EFFICIENT MARKETS

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EFFICIENT MARKETS

• A market is efficient with respect to a given
  information if it is impossible to make economic
  profits by trading on the basis of that
  information. By economic profits is meant the
  risk-adjusted returns net of all costs
• If the market for common stock is efficient,
  then prices are, on average, correct
• What efficiency does not imply
• The market price for a security is always correct
• No investor will beat the market in any time
  period
• All investors are perfectly rational

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WHY IS YOUR VIEW ON THIS IMPORTANT?

• Financial analysis uses market data
• If markets are inefficient, are analyses
  meaningful?
• Managerial decisions can be affected by views on
  efficiency
• Capital structure and capital raising sell
  security that is overpriced
• Mergers and acquisitions buy companies that are
  undervalued

3
IS EFFICIENCY PLAUSIBLE?

• Yes
• Main source of efficiency is competition
• To profit off information you must have better
  valuation and others must eventually figure this
  out
• No
• If new information is costly to uncover, some
  increased returns from analysis must be expected

4
DOT-COM FEVER

• AppNet Systems files for IPO under the symbol
  APPN
• Traders start buying the firm Appian Technology
  because it has the same symbol, APPN
• Appian stock price jumps 142,757 in two days (on
  no information) with trading volume of 7.3
  million shares (normal volume is less than 1000
  shares)
• Recent study finds that firms changing name to
  one ending in .com have average stock price
  jump of 80 on announcement (even if the business
  has nothing to do with the internet!)

5
THE IMPOSSIBLE CARVE OUT

• 3Com announced on December 13, 1999 that they
  would carve out their Palm division (which
  produces the popular palm pilot) creating a
  separate firm
• 3Com would own 94 of the new company, with new
  investors buying 6
• Once Palm started trading (under symbol PALM),
  the ratio of the market value of 3Coms holding
  in Palm to the total market value of 3Com was 1.6
  (i.e., the remainder of 3Com had a negative
  value)
• Other similar examples
• Daisyteks carve out of PFSWeb (December 1, 1999)
• Creative Computers carve out of uBid (July 2,
  1998)

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OTHER ANOMOLIES?

• Market over-reaction
• initial public offerings
• new exchange listings
• proxy fight target
• stock prices jump in the short-run but decline
  dramatically in the long-run, on average
• Market under-reaction
• earnings announcements
• share repurchase
• spin-offs
• Initial stock price reaction is positive and
  continues to rise over the long-run, on average

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MUTUAL FUND PERFORMANCE?

• Indexing involves less trading, resulting in
  lower trading costs and, therefore, lower
  management fees for investors
• Less trading has tax advantages for investors
• General Equity Funds that were outperformed by
  the Wilshire 5000 Equity Index (Lipper Analytical
  Services)

8
MUTUAL FUND PERFORMANCE BASED ON MORNINGSTAR
STYLE MAPPING (1992-96)

• Index is either a low cost index fund in style
  class or the appropriate Frank Russell Index
  (returns reduced by 0.3 to mimic fund costs)
• Risk is the annual standard deviation of fund
  returns
• Source Bogle, 1998, Journal of Portfolio
  Management

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BROKERAGE RECOMMENDATIONSSource Womack, Journal
of Finance, 1996

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WHAT DRIVES SHARE PRICE?

• Monitor Consulting study of SP500 firms from
  1992-96
• Percentage of stock price changes explained by
• changes in earnings 5
• changes in economic value added 3
• changes in analyst forecasts for near term
  earnings 16
• changes in analysts forecasts for long term
  earnings 22
• Effect on share price for a 1 change in
• earnings 0.8
• economic value added 0.6
• analyst forecasts for near term earnings 0.5
• analysts forecasts for long term earnings 3.5

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DELL - REVISITED
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DELL - REVISITED
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HARBOR CAPITAL KEY LEARNING POINTS

• Awareness of the role that security analysts play
  in the dissemination of information in capital
  markets
• Market efficiency Have a view!
• To gain familiarity with dividend discount model
  (DDM) to value equity and the concept of
  intrinsic value.
• To develop understanding of price-earnings ratios
  and how P/E ratios reflect growth and risk.