Corporate Financing and Market Efficiency

“If a man’s wit be wandering, let him study mathematics” – Francis Bacon, 1625

Market Efficiency

• Efficient market hypothesis says that security prices

reflect all available information

• ... or (slightly weaker but more reasonably) prices

reflect all information up to the point where extra

profits would not cover the cost of gaining more

information (i.e. no free lunches)

Three forms of the efficient market hypothesis

• Weak form

- prices reflect information in past prices

• Semi-strong form

- prices reflect public information

• Strong form

- prices reflect all available information

Some important implications

• securities always sell for ‘fair price’ (zero NPV)

• security price prediction is impossible

• security price changes will be random

How do Professional Money Managers Perform?

• Evidence from contests in The Wall street Journal

• Evidence of performance Relative to the S&P 500

• Both support the notion of efficient markets.

Annual returns of U.S. pension equity funds (source: Lakonishok, Shleifer &

Vishny)

Return on Funds under-Fund S&P 500 performing

1983 17.8% 22.5% 59%1984 3.8 6.3 631985 33.3 32.2 381986 18.1 18.5 501987 4.0 5.2 611988 17.9 16.8 471989 29.2 31.5 61Average 17.7% 19.0% 54%

The random walk hypothesis• the rough idea: at each point in time share price is

discounted value of forecast of future dividends.

• so change in share price is simply the discounted value of change in forecast of future dividends but . . .

• expected change in forecast is zero and so expected

change in price is zero.

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Which is the real market index?

This one?

Months

Level

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0 5 10 15 20 25 30 35 40 45 50 55 60

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... Or this one?

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Testing for random walks

• Some apparent non-randomness;

- Autocorrelation (i.e. correlation between price change at t and change at t+1)

Autocorrelation of weekly returns 1962-1985 (See Conrad & Kaul, 1988)

- Variance test (Does variance of price changes increase in proportion to length of time?)

Events studiesObject:

• To measure speed of response to events (i.e measure market efficiency)

• To measure effect of event on value (assuming market efficiency)

• Capital markets appear to react quickly to new information.

Examples of events:

mergers, earnings & dividend announcements, stock repurchases, stock splits, share & debt issues, block sales, listings, brokers reports, economic news, interest rate changes, etc.

Six lessons of market efficiency

1. Markets have no memory

2. Trust market prices

3. Reading the entrails

4. There are no financial illusions

5. The do-it-yourself alternative

6. Seen one stock, seen them all

Efficient Market TheoryFundamental Analysts

– Research the value of stocks using NPV and other measurements of cash flow

Efficient Market TheoryTechnical Analysts

– Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle wiggle watcherswatchers”)

Behavioral Finance

Factors related to efficiency and psychology

1. Attitudes towards risk

2. Beliefs about probabilities

3. Overreaction?

The Celebrated Fama and French (1992) study

• They study the relationship between the stock values (prices) and the accounting value of equity (book value). • Time Period Studied: 1963-1990• Methodology

• Order stocks according to price to book value ratio and divide into ten groups (portfolios)

• After one year record the return for each portfolio

• Repeat two steps above year after year.

The Results of the Fama & French (1992) study

• Portfolios made up of stocks with low price to book value ratios (value stocks) experienced a 21.4% return per year. (Removing inflation during this time period results in a 15.18% return per year.)

• Portfolios of stocks with high price to book value ratios (growth stocks) experienced a 8% return per year. (Removing inflation results in a 2.47% return per year.)

Who cares?• What will you have if you invest $2,000 per year

into your IRA? (Assume you are 30 and will work until you are 65, and use real rates.)• If you earn the return that was provided by the growth stocks:

– Your total accumulated wealth: $109,232– Your yearly income will be: $2,698

(You better go on a diet!)

• If you earn the return that was provided by value stocks:

– Your total accumulated wealth: $1,839,369– Your yearly income will be: $279,216

(How about some lobster?)

US performance of large & small firm stocks

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The Size Effect

• Many small stock are also value stocks.

• There is less information regarding small stocks (less analysts follow them), small stocks are less liquid than larger stocks.

• Several studies show small stocks earn higher returns than large firms. [For example: Banz (1981), Reinganum (1982), Keim (1983)] Is it because they are riskier? Are the results time specific?

Is the performance of small stocks driven by their high book value to price ratios?

• After controlling for size, Lakonishok, Scheilfer and Vishny (1993) report value stock returns are still higher than growth stocks.

• Other studies suggest that higher returns can be earned by investing in small firms that are value stocks (a combined effect.) [Loughran 1997)]

Are these results specific to the stock markets in the U.S. ?

• Fama and French (1997) find similar results (value stocks earn higher returns) in twelve developed countries.

• Barry, Goldreyer, Lockwood and Rodriguez (2000) find similar results for companies in emerging capital markets.

Can we expect similar results in the future?

• Do many money mangers know about these results?

• Why hasn’t competition already eliminated these opportunities?

• Does the market overreact?

In the long run

• several variables appear to forecast long-term returns

- past returns (regression towards mean)

- dividend yields

- P/E or P/BV ratios

- Size

- Seasonality effects (January)