Lesson 6 Seen One Stock Seen Them

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The elasticity of demand for any article measures the percentage change in the quantity demanded for each percentage addition to the price. If the article has close substitutes, the elasticity will be strongly negative; if not, it will be near zero. For example, coffee, which is a staple commodity, has a demand elasticity of about - .2. This means that a 5 percent increase in the price of coffee changes sales by — .2 X .05 = — .01; in other words, it reduces demand by only 1 percent. Consumers are likely to regard

36For a discussion of the evidence that investors are not fooled by earnings manipulation, see R. Watts, "Does It Pay to Manipulate EPS?" in J. M. Stern and D. H. Chew, Jr. (eds.), The Revolution in Corporate Finance, Oxford, Basil Blackwell, 1986.

37G. C. Biddle and F. W. Lindahl, "Stock Price Reactions to LIFO Adoptions: The Association between Excess Returns and LIFO Tax Savings," Journal of Accounting Research 20 (Autumn 1982, Part 2), pp. 551-588.

CHAPTER 13 Corporate Financing and the Six Lessons of Market Efficiency 369

different brands of coffee as much closer substitutes for each other. Therefore, the demand elasticity for a particular brand could be in the region of, say, —2.0. A 5 percent increase in the price of Maxwell House relative to that of Folgers would in this case reduce demand by 10 percent.

Investors don't buy a stock for its unique qualities; they buy it because it offers the prospect of a fair return for its risk. This means that stocks should be like very similar brands of coffee, almost perfect substitutes. Therefore, the demand for a company's stock should be highly elastic. If its prospective return is too low relative to its risk, nobody will want to hold that stock. if the reverse is true, everybody will scramble to buy.

Suppose that you want to sell a large block of stock. Since demand is elastic, you naturally conclude that you need only to cut the offering price very slightly to sell your stock. Unfortunately, that doesn't necessarily follow. When you come to sell your stock, other investors may suspect that you want to get rid of it because you know something they don't. Therefore, they will revise their assessment of the stock's value downward. Demand is still elastic, but the whole demand curve moves down. Elastic demand does not imply that stock prices never change when a large sale or purchase occurs; it does imply that you can sell large blocks of stock at close to the market price as long as you can convince other investors that you have no private information.

Here is one case that supports this view: In June 1977 the Bank of England offered its holding of BP shares for sale at 845 pence each. The bank owned nearly 67 million shares of BP, so the total value of the holding was £564 million, or about $970 million. It was a huge sum to ask the public to find.

Anyone who wished to apply for BP stock had nearly two weeks within which to do so. Just before the Bank's announcement the price of BP stock was 912 pence. Over the next two weeks the price drifted down to 898 pence, largely in line with the British equity market. Therefore, by the final application date, the discount being offered by the Bank was only 6 percent. In return for this discount, any applicant had to raise the necessary cash, taking the risk that the price of BP would decline before the result of the application was known, and had to pass over to the Bank of England the next dividend on BP.

If Maxwell House coffee is offered at a discount of 6 percent, the demand is unlikely to be overwhelming. But the discount on BP stock was enough to bring in applications for $4.6 billion worth of stock, 4.7 times the amount on offer.

We admit that this case was unusual in some respects, but an important study by Myron Scholes of a large sample of secondary offerings confirmed the ability of the market to absorb blocks of stock. The average effect of the offerings was a slight reduction in the stock price, but the decline was almost independent of the amount offered. Scholes's estimate of the demand elasticity for a company's stock was —3,000. Of course, this figure was not meant to be precise, and some researchers have argued that demand is not as elastic as Scholes's study suggests.38 However, there seems to be widespread agreement with the general point that you can sell large quantities of stock at close to the market price as long as other investors do not deduce that you have some private information.

38For example, see W. H. Mikkelson and M. M. Partch, "Stock Price Effects and Costs of Secondary Distributions," Journal of Financial Economics 14 (June 1985), pp. 165-194. Scholes's study is M. S. Scholes, "The Market for Securities: Substitution versus Price Pressure and the Effects of Information on Share Prices," Journal of Business 45 (April 1972), pp. 179-211.

Brealey-Meyers: Principles of Corporate Finance, Seventh Edition

IV. Financial Decisions and Market Efficiency

13. Corporate Financing and the Six Lessons of Market Efficiency

© The McGraw-H Companies, 2003

PART IV Financing Decisions and Market Efficiency

Here again we encounter an apparent contradiction with practice. Many corporations seem to believe not only that the demand elasticity is low but also that it varies with the stock price, so that when the price is relatively low, new stock can be sold only at a substantial discount. State and federal regulatory commissions, which set the prices charged by local telephone companies, electric companies, and other utilities, have sometimes allowed significantly higher earnings to compensate the firm for price "pressure." This pressure is the decline in the firm's stock price that is supposed to occur when new shares are offered to investors. Yet Paul Asquith and David Mullins, who searched for evidence of pressure, found that new stock issues by utilities drove down their stock prices on average by only .9 percent.39 We will come back to the subject of pressure when we discuss stock issues in Chapter 15.

39See P. Asquith and D. W. Mullins, "Equity Issues and Offering Dilution," Journal of Financial Economics 15 (January-February 1986), pp. 61-89.

The patron saint of the Bolsa (stock exchange) in Barcelona, Spain, is Nuestra Senora de la Esperanza—Our Lady of Hope. She is the perfect patroness, for we all hope for superior returns when we invest. But competition between investors will tend to produce an efficient market. In such a market, prices will rapidly impound any new information, and it will be difficult to make consistently superior returns. We may indeed hope, but all we can rationally expect in an efficient market is a return just sufficient to compensate us for the time value of money and for the risks we bear.

The efficient-market hypothesis comes in three different flavors. The weak form of the hypothesis states that prices efficiently reflect all the information in the past series of stock prices. In this case it is impossible to earn superior returns simply by looking for patterns in stock prices; in other words, price changes are random. The semistrong form of the hypothesis states that prices reflect all published information. That means it is impossible to make consistently superior returns just by reading the newspaper, looking at the company's annual accounts, and so on. The strong form of the hypothesis states that stock prices effectively impound all available information. It tells us that superior information is hard to find because in pursuing it you are in competition with thousands, perhaps millions, of active, intelligent, and greedy investors. The best you can do in this case is to assume that securities are fairly priced and to hope that one day Nuestra Senora will reward your humility.

While there remain plenty of unsolved puzzles, there seems to be widespread agreement that consistently superior returns are hard to attain. Thirty years ago any suggestion that security investment is a fair game was generally regarded as bizarre. Today it is not only widely discussed in business schools but also permeates investment practice and government policy toward the securities markets.

For the corporate treasurer who is concerned with issuing or purchasing securities, the efficient-market theory has obvious implications. In one sense, however, it raises more questions than it answers. The existence of efficient markets does not mean that the financial manager can let financing take care of itself. It provides only a starting point for analysis. It is time to get down to details about securities and issue procedures. We start in Chapter 14.

CHAPTER 13 Corporate Financing and the Six Lessons of Market Efficiency

The classic review articles on market efficiency are:

E. F. Fama: "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, 25:383-417 (May 1970).

E. F. Fama: "Efficient Capital Markets: II," Journal of Finance, 46:1575-1617 (December 1991).

For evidence on possible exceptions to the efficient-market theory, we suggest:

G. Hawawini and D. B. Keim: "On the Predictability of Common Stock Returns: WorldWide Evidence," in R. A. Jarrow, V. Maksimovic, and W. T. Ziemba (eds.), Finance, North-Holland, Amsterdam, Netherlands, 1994.

Martin Gruber's Presidential Address to the American Finance Association is an interesting overview of the performance of mutual fund managers.

M. Gruber: "Another Puzzle: The Growth in Actively Managed Mutual Funds," Journal of Finance, 51:783-810 (July 1996).

Andre Shleifer's book and Robert Shiller's paper provide a good introduction to behavioral finance. A useful collection of papers on behavioral explanations for market anomalies is provided in Richard Thaler's book of readings, while Eugene Fama's paper offers a more skeptical view of these behavioral theories.

A. Shleifer: Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press, Oxford, 2000.

R. J. Shiller: "Human Behavior and the Efficiency of the Financial System," in J. B. Taylor and M. Woodford (eds.), Handbook of Macroeconomics, North-Holland, Amsterdam, 1999.

R. H. Thaler (ed.): Advances in Behavioral Finance, Russell Sage Foundation, New York, 1993.

E. F. Fama: "Market Efficiency, Long-Term Returns, and Behavioral Finance," Journal of Financial Economics, 49:283-306 (September 1998).

The following book contains an interesting collection of articles on the crash of1987:

R. W. Kamphuis, Jr., et al. (eds.): Black Monday and the Future of Financial Markets, Dow-Jones Irwin, Inc., Homewood, IL, 1989.

FURTHER READING

1. Which (if any) of these statements are true? Stock prices appear to behave as though QUIZ successive values (a) are random numbers, (b) follow regular cycles, (c) differ by a random number.

2. Supply the missing words:

"There are three forms of the efficient-market hypothesis. Tests of randomness in stock returns provide evidence for the_form of the hypothesis. Tests of stock price reaction to well-publicized news provide evidence for the_form, and tests of the performance of professionally managed funds provide evidence for the

_form. Market efficiency results from competition between investors. Many investors search for new information about the company's business that would help them to value the stock more accurately. Such research helps to ensure that prices reflect all available information; in other words, it helps to keep the market efficient in the

_form. Other investors study past stock prices for recurrent patterns that would allow them to make superior profits. Such research helps to ensure that prices reflect all the information contained in past stock prices; in other words, it helps to keep the market efficient in the_form."

3. True or false? The efficient-market hypothesis assumes that a. There are no taxes.

b. There is perfect foresight.

c. Successive price changes are independent.

d. Investors are irrational.

PART IV Financing Decisions and Market Efficiency e. There are no transaction costs.

f. Forecasts are unbiased.

4. The stock of United Boot is priced at $400 and offers a dividend yield of 2 percent. The company has a 2-for-1 stock split.

a. Other things equal, what would you expect to happen to the stock price?

b. In practice would you expect the stock price to fall by more or less than this amount?

c. Suppose that a few months later United Boot announces a rise in dividends that is exactly in line with that of other companies. Would you expect the announcement to lead to a slight abnormal rise in the stock price, a slight abnormal fall, or no change?

5. True or false?

a. Financing decisions are less easily reversed than investment decisions.

b. Financing decisions don't affect the total size of the cash flows; they just affect who receives the flows.

c. Tests have shown that there is almost perfect negative correlation between successive price changes.

d. The semistrong form of the efficient-market hypothesis states that prices reflect all publicly available information.

e. In efficient markets the expected return on each stock is the same.

f. Myron Scholes's study of the effect of secondary distributions provided evidence that the demand schedule for a single company's shares is highly elastic.

6. Analysis of 60 monthly rates of return on United Futon common stock indicates a beta of 1.45 and an alpha of — .2 percent per month. A month later, the market is up by 5 percent, and United Futon is up by 6 percent. What is Futon's abnormal rate of return?

7. True or false?

a. Analysis by security analysts and investors helps keep markets efficient.

b. Psychologists have found that, once people have suffered a loss, they are more relaxed about the possibility of incurring further losses.

c. Psychologists have observed that people tend to regard recent events as representative of what might happen in the future.

d. If the efficient-market hypothesis is correct, managers will not be able to increase stock prices by creative accounting that boosts reported earnings.

8. Geothermal Corporation has just received good news: its earnings increased by 20 percent from last year's value. Most investors are anticipating an increase of 25 percent. Will Geothermal's stock price increase or decrease when the announcement is made?

9. Here again are the six lessons of market efficiency. For each lesson give an example showing the lesson's relevance to financial managers.

a. Markets have no memory.

b. Trust market prices.

c. Read the entrails.

d. There are no financial illusions.

e. The do-it-yourself alternative.

f. Seen one stock, seen them all.

PRACTICE

QUESTIONS

1. How would you respond to the following comments?

a. "Efficient market, my eye! I know lots of investors who do crazy things."

b. "Efficient market? Balderdash! I know at least a dozen people who have made a bundle in the stock market."

c. "The trouble with the efficient-market theory is that it ignores investors' psychology."

CHAPTER 13 Corporate Financing and the Six Lessons of Market Efficiency d. "Despite all the limitations, the best guide to a company's value is its written-down book value. It is much more stable than market value, which depends on temporary fashions."

2. Respond to the following comments:

a. "The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets."

b. "If everyone believes you can make money by charting stock prices, then price changes won't be random."

c. "The random-walk theory implies that events are random, but many events are not random. If it rains today, there's a fair bet that it will rain again tomorrow."

3. Which of the following observations appear to indicate market inefficiency? Explain whether the observation appears to contradict the weak, semistrong, or strong form of the efficient-market hypothesis.

a. Tax-exempt municipal bonds offer lower pretax returns than taxable government bonds.

b. Managers make superior returns on their purchases of their company's stock.

c. There is a positive relationship between the return on the market in one quarter and the change in aggregate profits in the next quarter.

d. There is disputed evidence that stocks which have appreciated unusually in the recent past continue to do so in the future.

e. The stock of an acquired firm tends to appreciate in the period before the merger announcement.

f. Stocks of companies with unexpectedly high earnings appear to offer high returns for several months after the earnings announcement.

g. Very risky stocks on average give higher returns than safe stocks.

4. Look again at Figure 13.9.

a. Is the steady rise in the stock price before the split evidence of market inefficiency?

b. How do you think those stocks performed that did not increase their dividends by an above-average amount?

5. Stock splits are important because they convey information. Can you suggest some other financial decisions that do so?

6. Here are alphas and betas for Intel and Conagra for the 60 months ending October 2001. Alpha is expressed as a percent per month.

Alpha

Beta

Intel

.77

1.61

Conagra

.17

.47

Explain how these estimates would be used to calculate an abnormal return.

7. It is sometimes suggested that stocks with low price-earnings ratios tend to be under-priced. Describe a possible test of this view. Be as precise as possible.

8. "If the efficient-market hypothesis is true, then it makes no difference what securities a company issues. All are fairly priced." Does this follow?

9. "If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin." Explain why this is not so.

10. The bottom graph in Figure 13.1 shows the actual performance of the Standard and Poor's 500 Index for a five-year period. Two financial managers, Alpha and Beta, are contemplating this chart. Each manager's company needs to issue new shares of common stock sometime in the next year.

PART IV Financing Decisions and Market Efficiency

Alpha: My company's going to issue right away. The stock market cycle has obviously topped out, and the next move is almost surely down. Better to issue now and get a decent price for the shares.

Beta: You're too nervous; we're waiting. It's true that the market's been going nowhere for the past year or so, but the figure clearly shows a basic upward trend. The market's on the way up to a new plateau. What would you say to Alpha and Beta?

11. What does the efficient-market hypothesis have to say about these two statements?

a. "I notice that short-term interest rates are about 1 percent below long-term rates. We should borrow short-term."

b. "I notice that interest rates in Japan are lower than rates in the United States. We would do better to borrow Japanese yen rather than U.S. dollars."

12. We suggested that there are three possible interpretations of the small-firm effect: a required return for some unidentified risk factor, a coincidence, or market inefficiency. Write three brief memos, arguing each point of view.

13. "It may be true that in an efficient market there should be no patterns in stock prices, but, if everyone believes that they do exist, then this belief will be self-fulfilling." Discuss.

14. Column (a) in Table 13.1 shows the monthly return on the British FTSE 100 index from August 1999 through July 2001. Columns (b) and (c) show the returns on the stocks of two firms. Both announced dividend increases during this period—Executive Cheese

TABLE 13.1

See practice question 14. Rates of return in percent per month.

TABLE 13.1

See practice question 14. Rates of return in percent per month.

Month

Market Return

Executive Cheese Return

Paddington Beer Return

1999:

Aug.

.2

-1.9

-.5

Sept.

-3.5

-10.1

-6.1

Oct.

3.7

8.1

9.8

Nov.

5.5

7.5

16.5

Dec.

5.0

4.3

6.7

2000:

Jan.

-9.5

-5.3

-11.1

Feb.

-.6

5.7

-7.3

Mar.

4.9

-9.7

4.5

Apr.

-3.3

-4.7

-14.8

May

.5

-10.0

-1.1

June

-.7

-2.7

-1.2

July

.8

.1

-2.6

Aug.

4.8

3.4

12.4

Sept.

-5.7

5.6

-7.9

Oct.

2.3

-2.2

11.5

Nov.

-4.6

-6.5

-14.4

Dec.

1.3

-.2

3.4

2001:

Jan.

1.2

-3.7

4.1

Feb.

-6.0

-9.0

-14.1

Mar.

-4.8

7.3

-6.5

Apr.

5.9

4.7

12.6

May

-2.9

-7.1

-.7

June

-2.7

0.5

-14.5

July

-2.0

-0.5

-11.4

CHAPTER 13 Corporate Financing and the Six Lessons of Market Efficiency in September 2000 and Paddington Beer in January 2000. Calculate the average abnormal return of the two stocks during the month of the dividend announcement.

15. On May 15, 1997, the government of Kuwait offered to sell 170 million BP shares, worth about $2 billion. Goldman Sachs was contacted after the stock market closed in London and given one hour to decide whether to bid on the stock. They decided to offer 710.5 pence ($11.59) per share, and Kuwait accepted. Then Goldman Sachs went looking for buyers. They lined up 500 institutional and individual investors worldwide, and resold all the shares at 716 pence ($11.70). The resale was complete before the London Stock Exchange opened the next morning. Goldman Sachs made $15 million overnight.40 What does this deal say about market efficiency? Discuss.

1. Bond dealers buy and sell bonds at very low spreads. In other words, they are willing to sell at a price only slightly higher than the price at which they buy. Used-car dealers buy and sell cars at very wide spreads. What has this got to do with the strong form of the efficient-market hypothesis?

2. "An analysis of the behavior of exchange rates and bond prices around the time of international assistance for countries in balance of payments difficulties suggests that on average prices decline sharply for a number of months before the announcement of the assistance and are largely stable after the announcement. This suggests that the assistance is effective but comes too late." Does this follow?

3. Use either the Market Insight database (www.mhhe.com/edumarketinsight) or (www.finance.yahoo.com) to download daily prices for 5 U.S. stocks for a recent 12-month period. For each stock construct a scatter diagram of successive returns as in Figure 13.2. Then calculate the correlation between the returns on successive days. Do you find any consistent patterns?

CHALLENGE QUESTIONS

40"Goldman Sachs Earns a Quick $15 Million Sale of BP Shares," The Wall Street Journal, May 16, 1997, p. A4.

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