Chapter 5 INEFFICIENT MARKETS AND CORPORATE DECISIONS Behavioral

Chapter 5 INEFFICIENT MARKETS AND CORPORATE DECISIONS Behavioral Corporate Finance by Hersh Shefrin 0

Traditional Approach to Market Efficiency w The risk premium for a security is the additional expected return, over and above the risk-free rate, that investors require in order to compensate them for risk. w When the additional expected return exceeds the risk premium, investors are said to earn a positive abnormal return. 1

Cont… w The efficient-market hypothesis holds that investors cannot expect to make abnormal returns because market prices correctly reflects the information available to the market as a whole. w Market efficiency is subtle and involves three different versions: n n n weak-form efficiency semi strong-form efficiency. 2

Cont… w Weak-form efficiency pertains to information in past prices, semistrongform efficiency to all publicly available information, and strong-form efficiency to all information including the information held by insiders. 3

Cont… w In the traditional framework, rational investors smart money constantly monitor markets for abnormal profit opportunities. w The buying of underpriced securities and selling of overpriced securities, is known as (risky) arbitrge. 4

Cont… w Arbitrage will eliminate the opportunities as smart money bids up the prices of underpriced securities and bids down the prices of overpriced securities. w Therefore, in the traditional view, inefficiencies will be small, temporary, and unpredictable. 5

Cont… w This is because a firm whose market value of equity lies below its book value of equity is more likely to be facing financial distress than a firm whose market value of equity lies above its book value of equity. 6

The Market Efficiency Debate: Anomalies w An issue of great debate between finance traditionalists and behaviorists is whether or not markets are efficient. w Traditionalists contend that markets are efficient in the sense that departures from efficiency are temporary, small, and infrequent. 7

Cont… w Behaviorists contend that because of the behavioral phenomena, there are particular circumstances in which departures from efficiency are likely to be large and occur for long periods of time. 8

Long-Term Reversals: Winner-Loser Effect w Winner-Loser Effect: Extreme past losers tend subsequently to outperform the market, and extreme past winners tend subsequently to underperform the market. w Behaviorists suggest that the winner-loser effect occurs because representativeness leads investors to exhibit extrapolation bias in respect to prior earnings. 9

Cont. . w In the behavioral perspective, investors overreact to stocks that have been past losers, causing those stocks to become undervalued. w By the same token, investors overreact to past winners, causing those stocks to become overvalued. 10

Momentum: Short-Term Continuation w Momentum: recent losers tend subsequently to underperform the market, and recent winners tend subsequently to outperform the market. 11

Cont… w Behaviorists view short-term momentum as evidence against weak-form efficiency and propose three possible explanations for its occurrence: n n The first explanation is that analysts and investors under react to new information. A second explanation is that subsequent to a news event and the initial market reaction, overconfident investors overreact to later events. 12

Cont… n A third explanation for momentum is based on investors who behave in accordance with prospect theory. In the event of good news about a stock, risk aversion predisposes investors to sell the stock at a gain relative to the original purchase price, thereby retarding the increase in price. 13

Cont… w Underreact: The percentage change in market price in response to an event is too small. w Overreact: The percentage change in market price in response to an event is too large. 14

Post-Earnings. Announcement Drift w Post-earning-announcement drift: The stocks of firms giving rise to positive earnings surprises experience positive drift after the announcement, while the stocks of firms giving rise to negative earnings surprises experience negative drift after the announcement. 15

Cont… w Post-earnings-announcement drift is a phenomenon that illustrates both short-term continuation and long-term reversal. w Post-earnings-announcement drift features momentum for a year after the first earnings surprise, but reversal after a year. w In other words, momentum continues for up to 12 months and is then followed by reversal. 16

Cont… w Given that earnings constitute nonprice public information, behaviorists interpret post-earnings-announcement drift as evidence against semistrong-form efficiency. 17

Limits of Arbitrage w Limits of Arbitrage: Smart investors do not fully exploit mispricing because of the attendant risks that the mispricing will become larger before it becomes smaller. w Arbitrage is the process of exploiting mispricing, essentially buying low and selling high. 18

Do Managers Trust Prices? w Managers appear to behave as if they believe markets are inefficient. w Managers indicate that they would reject positive NPV projects if accepting those projects would lower their firm’s EPS. w Managers split their stocks, even though doing so has no value when markets are efficient. w Managers time IPOs to take advantage of hot issue markets. 19

Market Efficiency, Earnings Guidance, and NPV w Financial managers routinely disclose information to security analysts in a process called guidance w Among the most important information that managers disclose is the managers’ own forecasts of what future earnings per share will be for their firms. 20

Cont… w For this reason, managers are able to influence stock prices by choosing to disclose information to analysts and investors. w Net present value (NPV), when properly computed, measures incremental intrinsic value. 21

Cont… w In an efficient market, maximizing NPV is equivalent to maximizing market value. w When prices are inefficient, maximizing NPV based on cash flows might not be the same as maximizing the market value of the firm. w As a result, market inefficiency can present financial managers with a 22 dilemma.

Stock Splits w According to the efficient-market view, a firm that splits stock should not expect to see an abnormal change in its market value of equity. w However, it turns out that there is positive drift associated with stock splits. 23

Example: Tandy’s Stock Split w Firms that announce stock splits are much less likely to experience a decline in future earnings, relative to firms with comparable characteristics. 24

To IPO Or Not To IPO 25

Three Phenomena w IPO decisions take place against the backdrop of three phenomena: a hot issue market, initial underpricing, and long-term underperformance. w Hot issue market: Demand for new issues is relatively high. w Initial underpricing: The offer price is too low, resulting in a large first-day price 26 pop.

Cont… w Long-Term underperformance: New issues earn lower returns than stocks with comparable characteristics against which they have been matched. 27

The end 28