Causal Relationships Only

Understanding how x causes y is a must for Dr. James Weston

James Weston arrived home from work one evening and settled into his routine of grabbing a beer and watching PBS NewsHour. Before the program started, there was a 20-second commercial sponsored by BASF. He recalled it went something like this. “We don’t make computers, we make them lighter; we don’t make bridges, we make them more durable. We don’t make a lot of things you use, but we make them better.”

His first reaction — what is this? Why would a company that does not produce consumer products buy media time on television to basically say they exist? That commercial nagged at him until finally, some time later, BASF did a seasoned equity offering. Now, it was starting to make sense. BASF was advertising — hey, get familiar with us before we do a public equity offering. Their media buys were on PBS and during golf tournaments where viewers were likely to be educated and affluent, essentially their investor base. And, Weston thought, “This could be a paper!”

It turned out to be a highly cited paper. Working with Rice colleagues George Kanatas and Gustavo Grullon, Weston collected information on thousands of public firms and their advertising expenditures and examined how it related to stock market liquidity and security offerings. Their research showed that firms that are well-known among the investor base have a much easier time raising public equity.

Got Questions?

The BASF commercial was just one example of the many questions rolling around inside Weston’s brain. He’s always mulling a number of them, and then one will jump out because he finally has figured out where to find the data to answer it. Weston takes a natural science approach to causality. His pet peeve is soft research that is qualitative and hard to pin down. “You have to test hypotheses that come from theories and accept or reject them,” said Weston. “You have to be scientific about weighing the evidence.”

Along with several Rice colleagues, Weston challenged some of the earlier work in the area of behavioral finance and actually got into a war of papers with a group from Harvard. “They wrote a paper basically saying that managers regularly can fool investors, and we challenged that notion with hard evidence that showed what they were saying was not true.” Harvard shot back with a critical paper; the Rice group responded, and additional written volleys came from both sides. “It was kind of fun, and it all got published in the finance journals,” said Weston. “And I think we put a lid on their literature.”

Weston’s questions and ideas come from, well, everywhere. He loves the quirky and runs an eclectic research program. Consider his workin- progress on religion and corporate misbehavior. The behaviors he is measuring are not illegal, but consist of policies and practices one would rather not show up in the Wall Street Journal. It has been a huge project that involves collecting samples from every public company for the past 40 years as well as data from the religious census conducted every ten years.

While Weston is not attempting to make an association between morality and religion, the data shows that firms headquartered in counties ranked higher in religion do exhibit different behaviors across the board. “Perhaps when you’re headquartered in rural religious towns, you feel it’s more likely that you’ll be monitored and so you’re more controlled in your behavior,” said Weston. “You’re less likely to make a sneaky earnings play, adapt some questionable strategy, or pay your CEO forty times that of the average worker.”

Taking Stock

A fundamental question in finance that piqued Weston’s curiosity was, “Why pay dividends?” Dividends are correlated with many things, but Weston and his colleagues wanted to pull out causation. They started looking at companies on the Russell 1000, the largest public firms in the U.S., and the Russell 2000, the next 2,000 firms. Each is a value-weighted index, so if you happen to be 998 on the Russell 1000, you’re a trivial member of the group. But, say over the course of a year, you lose a few dollars of market cap and end up being 1002 on the Russell 2000. You go from being a grain of sand to a whale, and every institutional investor has to own you and benchmark against you. In the meantime, the firm that got a little bigger and went from 1001 to 999 becomes the grain of sand. “These firms didn’t do anything differently in that narrow range around the cutoff,” explained Weston. “But there is a huge movement in institutional ownership, so you take a nosedive or soaring jump depending on the threshold.”

What happens when all these institutions pile into a stock? Do they make the firm pay dividends, and when they pile out, do dividends stop? Using the Russell variation to test the causal effect of dividend policy, Weston found that, yes; institutions do force firms to pay dividends.

“We look at a couple of dozen firms above and below the threshold every year when the Russell is rebalanced,” said Weston. “Companies don’t know where they will land. You cannot choose to be above or below the line. It’s random; and that’s exactly how I want it to be as a scientist.”

And that attitude is exactly what makes Dr. Weston’s research so impactful in the world of finance research.

James P. Weston is a professor of finance at the Jones School. He joined the faculty in 2000 and currently teaches the core finance course which focuses on valuation, corporate finance, and financial modeling. His research covers a wide array of corporate finance issues and his articles have appeared in many of the leading academic finance publications as well as being cited in the popular press. He is a former assistant economist at the Federal Reserve Bank of New York and holds a Ph.D. and M.A. in economics from the University of Virginia. He also earned a B.A. in economics from Trinity College. 

— Ann S. Boor, Jones Journal - Fall 2012