Chapter 14 – Market Efficiency

Efficient capital markets are capital markets where current market prices reflect available
information. So the market prices today are the “right” prices today.

When making capital expenditures, it is possible to find positive NPV opportunities, but
it is not easy to do so in a competitive world. Financial markets are very competitive, so
there should be very few positive NPV financing opportunities.

The Efficient Market Hypothesis (EMH) implies investors should expect to earn only a
normal rate of return; once new information is released, prices adjust before investors can
trade on the new information.

The EMH comes in three flavours:

• weak
• semi strong
• strong

The weak form: A stock market is weak form efficient if prices reflect information
contained in the record of past stock prices. If the weak form of the EMH is true, then
studying charts of prices (and volumes), that is, technical analysis, is a waste of time.

The weak form can be represented mathematically as follows:

Pt = Pt-1 + expected return + random component, where t = time is weeks or months, for
instance.

This equation states:

The price today = the price last week + the expected return in the last week, + a random
component. The expected return is a function of the securities risk, based on a model like
CAPM, and the random component is a function of new information. The random
component in any one period is unrelated to the random component in any past period. If
stock prices follow this equation, they are said to follow a random walk.

Example: technical analysis – typical patterns

The semi strong form of the EMH:

The semi strong form of the EMH says that prices reflect all publicly available
information. If true, this means that one cannot earn abnormal returns by analysing
publicly available information like press releases, annual reports, etc.

1
The strong form of the EMH:

This form of the EMH says that prices reflect all public and private information. So, for
instance, if the strong form of the EMH is true, and if you know that the board of
directors has just agreed to increase the dividend on the stock, that information does not
enable you to make “extra” profits. If the strong form of the EMH is true, and if the board
has just completed negotiations to accept a takeover offer at a substantial premium to the
current stock price, that information does not enable you to make extra returns. The
strong form of the EMH asserts that even insider information doesn’t enable abnormal
profits. What do you think? I think this form of the EMH is clearly not true.

Most investors would say that the markets are generally weak form and semi strong form
efficient, but not strong form efficient – but these conclusions are subject to considerable
debate and discussion.

Illustrative example:
Suppose you have a strategy to always sell a stock holding after a “decent” price rise. If
the market is only weak form efficient, that strategy won’t work.

Illustrative example: Momentum players – their strategy is to jump into stocks that have
recently been on an up-trend. If the weak form of the EMH is true, this strategy won’t
work.

Illustrative example:
Invest immediately in stocks that announce or report strong earnings growth. If markets
are semi strong efficient, that strategy won’t work.

Does all this mean you may as well just throw darts at the stock page to determine which
stocks to invest in? No, because that approach doesn’t take into account differing
tolerances for risk.

All this does mean that investors don’t need to worry they are paying too much for a
stock with a low dividend, or a stock of a company in a risky industry, because the
market has already taken that into account in the pricing of the stock.

Question: Do you believe that some mutual fund managers, or some smart individual
investors can consistently outperform the market over a long period of time (for instance,
15-25 years)?

Answer: start with 1,000 mutual fund managers….

2
Anomalies:

• Small cap stocks outperform large cap stocks, and the difference exceeds that
which could be explained by differing risk

• The January effect: stocks tend to do better in January

• Value stocks (high book value to stock price) outperform growth stocks (low
book value to stock price)

Bubbles and crashes:

• October 19, 1987 NYSE dropped over 20% in 1 day for no very apparent
reason.

• Late 1990’s: the high technology internet bubble

• 1929 crash

• The tulip bubble in the Netherlands in the 17th century

Accounting and Efficient markets:

Generally studies show that how accounting is used to present financial results (i.e
favourably or not) has no effect on stock prices. Accountants talk about the “quality” of
earnings.

Do managers act as though markets are efficient?

Sometimes no:

Managers (wanting to raise external cash via equity offerings), will sometimes announce
that they believe their shares are undervalued in the market. Sometimes they will initiate
stock repurchase programs designed to support and increase their stock price.

Investors watch what managers do: If managers decide to issue equity, that is sometimes
taken as a sign that managers (who have access to more information about the company
than investors) believe the shares are overvalued, or fully valued (certainly not
undervalued). If managers issue debt, that may be considered a positive sign (if the debt
level is deemed not to be excessive).