Chapter 5 Inefficient Markets and Corporate Decisions

Learning Objectives
1. Differentiate among sentiment and fundamental risk as drivers of expected returns.
2. Explain how the limits to arbitrage can interfere with market efficiency even in the
presence of smart money.
3. Describe the implications of the market efficiency debate in respect to catering
behavior and market timing for corporate financial decisions involving project
selection, earnings guidance, stock splits, and new equity issues.
Traditional Treatment
• In the traditional framework, rational investors or smart money constantly monitor
markets for abnormal profit opportunities.
• Risky arbitrage will eliminate the opportunities as smart money bids up the prices of
underpriced securities and bids down the prices of overpriced securities.
• Therefore, inefficiencies will be small, short-lived, and unpredictable.
Joint Hypothesis
• In practice, the notion of market efficiency involves an asset pricing model such as the
capital asset pricing model (CAPM) or a multifactor model such as the Fama-French
model.
• In its original form, the Fama-French model featured three factors respectively
corresponding to the market premium, firm size measured by market capitalization of
equity, and the ratio of book-to-market equity (B/M).
• Subsequently, Fama and French added factors relating to profitability and firm
investment, bringing the number of factors to five.
Trust Market Prices
• The main message from traditional textbooks is that corporate managers should trust
market prices, as far as publicly available information is concerned.
• This means that managers should not believe that the securities of their firms are
mispriced, unless as managers they have private information to the contrary.
Irrational Exuberance 非理性繁荣
• Excessive optimism and overconfidence cause the stock market to be overvalued.
• Enthusiasm that drives asset prices higher than those assets' fundamentals justify.
• Given the strong linear relationship in Exhibit 5-1, the evidence suggests that negative
returns, as well as risk premiums, are predictable when P/D is sufficiently high.
Speculative Stocks
• When sentiment rises, investors increase the riskiness of their portfolios by holding a
higher proportion of stocks and by shifting into more speculative stocks.
• The primary example of a speculative stock is a company that is young, currently
unprofitable but potentially very profitable, has no earnings history, and a highly
uncertain future.
• These characteristics support a wide range of investor valuations.
Safe Stocks
• At the other end of the spectrum are stocks of firms that feature a long history of
earnings, tangible assets, and stable dividends.
• These stocks tend to be easier to value, less likely to generate a wide range of
valuations, and safer than speculative stocks.
• In practice, stocks are sorted from safe to speculative according to their total historical
volatility.
Sentiment Beta
• Baker-Wurgler sentiment index (B-W).
• A stock’s sensitivity to sentiment is measured in terms of a sentiment beta.
• When investors become excessively optimistic, stocks with high and positive
sentiment betas tend to be overvalued.
• However, as future events typically fail to live up to inflated expectations, subsequent
returns tend to be inferior.
• Conversely, when investors are excessively pessimistic, stocks with high and positive
sentiment betas tend to be undervalued, leading their subsequent returns to be
superior.
Limits of Arbitrage
• Smart investors face limits in quickly taking advantage of mispricing caused by
irrational investors.
• For example, restrictions on short selling can limit arbitrage.
– Even when the optimism of some investors is counterbalanced by the
pessimism of other investors, the higher transaction costs of taking short
positions in stocks, relative to long positions, dampens arbitrage activity and
results in market prices reflecting optimism.
Mispricing Risk 错误定价风险
• Mispricing can become worse before it gets better.
• Therefore, smart investors might temper their trades, and as a result the inefficiencies
might be neither small nor temporary.
 • Unless they have long horizons and very deep pockets, investment managers might
not have the patience to withstand mispricing becoming worse before it gets better.
• This is especially true when their clients mistakenly conclude that the managers lack
skill, and head for the exits by withdrawing funds in the face of losses.
Related Issues
• A related risk stems from liquidity, when a wave of pessimism turns to panic and a
preponderance of investors seek to sell at the same time.
• Some stocks are more difficult to arbitrage than others.
• A notable example consists of stocks of young, small companies that are unprofitable
or experiencing extreme growth.
Anomalies and Momentum
• Anomalies are findings that are inconsistent with the joint hypothesis that markets are
efficient and risk and return are related through a particular asset pricing model.
• The momentum effect is an anomaly that involves recent losers subsequently
underperforming the market, and recent winners subsequently outperforming the
market, both on a risk adjusted basis.
• Other anomalies include size effect, book-to-market effect (value vs growth stock),
etc.
Market Timing
• Corporate managers are natural candidates to be arbitrageurs in the securities of their
own firms when those securities are mispriced, by engaging in market timing or
catering behavior.
• When the equity in their firms becomes overvalued, and money managers need to
contemplate the trading costs of short selling, corporate managers can issue new
shares.
• In addition, corporate managers tend to have longer horizons on which their
performance is evaluated, and less of a need to have deep pockets to deal with
redemptions.
Earnings-Based Catering
• Managers manipulate earnings in order to avoid reporting negative earnings per share
(EPS), if they can avoid doing so.
• They are more inclined to manage earnings when compensated with company stocks
and options.
• Managers also use earnings guidance (disclosing information e.g. earnings forecast, to
analysts) to influence perception about the company.
Managerial Corporate Decisions
 1. Investment policy in combination with earnings guidance
2. Stock Splits
3. Undertaking Initial Public Offerings
Earnings Guidance
• Disclosing information to analysts and investors to influence company stock prices
• Examples: company earnings forecast.
• When earnings are used to arrive at company’s value (instead of using cash flows and
NPV), then prices will be inefficient.
• Hence, managers can cater to investor’s biases.
Evidence
• Evidence from a survey of chief financial officers indicates that the majority view
earnings rather than cash flows as the key variable upon which investors rely to judge
value.
• Because the market reacts very negatively when a firm misses an earnings target, a
strong majority of managers are willing to sacrifice fundamental value in order to
meet a short-run earnings target (for eg reduce investment in R&D to reduce current
expense, at the expense of long-term benefits)
Behavioral Pitfalls Box
• What behavioral phenomena come to mind as you read its contents?

Earnings and R&D

• The relationship between investment and earnings can also be direct in that managers
can use expenditures on research and development (R&D) to affect earnings.
• For example, if managers are concerned that the firm’s actual earnings will fall below
analysts’ earnings expectations, they tend to postpone planned expenditures for R&D.
Stock Splits
• Firms that decide to split their stocks tend to feature pessimistic coverage by analysts
in respect to earnings forecasts.
 • Firms that announce stock splits are much less likely to experience a decline in future
earnings, relative to firms with comparable characteristics.
• The returns to stocks of firms that split exhibit price drift.
– Stocks earn an average abnormal return of 7.93% in the first year, and 12.15%
in the first three years.
• This is not consistent to EMH!
Initial Public Offers (IPOs)
• This is a process where a company sells its share to the investors in the primary
market.
• From research, there are three phenomenon that reflect decisions made by managers:
1. Hot issue markets
2. Initial underpricings
3. Long-term underperformance
IPOs: Hot Issue Markets and Initial Underpricing
• Exhibit 5-2 displays two monthly series for the time period 1980 to mid-2015,
– the number of offerings; and
– the average first-day return to an IPO (in percent).
• Notice how the number of IPOs occurs in waves, giving rise to so-called hot and cold
issue markets.
• This show that manager practice market timing in IPOs to exploit hot issue market.
Initial Underpricing Average First Day Returns
1. 7% in the 1980s.
2. 15% in the 1990s.
3. 65% during the bubble period.
4. 12% in the post-bubble period.
Long-Term Underperformance
• Exhibit 5-3 displays the general finding about long-term underperformance for the
period 1980 to mid-2015.
• Notice that during the first six months, the returns of issuing firms were higher than
the returns of comparable firms that were similar in size and book-to-market equity,
but did not issue new shares.
• But thereafter, what happens?
Money Left on the Table? Time Series of Table Scraps
 • Exhibit 5-4 shows that the magnitude of underpricing increased throughout the 1990s
and soared during the bubble period, 1999–2000.
Agency Conflicts
• Investment banks that underwrite IPOs employ analysts.
• Investment banks employing all-star analysts tend to gain underwriting market share.
• Investment banks typically charge an underwriting fee that amounts to 7% of the
gross offering.
• Spinning, "Friends of Frank" accounts.
Corporate Nudges
• Identify all the benefits and costs associated with going IPO.
• Think explicitly about treating opportunity costs in the same way as out-of-pocket
costs.
Summary
• Managers appear to behave as if they believe markets are inefficient, leading them to
engage in catering behavior and market timing.
• They indicate that they would reject positive NPV projects if accepting those projects
would lower their firm’s EPS.
• They split their stocks, even though doing so has no value when markets are efficient.
• And they time IPOs to take advantage of hot issue markets.