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Chapter 5INEFFICIENT MARKETS AND
CORPORATE DECISIONS
Behavioral Corporate Finance byHersh Shefrin
McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights
reserved.
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Winner-Loser EffectStocks whose returns have been
worst over a 3-year period have
outperformed the market over thesubsequent 5 years by about 30%.
Stocks whose returns have been best
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over a 3- year period have
underperformed the market over the
subsequent 5 years by about 10%.
On a cumulative basis, losers
outperform
winners by about 40% over 5 years.1
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MomentumA portfolio formed by holding the
winners from the past 6 months,
and shorting the losers from the
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past 6 months earned more than
10% per year.Pattern is pronounced among small
cap stocks.2
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Post-Earnings- Cumulative Abnormal Returns for Different Earnings
Surprises
6.00
-100 -50 4.00 2.00
0.00
-2.00 0 -4.00
50 100
Announcement Drift-6.00-8.00
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When a firm announces that
its earnings have exceeded theconsensus analyst forecast, the
outcome is a positive surprise.
Negative surprise similarly
defined. Stock prices adjust
slowly to surprises,
exhibiting drift.
31.
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Traditional PositionOverreaction and
underreaction are the results of
random variation consistent with
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market efficiency. Fama
pointed out that empirically,findings of overreaction occur
about as frequently as findings
of underreaction4
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Limits of ArbitrageWill smart investors quickly take
advantage of
mispricing caused by irrationalinvestors, thereby rendering the
mispricing small and temporary?
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Mispricing can become worse before
it gets
better. Therefore, smart
investors might temper their
trades, and as a result the
inefficiencies might be neither smallnor temporary.5
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Limits of Arbitrage Pick
a Number Game1. Playing the game skillfully requires
an
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understanding of the errors to which
the other players are susceptible. 2.
The appropriate course of action is
different
when the other players commit errors
than when they do not. 3. Skilled playby the winner does not
necessarily bring the outcome close
to what would occur if few players
committed errors.6
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Do Managers Trust
Prices?Managers appear to behave as if
they believe
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markets are inefficient.
Managers indicate that they would
reject
positive NPV projects if accepting
those projects would lower their firms
EPS. Managers split their stocks, even though doing
so has no value when markets are
efficient. Managers time IPOs to
take advantage of hotissue markets.7
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Earnings vs. NPVMajority of CFOs view earnings
rather than
cash flows as the key variable uponwhich investors rely to judge value.
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The majority of managers are willing
to
sacrifice fundamental value in order
to meet a short-run earnings target.
Over half of managers would avoid initiating
a very positive NPV project if doing so
meant missing analysts target for the
current quarters earnings. Example:
Herman-Miller
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Stock SplitsFirms that decide to split their
stocks tend to
feature pessimistic coverage byanalysts in respect to earnings
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forecasts. Firms that announce
stock splits are much less
likely to experience a decline in future
earnings, relative to firms with
comparable characteristics. The
returns to stocks of firms that splitexhibit
price drift.
Stocks earn an average abnormal return of
7.93% in the first year, and 12.15% in the
first three years.
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