If financial managers are to achieve corporate goals, they require well-developed finan- cial markets where transfers of wealth from savers to borrowers are efficient in both pricing and operational cost.
Efficiency can mean many things. The economisttalks about allocative efficiency– the extent to which resources are allocated to the most productive uses, thus satisfying society’s needs to the maximum. The engineertalks about operatingor technical effi- ciency– the extent to which a mechanism performs to maximum capability. The soci- ologist and the political scientist talk about social efficiency – the extent to which a mechanism conforms to accepted social and political values. The most important con- cept of efficiency for our purposes is pricingor information efficiency. This refers to the extent to which available information is built into the structure of share prices. If infor- mation relevant for assessing a company’s future earnings prospects (including both past information and relevant information relating to future expected events) is wide- ly and cheaply available, then this will be impounded into share prices by an efficient market. As a result, the market should allow all participants to compete on an equal basis in a so-called fair game.
We often hear of the shares of a particular company being ‘under-valued’ or ‘over-val- ued’, the implication being that the stock market pricing mechanism has got it wrong and that analysts know better. In an efficient stock market, current market prices fully reflect avail- able informationand it is impossible to outperform the market consistently, except by luck.
Consider any major European stock market. On any given trading day, there are hundreds of analysts – representing the powerful financial institutions which domi- nate the market – closely tracking the daily performance of the share price of, say, Wimpey, the construction company. They each receive at the same time new informa- tion from the company – a major order, a labour dispute or a revised profits forecast.
This information is rapidly evaluated and reflected in the share price by their decisions to buy or sell Wimpey shares. The measure of efficiency is seen in the extent and speed with which the market reflects new information in the share price.
The Law of One Price suggests that equivalent securities must be traded at the same price (excluding differences in transaction costs). If this is not the case, arbi- trageopportunities arise whereby a trader can buy a security at a lower price and simultaneously sell it at a higher price, thereby making a profit without incurring allocative efficiency
The most efficient way that a society can allocate its overall stock of resources
operating/technical efficiency
The most cost-effective way of producing an item, or organis- ing a process
social efficiency The extent to which a socio- economic system accords with prevailing social and ethical standards
pricing/information efficiency
The extent to which available information is impounded into the current set of share prices fair game
A competitive process in which all participants have equal access to information and therefore similar chances of success
arbitrage
The process whereby astute entrepreneurs identify and exploit opportunities to make profits by trading on differen- tials in price of the same item as between two locations or markets
FT
any risk. In an efficient market, arbitrage activity will continue until the price dif- ferential is eliminated.
■ The Efficient Market Hypothesis (EMH)
Information can be classified as historical, current or forecast. Only current or histori- cal information is certain in its effect on price. The more information that is available the better the situation. Informed decisions are more likely to be correct, although the use of inside information to benefit from investment decisions (insider dealing) is ille- gal in the UK.
Company information is available both within and without the organisation.
Those within the organisation will obviously be better informed about the state of the business. They have access to sensitive information about future investment projects, contracts under negotiation, forthcoming managerial changes, etc. The additional knowledge will vary according to a person’s level of responsibility and place in the organisational hierarchy.
Outsider investors fall into two categories: individual investors and the institutions.
Of these two groups, the institutions are the better informed, as they have greater access to senior management, and may be represented on the board of directors.
Different amounts of financial information are available to different groups of peo- ple. There is unequal access to the information, called ‘information asymmetry’, which may affect a company’s share price. If you are one of the well-informed, this gives you the opportunity to keep one step ahead of the market. Otherwise, you may lose out.
The share price reflects who knows what about the company. You should note, how- ever, that in the UK, share dealings by company directors are tightly circumscribed; for example, they can only buy and sell at specific times, and details of all such trades must be publicly disclosed.
Market efficiency evolved from the notion of perfect competition, which assumes free and instantly available information, rational investors and no taxes or transaction costs. Of course, such conditions do not exist in capital markets, so just how do we assess their level of efficiency? Market efficiency, as reflected by the Efficient Markets Hypothesis (EMH), may exist at three levels:
1 The weak formof the EMH states that current share prices fully reflect all informa- tion contained in past price movements. If this level of efficiency holds, there is no value in trying to predict future price movements by analysing trends in past price move- ments. Efficient stock market prices will fluctuate more or less randomly, any departure from randomness being too expensive to determine. Share prices are said to follow a random walk.
2 The semi-strong formof the EMH states that current market prices reflect not only all past price movements, but all publicly available information. In other words, there is no benefit in analysing existing information, such as that given in published accounts, dividend and profits announcements, appointment of a new chief execu- tive or product breakthroughs, after the information has been released. The stock market has already captured this information in the current share price.
3 The strong formof the EMH states that current market prices reflect all relevant information– even if privately held. The market price reflects the ‘true’ or intrinsic value of the share based on the underlying future cash flows. The implications of such a level of market efficiency are clear: no one can consistently beat the market and earn abnormal returns. Few would go so far as to argue that stock markets are efficient at this level.
You will have noticed that as the EMH strengthens, the opportunities for profitable speculation reduce. Competition between well-informed investors drives share prices to reflect their intrinsic values.
weak form
A weak-form efficient share market does not allow investors to look back at past share price movements and identify clear, repetitive patterns
semi-strong form A semi-strong efficient share market incorporates newly released information accurately and quickly into the structure of share prices
strong form
In a strong-form efficient share market, all information includ- ing inside information is built into share prices
■ The EMH and fundamental and technical analysis
Investment analysts who seek to determine the intrinsic worth of a share based on underlying information undertake fundamental analysis. The EMH implies that funda- mental analysis will not identify under-priced shares unless the analyst can respond more quickly to new information than other investors, or has inside information.
Chapter 4 adopts a fundamental analysis approach in its examination of share valuation.
Another approach is technical analysis, its advocates being labelled chartists because of their reliance upon graphs and charts of price movements. Chartists are not interested in estimating the intrinsic value of shares, preferring to develop trading rules based on patterns in share price movement over time, or ‘breakout’ points of change. Charts are used to predict ‘floors’ and ‘ceilings’, marking the end of a share price trend. Figure 2.2 shows how charts are used to detect patterns of ‘resistance’ (for shares on the way up) and ‘support’ (for shares on the way down). This approach can often prove to be a ‘self-fulfilling prophecy’. In the short term, if analysts predict that share prices will rise, investors will start to buy, thus creating a bull market and result- ing in upward pressure on prices.
Even in its weak form, the EMH questions the value of technical analysis; future price changes cannot be predicted from past price changes. However, the fact that many ana- lysts, using fundamental or technical analysis, make a comfortable living from their investment advice, suggests that many investors find comfort in the advice given.
Considerable empirical tests on market efficiency have been conducted over many years. In the USA and the UK, until the 1987 stock market crash, the evidence broadly supported the semi-strong form of efficiency. More specifically, it suggests the following:
1 There is little benefit in attempting to forecast future share price movements by analysing past price movements. As the EMH seems to hold in its weak form, the value of charts must be questioned.
2 For quoted companies that are regularly traded on the stock market, analysts are unlikely to find significantly over- or under-valued shares through studying publicly held information. Studies indicate (e.g. Ball and Brown 1968) that most of the information content contained in annual reports and profit announcements is reflected in share prices anything up to a year before release of the information, as investors make judgements based on press releases and other information during the year. However, analysts with specialist knowledge, paying careful attention to smaller, less well- traded shares, may be more successful. Equally, analysts able to respond to new information slightly ahead of the market may make further gains. The semi-strong form of the EMH seems to hold fairly well for most quoted shares.
time Share
price
Resistance line
Support line Breakout
Figure 2.2
Chart showing break- out beyond resistance line
intrinsic worth
The inherent or fundamental value of a company and its shares
fundamental analysis Analysis of the fundamental determinants of company financial health and future per- formance prospects, such as endowment of resources, quali- ty of management, product innovation record, etc.
technical analysis The detailed scrutiny of past time series of share price move- ments attempting to identify repetitive patterns chartists
Analysts who use technical analysis
3 The strong form of the EMH does not hold, so superior returns can be achieved by those with ‘inside knowledge’. However, it is the duty of directors to act in the share- holders’ best interests, and it is a criminal offence to engage in insider trading for personal gain. The fact that cases of insider trading have led to the conviction of sen- ior executives shows that market prices do not fully reflect unpublished information.
Recent governments have encouraged greater market efficiency in several ways:
■ Stock market deregulation and computerised dealing have enabled speedier adjust- ment of share prices in response to global information.
■ Mergers and takeovers have been encouraged as ways of improving managerial efficiency. Poorly performing companies experience depressed share prices and become candidates for acquisition.
■ Governments have seen privatisation of public utilities as a means of subjecting previously publicly-owned organisations to market pressures.
How people trade in London
The Big Bang in 1986 gave the London Stock Exchange a huge advantage over most of its competitors. The result was strong growth in trading activity and international par- ticipation. But Big Bang was only a partial revolution – automating the distribution of price information, but stopping short of automating the trading function itself.
Since 1986, global equity markets have become increasingly complex, with investors constantly looking for greater choice and lower costs. The London Stock Exchange made various attempts to retain its reputation as one of the most efficient stock mar- kets. In 1997, it took a major step by moving from a quote-based trading system, under which share dealing is conducted by telephone, to order-driven trading, termed SETS – the Stock Exchange Electronic Trading Service. The aim was to improve efficiency and reduce costs by automating trading and narrowing the spread between buying and sell- ing prices. This it achieves by the automatic matching of orders placed electronically by prospective buyers and sellers.
The system, which initially only applies to heavily traded shares, works as follows.
Instead of agreeing to trade at a price set by a market maker, prospective buyers and sellers can:
(a) advertise through their broker the price at which they would like to deal, and wait for the market to move, or
(b) execute immediately at the best price available.
An investor wishing to buy or sell will contact his or her broker and agree a price at which the investor is willing to trade. The broker enters the order in the order book, which is then displayed to the entire market along with other orders. Once the order is executed, the trade is automatically reported to the Exchange. Time will tell whether it does lead to greater efficiency, but it is hoped that it will offer users more attractive, transparent and flexible trading opportunities.
Heads, shoulders and broadening bottoms
The popularity of business television channels such as CNBC has done wonders for the careers of Wall Street’s technical analysts, who claim to be able to predict future share prices by spot- ting trends in past prices. Their market charts, showing descriptively named patterns such as
‘head and shoulders’ – a big peak surrounded by two smaller peaks – or ‘broadening bottoms’ – a series of troughs, each lower than the preceding one – make ideal graphics for television
Continued
■ Implications of market efficiency for corporate managers
In quoted companies, managers and investors are directly linked through stock mar- ket prices, corporate actions being rapidly reflected in share prices. This indicates the following:
1 Investors are not easily fooled by glossy financial reports or ‘creative accounting’
techniques, which boost corporate reported earnings but not underlying cash flows.
2 Corporate management should endeavour to make decisions that maximise share- holder wealth.
3 The timing of new issues of securities is not critical. Market prices are a ‘fair’ reflec- tion of the information available and accurately reflect the degree of risk in shares.
4 Where corporate managers possess information not yet released to the market, there is an opportunity for influencing prices. For example, a company may retain information so that, in the event of an unwelcome takeover bid, it can offer positive signals.
producers in need of something pretty for viewers to watch while the glamorous reporters are busy off-camera, catching up on the latest market gossip. The simple trading advice conveyed by charts is, for CNBC’s stock-tip-hungry viewers, manna from heaven.
But technical analysis is not merely for gullible CNBC-watchers. It has been around a long time, dating back a century to Charles Dow, the founder of Dow Jones, who invented the ‘Dow theory’ for identifying trends in share prices. Charts are used by some of the world’s most suc- cessful investors.
Nevertheless, economists who study financial markets have long regarded technical analysis as mumbo jumbo, bearing much the same relationship to rigorous economic ‘fundamental analysis’ that astrology does to astronomy. Since the 1960s, economists have believed, more or less, in ‘efficient-market theory’. In an efficient market, prices reflect all available informa- tion, and so scouring past prices for patterns can tell you nothing useful about whether in future prices will go up or down. Instead, prices will move unpredictably, in a ‘random walk’.
In the past decade some economists have challenged efficient-market theory, by finding numerous examples of apparently predictable movements in share prices. But there is still a fierce debate about whether these movements are predictable enough for investors to make money trading on the basis of expected price changes. The evidence was described at length in A Non-Random Walk Down Wall Street(Princeton University Press, 1999), a book by Craig MacKinlay, of the Wharton School, and Andrew Lo, of the Massachusetts Institute of Technology.
Mr Lo and two new co-authors have now come to the defence of technical analysis.* Using American share prices during 1962–96, they investigated the predictive ability of five pairs of widely-used technical patterns. The results showed that the various technical patterns mostly occurred far more frequently than they would have done if they were truly random events. The most common patterns were double tops and bottoms – two peaks (or two troughs) at similar prices to each other – followed by head and shoulders and inverted head and shoulders. In general, the charts contained useful information about future share prices. The study does not test whether this information was useful enough to allow investors to make sufficient profit trading on it to justify the extra risk.
Since investors have been using charts for 100 years or so and they still seem to work, the patterns may be so deeply ingrained that their predictive powers will persist come what may.
*‘Foundations of technical analysis’ by Lo, Mamaysky and Wang,Journal of Finance, August 2000.
Source:Based on The Economist, 19 August 2000.
Self-assessment activity 2.4
Consider why a dealing rule like ‘Always buy in early December’ should be doomed to fail- ure. This rule is designed to exploit the so-called ‘end-of-year-effect’ claiming that share prices ‘always’ rise at the end of the year.
(Answer in Appendix A at the back of the book)
■ Surfing towards greater stock market efficiency
One of the essential requirements of stock market efficiency is that all participants have roughly equal access to price-sensitive information. In the past, the big players – with online databases – were able to obtain information, and thereby enjoy a competitive advantage, well before the small investors who may have had to rely on the daily news- paper to keep abreast of recent events and price movements.
The Internet offers enormous scope for narrowing the information gap between big and small market participants. This arises in various ways.
1 Company information. Electronic reporting of company information will result in a significant enfranchisement of shareholders and enable greater accountability and corporate governance. The electronic information revolution should also give rise to a movement away from conventional accounting-based information to more user-friendly shareholder information which focuses on the key determinants of value. For example, customer satisfaction and market penetration may be regular information as part of a ‘balanced scorecard’ performance measurement system.
Videos of AGMs, analysts’ presentations and information on ethical/environmen- tal investment will become standard, enabling all investors to be kept up-to-date on corporate progress.
2 Market information. There are already thousands of Web pages devoted to invest- ment and personal finance information, much of which was hitherto only available to professional users. Although a charge is made for real-time information, those with share prices on a 20-minute delay are often free.
The following websites may be of interest:
Yahoo! (finance.yahoo.co.uk) focuses on providing share information for London, Frankfurt and Paris, with links to the US exchanges.
Moneyworld (www.moneyworld.co.uk) covers a much wider range of financial serv- ices as well as share prices.
The website of the Motley Fool (www.fool.co.uk) also ‘exists to educate, amuse and enrich the individual investor’.
However much information efficiency may improve through surfing the Web’s financial pages, remember that the market is renowned for its occasional catastrophic share price waves, which few can predict and even fewer ride.
Self-assessment activity 2.5
Share prices of takeover targets invariably rise before the formal announcement of a takeover bid. What does this suggest for the EMH?
(Answer in Appendix A at the back of the book)