

Before the closure of the plant, Duncan did business of Rs 1797 crs in 2001. It has got installed capacity of 6.75 lac tons of fertilizers and worked above installed capacity in 2001. It tea production is on an average of 17 mn kgs in last 4 years.

Promoter's stake is as high as 79% and free float as low as 8%. The Networth of the company is Rs 700 crs whereas its debt is Rs 1000 crs. G P is set to reduce the debt substantially by debt restructuring and also be repaying out of the sell of assets of Rs 240 crs.

In short, Duncan is set to return to its lost glory in next 12 to 18 months. It is a repeat of Triveni Sheet glass. Govt has frozen Rs 400 crs subsidy of Duncan which had brought the downfall of Duncan. With GP's fortune changing in right spirit, who knows he will get back his Rs 400 crs from Govt which could a real bonanza.

From tomorrow, almost all the analysts will start tracking this  fertilizer cum tea stock which is riding high at the moment.

Mergers and machismo — Are takeover chiefs acting rationally?

Interesting Read from Hindu Business Line

WHY are some corporate heads so gung-ho about mergers and acquisitions (M&A) when the empirical evidence available strongly suggests that the value created by these exercises accrues almost completely to shareholders of the target company rather than to those of the acquiring firm?

If the popular assumption that corporate chiefs act rationally isvalid, why do so many mergers and acquisitions nevertheless take place? Does this mean that the assumption about the rationality of all corporate heads may, not be entirely valid?

These are some of the questions addressed in a recent study titled Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction, by Ulrike M. Malmendier, assistant professor of finance at the Graduate School of Business, Stanford University, and Geoffrey A. Tate, assistant professor of finance at the Wharton School of the University of Pennsylvania.

In their study, which has been in circulation in the US as a National Bureau of Economic Research working paper, the authors argue that "overconfidence among acquiring CEOs is an important explanation of merger activity", which they describe as "among the most significant and disruptive activities undertaken by large corporations."

"The staggering economic magnitude of these deals has inspired a myriad of research on their causes and consequences. Most theories focus on the efficiency gains that motivate takeover activity, often for specific epochs. The empirical results on returns to mergers, however, are mixed, suggesting that mergers may not create value on average.

Moreover, even if there are gains from mergers, they do not appear to accrue to the shareholders of the acquiring company.

There is a significant positive gain in target value upon the announcement of a bid, and a significant loss to the acquirer. These findings suggest that mergers are often not in the interest of the shareholders of the acquiring company."

But how do we spot overconfidence in a CEO?

Overconfident CEOs, according to Malmendier and Tate, "over-estimate their ability to generate returns." Thus, on the margin, they undertake mergers that destroy value. They also perceive outside finance to be over-priced. "We classify CEOs as overconfident when, despite their under-diversification, they hold options on company stock until expiration (emphasis added). We find that these CEOs are more acquisitive on an average, particularly via diversifying deals." The effects are largest in firms with abundant cash and untapped debt capacity.

Using press coverage as "confident" or "optimistic" to measure overconfidence, confirms these results. We also find that the market reacts more negatively to takeover bids by overconfident managers.

The authors tested their thesis empirically on a sample of Forbes 500 firms from 1980 to 1994.

Their main empirical measure of overconfidence made use of time series data on the CEOs' holdings of company stock options in their private portfolios. "Previous literature in corporate finance shows that risk averse CEOs should exercise stock options well before expiration due to the sub-optimal concentration of their portfolio in company-specific risk.

As in Malmendier and Tate (2003), we classify CEOs as overconfident when they display the opposite behaviour, that is, if they hold company stock options until the last year before expiration.

This behaviour suggests that the CEO is persistently bullish about his company's future prospects. We find that overconfident CEOs are more likely to conduct mergers than rational CEOs at any point in time. The higher acquisitiveness of overconfident CEOs — even "on average" — suggests that overconfidence is an important determinant of merger activity."

"Moreover, the effect of overconfidence on merger activity comes primarily from an increased likelihood of conducting diversifying acquisitions. Previous literature suggests that diversifying mergers are unlikely to create value in the acquiring firm. Thus, it is consistent with our theory that overconfident managers are particularly likely to undertake them.

Second, we find that the relationship between overconfidence and the likelihood of doing a merger is strongest when CEOs can avoid equity-financing, that is, least equity dependent firms. Overconfident CEOs strongly prefer cash-or debt-financed mergers to stock deals, unless their firm appears to be overvalued by the market."

"Additional empirical tests corroborate our results. We show that the observed differences in option exercises and merger decisions are not due to inside information. Instead, the hypothetical returns, CEOs could have obtained by exercising their options earlier are positive on average. In addition, the acquisitions of overconfident managers are distributed uniformly over their tenures suggesting that the effect of overconfidence is a true managerial fixed effect."

To bolster their portfolio measure of overconfidence, Malmendier and Tate constructed an alternative measure based on how a CEO was characterised in the press. They analysed the difference in merger activity between CEOs who were portrayed in the business press as "confident" and "optimistic" and CEOs who were portrayed as "reliable," "cautious," "conservative," "practical," "frugal," or "steady."

Controlling the total number of press mentions, they performed the same empirical analysis as with the portfolio overconfidence measure. The results replicated. Furthermore, the two measures turned out to be "highly correlated."

Finally, they looked directly at the market's perception of the merger decisions made by overconfident CEOs. Using standard event study methodology, they demonstrated that outside investors reacted more negatively to the announcement of a bid if the CEO was overconfident.

This result also held for controlling relatedness of the target and acquirer, ownership stake of the acquiring CEO, corporate governance of the acquirer, and method of financing the merger. Their results suggested that, even if overconfident, CEOs created firm value along some dimensions — and mergers and acquisitions were not among them.

"Our theory of managerial overconfidence provides a natural complement to standard agency theory." Both "empire-building preferences" and overconfidence predict heightened managerial acquisitiveness — as given abundant internal resources — and, as shown in Malmendier and Tate (2003), a heightened sensitivity of corporate investment to cash flow.

Unlike empire-builders, overconfident CEOs believe that they are acting in the interest of the shareholders. Thus, overconfidence, cast as an agency problem, challenges the effectiveness of stock and option grants to top executives as an incentive mechanism. On the other hand, it provides additional underpinning for models of debt overhang.

High leverage may effectively counterbalance an overconfident CEO's eagerness to invest and acquire, given his reluctance to issue equity he perceives as undervalued. In addition, the failure of traditional incentives to mitigate overconfidence underscores the importance of an independent board of directors.

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