The efficient-market hypothesis emphasizes that arbitrage will rapidly eliminate any profit opportunities and drive market prices back to fair value. Behavioral-finance specialists may concede that there are no easy profits, but argue that arbitrage is costly and sometimes slow-working, so that deviations from fair value may persist.
Sorting out the puzzles will take time, but we suggest that financial managers should assume, at least as a starting point, that stock and bond prices are “right” and that there are no free lunches to be had on Wall Street.
The “no free lunch” principle gives us the following five lessons of market efficiency. After reviewing these lessons, we consider what market inefficiency can mean for the financial manager.
1. Lesson 1: Markets Have No Memory
The weak form of the efficient-market hypothesis states that the sequence of past price changes contains no information about future changes. Economists express the same idea more concisely when they say that the market has no memory. Sometimes financial managers seem to act as if this were not the case. For example, after an abnormal market rise, managers prefer to issue equity rather than debt.[1] The idea is to catch the market while it is high. Similarly, they are often reluctant to issue stock after a fall in price. They are inclined to wait for a rebound. But we know that the market has no memory and the cycles that financial managers seem to rely on do not exist.[2]
Sometimes a financial manager will have inside information indicating that the firm’s stock is overpriced or underpriced. Suppose, for example, that there is some good news that the market does not know but you do. The stock price will rise sharply when the news is revealed. Therefore, if your company sells shares at the current price, it would offer a bargain to new investors at the expense of present stockholders.
Naturally, managers are reluctant to sell new shares when they have favorable inside information. But such information has nothing to do with the history of the stock price. Your firm’s stock could be selling at half its price of a year ago, and yet you could have special information suggesting that it is still grossly overvalued. Or it may be undervalued at twice last year’s price.
2. Lesson 2: Trust Market Prices
In an efficient market, you can trust prices because they impound all available information about the value of each security. This means that in an efficient market, there is no way for most investors to achieve consistently superior rates of return. To do so, you not only need to know more than anyone else; you need to know more than everyone else. This message is important for the financial manager who is responsible for the firm’s exchange-rate policy or for its purchases and sales of debt. If you operate on the basis that you are smarter than others at predicting currency changes or interest-rate moves, you will trade a consistent financial policy for an elusive will-o’-the-wisp.
Procter & Gamble (P&G) supplied a costly example of this point in early 1994, when it lost $102 million in short order. It seems that in 1993, P&G’s treasury staff believed that interest rates would be stable and decided to act on this belief to reduce P&G’s borrowing costs. They committed P&G to deals with Bankers Trust designed to do just that. Of course, there was no free lunch. In exchange for a reduced interest rate, P&G agreed to compensate Bankers Trust if interest rates rose sharply. Rates did increase dramatically in early 1994, and P&G was on the hook. Then P&G accused Bankers Trust of misrepresenting the transactions—an embarrassing allegation since P&G was hardly investing as a widow or orphan—and sued Bankers Trust.
We take no stand on the merits of this litigation, which was eventually settled. But think of P&G’s competition when it traded in the fixed-income markets. Its competition included the trading desks of all the major investment banks, hedge funds, and fixed-income portfolio managers. P&G had no special insights or competitive advantages on the fixed-income playing field. Its decision to place a massive bet on interest rates was about as risky (and painful) as playing leapfrog with a unicorn.
Why was it trading at all? P&G would never invest to enter a new consumer market if it had no competitive advantage in that market. In Chapter 11, we argued that a corporation should not invest unless it can identify a competitive advantage and a source of economic rents. Market inefficiencies may offer economic rents from convergence trades, but few corporations have a competitive edge in pursuing these rents. As a general rule, nonfinancial corporations gain nothing, on average, by speculation in financial markets. They should not try to imitate hedge funds.[3]
The company’s assets may also be directly affected by management’s faith in its investment skills. For example, one company may purchase another simply because its management thinks that the stock is undervalued. On approximately half the occasions, the stock of the acquired firm will, with hindsight, turn out to be undervalued. But on the other half, it will be overvalued. On average, the value will be correct, so the acquiring company is playing a fair game except for the costs of the acquisition.
3. Lesson 3: Read the Entrails
If the market is efficient, prices impound all available information. Therefore, if we can only learn to read the entrails, security prices can tell us a lot about the future. For example, in Chapter 23, we show how information in a company’s financial statements can help to estimate the probability of bankruptcy. But the market’s assessment of the company’s securities can also provide important information about the firm’s prospects. Thus, if the company’s bonds are trading at low prices, you can deduce that the firm is probably in trouble.
Here is another example: Suppose that investors are confident that interest rates are set to rise over the next year. In that case, they will prefer to wait before they make long-term loans, and any firm that wants to borrow long-term money today will have to offer the inducement of a higher rate of interest. In other words, the long-term rate of interest will have to be higher than the one-year rate. Differences between the long-term interest rate and the shortterm rate tell you something about what investors expect to happen to short-term rates in the future.
The nearby box shows how market prices reveal opinions about issues as diverse as a presidential election, the weather, or the demand for a new product.
4. Lesson 4: The Do-It-Yourself Alternative
In an efficient market, investors will not pay others for what they can do equally well themselves. As we shall see, many of the controversies in corporate financing center on how well individuals can replicate corporate financial decisions. For example, companies often justify mergers on the grounds that they produce a more diversified and hence more stable firm. But if investors can hold the stocks of both companies, why should they thank the companies for diversifying? It is much easier and cheaper for them to diversify than it is for the firm.
The financial manager needs to ask the same question when considering whether it is better to issue debt or common stock. If the firm issues debt, it will create financial leverage. As a result, the stock will be more risky, and it will offer a higher expected return. But stockholders can obtain financial leverage without the firm’s issuing debt; they can borrow on their own accounts. The problem for the financial manager is, therefore, to decide whether there is an advantage to the company issuing debt rather than the individual shareholder.
5. Lesson 5: Seen One Stock, Seen Them All
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% increase in the price of coffee changes sales by -.2 x .05 = -.01; in other words, it reduces demand by only 1%. Consumers are likely to regard 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% increase in the price of Maxwell House relative to that of Folgers would in this case reduce demand by 10%.
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 to cut the offering price only 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.
6. What If Markets Are Not Efficient? Implications for the Financial Manager
Our five lessons depend on efficient markets. What should financial managers do when markets are not efficient? The answer depends on the nature of the inefficiency.
What If Your Company’s Shares Are Mispriced? The financial manager may not have special information about future interest rates, but she definitely has special information about the value of her own company’s shares. Or investors may have the same information as management, but they may be slow in reacting to that information or may be infected with behavioral biases.
Sometimes you hear managers thinking out loud like this:
Great! Our stock is clearly overpriced. This means we can raise capital cheaply and invest in Project X. Our high stock price gives us a big advantage over our competitors who could not possibly justify investing in Project X.
But that doesn’t make sense. If your stock is truly overpriced, you can help your current shareholders by selling additional stock and using the cash to invest in other capital market securities. But you should never issue stock to invest in a project that offers a lower rate of return than you could earn elsewhere in the capital market. Such a project would have a negative NPV. You can always do better than investing in a negative-NPV project: Your company can go out and buy common stocks. In an efficient market, such purchases are always zero NPV.
What about the reverse? Suppose you know that your stock is underpriced. In that case, it certainly would not help your current shareholders to sell additional “cheap” stock to invest in other fairly priced stocks. If your stock is sufficiently underpriced, it may even pay to forgo an opportunity to invest in a positive-NPV project rather than to allow new investors to buy into your firm at a low price. Financial managers who believe that their firm’s stock is underpriced may be justifiably reluctant to issue more stock, but they may instead be able to finance their investment program by an issue of debt. In this case the market inefficiency would affect the firm’s choice of financing but not its real investment decisions. In Chapter 15, we will have more to say about the financing choice when managers believe their stock is mispriced.
What If Your Firm Is Caught in a Bubble? On occasion, your company’s stock price may be swept up in a bubble like the dot-com boom of the late 1990s. Bubbles can be exhilarating. It’s hard not to join in the enthusiasm of the crowds of investors bidding up your firm’s stock price.[4] On the other hand, financial management inside a bubble poses difficult personal and ethical challenges. Managers don’t want to “talk down” a high-flying stock price, especially when bonuses and stock-option payoffs depend on it. The temptation to cover up bad news or manufacture good news can be very strong. But the longer a bubble lasts, the greater the damage when it finally bursts. When it does burst, there will be lawsuits and possibly jail time for managers who have resorted to tricky accounting or misleading public statements in an attempt to sustain the inflated stock price.
When a firm’s stock price is swept upward in a bubble, CEOs and financial managers are tempted to acquire another firm using the stock as currency. One extreme example where this arguably happened is AOL’s acquisition of Time Warner at the height of the dot-com bubble in 2000. AOL was a classic dot-com company. Its stock rose from $2.34 at the end of 1995 to $75.88 at the end of 1999. Time Warner’s stock price also increased during this period, but only from $18.94 to $72.31. AOL’s total market capitalization was a small fraction of Time Warner’s in 1995, but overtook Time Warner’s in 1998. By the end of 1999, AOL’s outstanding shares were worth $173 billion, compared with Time Warner’s $95 billion. AOL managed to complete the acquisition before the Internet bubble burst. AOL-Time Warner’s stock then plummeted, but not by nearly as much as the stocks of dot-com companies that had not managed to find and acquire safer partners.[5]
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