BU52042 Lecture 2 Market Efficiency - Slides

BU52042
Security Analysis and Equity

Valuation
Dr Murat Mazibas PhD CFA FRM
02 February 2024
dundee.ac.uk BU52042 Security Analysis and Equity Valuation by Dr Murat Mazibas CFA FRM Page 1
Lecture Syllabus
 Lecture 1: Introduction: Financial Securities and Security markets.
 Lecture 2: Market Efficiency: Technical analysis, fundamental analysis,

behavioral finance.
 Lecture 3-6: Analysis & Valuation of Equity Securities:

 Economic analysis
 Industry analysis
 Company analysis
 Financial statement analysis
 Lecture 7: Fixed Income Securities: Bond & FI fundamentals, bond valuation,
convertible securities.
 Workshop: Security Analyst Report presentations
Lecture Agenda
 Efficient Markets and Anomalies
 Behavioral Finance
 Technical Analysis
Efficient Markets &
Market Anomalies
Lecture 2
dundee.ac.uk BU52042 Security Analysis & Equity Valuation by Dr Murat Mazibas CFA FRM Page 4
Efficient Market Hypothesis (EMH)
“All securities are correctly priced at any point in time”
 Implies neither fundamental analysis nor technical analysis work to profitably

predict security valuation
 The market rapidly processes and prices all new information
 Requires a large number of profit-maximizing participants
 Focused on analysis, valuation, and profitable trading of securities
 Any relevant news is immediately acted upon and rapidly exploited by profit-maximizing
individuals
 Applies most directly to large firms trading on major security exchanges
 No stock price can be in disequilibrium or improperly priced for any extended
period of time
 Information travels in a random, independent fashion
 Prices are an unbiased reflection of all currently available information
Efficient Market Hypothesis
 The Efficient Market Hypothesis (EMH) is stated

and tested in three forms:
1. The weak form
2. The semi-strong form
3. The strong form
1. Weak Form of the Efficient Market Hypothesis
 No relationship exists between past and future prices

of securities
 Prices of securities are presumed to be independent
over time
 Current prices reflect all available information, and
information travels in a random fashion
 Little or nothing is to be gained from studying past
stock prices
Tests of Weak Form EMH
 Has been tested in two ways:

 Tests of independence
 Trading rule tests
 Both tests seem to uphold the weak form of the
EMH:
 Security prices do appear to be independent over time or
move in the pattern of a random walk
Tests of Independence
 The serial correlation between stock prices over

time
 not statistically significant – they follow “martingale” or
random process
 Only factor affecting stock prices is introduction
of previously unknown news or information
Tests of Independence
 Test based on the frequency and extent of runs in stock price

data – sequences of two or more price changes in the same
direction – also tends to indicate that stock price movements are
independent over time
(+ + + + - + - + - + - - - + - +)
run run
Price changes
over time
Trading Rule Tests
 Try to determine whether given trading rules based on

past price data, volume, and so forth, can be used to
beat naïve buy-and-hold approach
 Simulates conditions under which a given trading rule

is used to determine if superior returns were produced
 after considering transaction costs and risks
Example: Trading Rule Test
 Stock price moves up 5% or more, “buy”

 Assumes this represents a “breakout” and should be considered
bullish
 If price drops 5%, “sell”
 This is a follow-the-market-trend strategy rather than
a buy-low/sell-high strategy
Since stock prices move randomly, such rules do not

consistently achieve superior results.
Implications for Technical Analysis
 Any trading rule that relies on historical data and

information will be of little value
 Security prices do appear to be independent over time,

or, more specifically, move in the pattern of a random
walk
Weak Form EMH Tests imply:
 Prices move independently over time
 Past trends cannot be used easily to predict the future
 Charting/technical analysis may have limited value
 No exceptional returns can be earned using investment

strategies based on historical stock prices or other
financial data
2. Semistrong Form of the Efficient Market Hypothesis
 All public information is already impounded into the

value of a security
 Including issued financial statements and public information about M&A
activity
 No learning lag in the dissemination of public

information
 This may depend upon the size of the firm which issued the stock and
attention being paid to it by analysts
 Tests of this form of the EMH attempt to see if

investors acting on the basis of newly released public
information are able to earn superior returns adjusting
for risk and transaction costs
Example: Semistrong Form EMH
 Assume a stock goes up 15% and the stock is 20%

riskier than the market.
 Assume the overall market rises by 10%.
 On a risk-adjusted basis, the stock would need to go up

in excess of 12% [10% mkt return x 1.2 risk factor] to
beat the market.
 Since the stock rose by more than 12%, it is said to

have beaten the market on a risk-adjusted basis.
Tests for Semistrong Form
 Tests examining the effects stock splits, stock dividends, and

changes in accounting policy indicate that the market is
generally efficient in a semistrong sense.
 Almost all of the market impact of a stock split appears to occur

before the public announcement; little is gained from acting on
the announcement
 Tests indicate that investors see through changes in accounting

information that do not have economic consequences
 For example, changing depreciation schedules for financial reporting (but not tax purposes)
make earnings per share appear higher but provides no economic benefit to the firm – the
change in earnings does not affect the economic value of the firm to a shareholder and
share prices do not change.
Implications for Fundamental Analysis
 Fundamental analysis cannot be used to determine whether a

stock is undervalued or overvalued
 The collective wisdom of the marketplace in which all
participants are attempting to earn superior risk adjusted
returns will dominate any individual’s judgment on the value of a
stock
 Fundamental analysis itself makes the market efficient because
everyone is conducting fundamental analysis, there is little in
the way of unabsorbed or undigested information
 Anomalies or deviations from the basic proposition that the

market is efficient still do occur
3. Strong Form of the Efficient Market Hypothesis
 Stock prices fully reflect all information, public, non-

public and otherwise
 Perfect markets exist where all information is available to everyone at the
same time (full transparency)
 No group of investors has a monopoly on access to any

information
 No group of investors can be expected to show superior risk-adjusted
returns under any circumstances
Strong Form of EMH
Test results of strong form EMH do not support its existence
 Specialists on security exchanges have been able to earn

superior rates of return on invested capital
 Corporate insiders consistently earn higher returns than would

be expected in a perfect capital market
• Range of participants with access to superior information is not large
• Those acting illegally with insider information may initially achieve higher
returns from special access to information, but the price of their actions (i.e.,
forfeiture of gains, payment of fines, jail time) may be high
Special or Abnormal Returns
 Gains beyond what the market would normally provide

after adjustment for risk
 Often referred to as “Anomalies”
 Transactions costs must be included when determining

the existence of an anomaly
Market Anomalies
1. Mergers and Acquisitions

2. New Stock Issues
3. Exchange Listings
4. Stock Repurchase
5. Small-Firm & Low-P/E Ratio Effect
6. The Book Value to Market Value Effect
7. Other Stock-Related Anomalies
• The January Effect
• The Weekend Effect
• The Value Line Ranking Effect
• The Surprise-Earnings Effect
dundee.ac.uk Page 22
Anomaly 1: Mergers and Acquisitions
 Premiums for Acquired Company
 Acquiring Company Performance
 Form of Payment
Premiums for Acquired Company
Merger price premium = Offer price/share

– Market price/share (prior to offer)
Example:
Firm selling for $25 per share may attract a purchase price of $37.50
 Merger premium price:
 $37.50 - $25.00 = $12.50
Premiums Paid in Mergers and Acquisitions
Premiums for Acquired Company – Problem from an
investment viewpoint
 Does not support an efficient market

DEFINITION:
Efficient market = full information
(transparency) distributed instantaneously
 Approximately 2/3 of price gain appears to benefit only the

insiders
 If market were perfectly efficient, insiders would not be able to
benefit
Stock Movement of Potential Acquirees in Canceled
Mergers
Premiums for Acquired Company – Other Issues
 Unfriendly takeover
 White knight
 Poison pill
 Golden parachutes for the executives of the acquired

company
Acquiring Company Performance
 Mandelker study indicated no abnormal gain for the

acquiring company
 Synergy (2 + 2 = 5) effect offset by
 Clash of management philosophies

 Fear price paid was too high
Form of Payment
 Cash offers
 Higher premium due to immediate tax consequences
 Stock offers (stock-for-stock trade)
 Tax consideration (current or delayed at the acquired
company stockholders’ discretion)
Current
Cash offers Stock offers
trend
Anomaly 2: New Stock Issues
 IPO (initial public offering)
Definition of IPO:
When a company goes public by selling
formerly privately held shares to new investors
 IPO price may not fully reflect the true value

 To avoid unwanted inventory, investment banker may under-
price the issue by 5 to 10%
 Positive excess returns related to issue of new stock
New Stock Issues (cont’d)
 Best time to buy is on initial distribution from

underwriting syndicate
 Investment bankers
 Dealers
 Brokers
 Best time to sell is shortly after initial distribution
 New issues may actually underperform the market over
the long-term
Performance of Investment Bankers
 IPOs are not that good of an investment for (average) investors

seeking high initial returns
 Investors benefit from lower IPO price
• Lower IPO price increases potential abnormal gain
 Corporations benefit with higher IPO price
• Receive more capital from the issue
 Investment Banks (underwriters) want to purchase shares at a discount
and issue at a premium
 Corporations search for an investment bank who will price the
issue close to intrinsic value. Companies want the benefit to go
to the corporation, not buyers of the IPO.
Anomaly 3: Exchange Listings
 An exchange is a market where securities,

commodities, options, or futures are traded
 Examples: NYSE, Nasdaq, and Amex
 Two types of Step-up occur
 From over-the-counter to an exchange
 From one exchange to another
• Example: from the Amex to the NYSE
Exchange Listings
 Securities accepted for trading purposes by regulated exchanges

have higher liquidity
 Issues assigned to specialists who maintain continuous and orderly market
 Issues become more acceptable for margin trading and short selling
 Strong upward movement associated with securities to be listed
 Strong sell-off after listing has occurred
 Delisting has strong negative effect on security
Minimum Requirements for NYSE Listing
Anomaly 4: Stock Repurchase
 Repurchase by a firm of its own shares

 Increases demand for shares
 Decreases effective supply
Reasons for Repurchase:

 Management believes the stock is undervalued
 Others might see the repurchase as a sign that:
 Management is NOT creative
 Lacks investment opportunities
 Firms that engage in repurchases tend to have:
 Low sales growth
 Low earnings growth
 Lower return on net worth
Actual Market Effect
 Mixed results - Cannot give a conclusive answer
 Most stock repurchases announced as future intentions instead

of firm commitments
 Many of these shares are never actually repurchased
 For value-oriented stocks with solid fundamentals

 Abnormal return was 45.3% over four-year horizon
 For high-flying “glamour stocks,”

 Returns were neutral to slightly negative
Anomaly 5: Small-Firm & Low-P/E Ratio Effect
University of Chicago doctoral studies in 1980s
Superior risk-adjusted
rates of return
Correlation
Investing in firms with

small market capitalizations
Market capitalization =
# of shares outstanding x price per share
Small-Firm & Low-P/E-Ratio:
Criticisms and Weaknesses
 Roll suggested that small-capitalization studies

underestimate:
 Risk factor (beta)
 Infrequent/irregular trading patterns
 Transaction cost
 Buy-sell spread (small-cap low-priced stocks =
approx. 4 or 5 times large-cap)
Synopsis of Results – Reinganum Study
Small-Firm & Low-P/E Ratio Effect
Peavy and Goodman
Higher risk-adjusted
rates of return
Relationship
Investing in firms with
lower P/E ratios
P/E Ratio =
price per share/earnings per share
P/E Ratios and Performance:
The Electronics Industry (1970-1980)
Small-Firm & Low-P/E-Ratio
Summary
HOW TO GET SUPERIOR RETURNS?
 Some researchers (Benz & Reinganum) say that small

size is the primary variable
 Other researchers (Basu) argue it is the low-P/E-ratio

effect
The Latest Theory (Fama-French):
Anomaly 6: The Book Value to Market Value Effect
Higher
Book value
Market value Higher potential
or Ratio return on the stock
Market value
Book value
Lower
The Latest Theory –
The Book Value to Market Value Effect
Book value Market value
Market value Book value
(1) (2)
$20 $100 = 5
= .20
$100 $20
(1) Book value is 20% of market value
(2) Stock is trading at 5 times its book value
Is company due for a correction

(i.e. decrease in price)?
The Latest Theory –
The Book Value to Market Value Effect
Book value Market value
Market value Book value
(1) (2)
$80 $100
= .80 $80
= 1.25
$100
(1) Book value is 80% of market value
(2) Stock is trading at 1.25 times its books value
More likely that this stock is undervalued.
Other Stock-Related Anomalies
 The January Effect
 The Weekend Effect
 The Value Line Ranking Effect
 The Surprise-Earnings Effect
The January Effect
Stockholders may sell off their losers in late December to

establish tax losses
Depress the value of these stocks
January may represent

bargains & opportunity
for high returns
The Weekend Effect
 Stocks tend to peak in value on Friday
 Generally decline in value on Monday
 Price movement too small to profitably cover

transaction costs
 Long-term investors may:

 prefer to sell later in the week
 buy at the beginning of the week
The Value Line Ranking Effect
 Value Line Investment Survey on 1700 stocks

 Each company rated from 1 through 5
 One is the highest possible rating
 Five is the lowest rating
 100 stocks are always in category 1
 Research studies indicate:
Category 1 stocks provide

superior risk-adjusted returns
compared to other 4 categories &
the market in general
The Surprise-Earnings Effect
•Accounting
• Efficient market Discounts •Finance
•Any news
Little, or no opportunity
to garner superior returns
from the surprise-earnings news
Truly Superior Returns or Mismeasurement?
High Less than efficient

Superior
capital market investment
returns strategy
High Mis-
Efficient market measurement
returns
• Used wrong risk category (wrong beta) ?

• Adjusting for risk may show markets are still
perfectly efficient
 There is, to some degree, mismeasurement (i.e., efficient

market)
 But “special situations” (i.e., market inefficiencies) do exist
Special situations properly analyzed may

provide abnormally high risk-adjusted returns
 Strict application of efficient markets not as popular as 20

years ago
Behavioral Finance
Lecture 2
Behavioral Finance:
The Psychology of Financial Behavior
 Psychologists have found that humans do not act as

rationally as assumed
 Behavioral Finance attempts to answer:

 What happens when humans do not behave rationally?
 Do investors consistently make rational decisions?
 Do they really maximize their utility and overall wealth?
Behavioral Finance:
Market Bubbles
 Support for behavioral finance comes from the

incidence of Market Bubbles
 Dutch Tulip Bulb Mania – 1800s
 Florida Land Bubble – 1920s
 Technology Stocks – 1990s
 Real Estate – 2006-2008
 Were the buyers at the top of the market acting

rationally?
Behavioral Finance
 Heuristics
 Techniques for problem-solving based on experiential learning
 Non-reflective, intuitive mechanisms for coping with complexity
 We may adhere to social trends and fads even if they are false
 Humans make judgments based on:
 Representativeness
• People assess the chances of an event occurring based on how similar the
event is to a stereotype
 Availability
• People remember more-recent events more intensely than distant events
 Anchoring-and-Adjustment
• First impressions are not sufficiently adjusted to reflect new information
Behavioral Finance
 Prospect Theory
 Alternative to Utility Theory
 Investors do not use all available information when making
decisions
• Leads to inconsistent choices when provided with identical
alternatives presented in different forms
 Investors tend to focus on gains and losses of individual
investments
• Utility Theory assumes an investor’s focus is on total wealth creation
instead of individual investment performance
 Explains why investors prefer certain or guaranteed outcomes
over probable outcomes
Behavioral Finance
Example:
Which would you choose?
A. A $450 guaranteed amount
B. A 50% probability of $1,000 and a 50% probability of $0, expected
value of $500
 People overwhelmingly chose “A”

 Utility Theory assumes people would answer “B”
Is this rational behavior? Humans prefer certainty.

Behavioral Finance and Prospect Theory call this the Certainty
Effect
Behavioral Finance
 Overreaction
 Investors systematically overreact to unexpected or dramatic events
 Causes inefficiencies in the stock market
 Includes both good and bad news
 Winner/Loser Effect
• Current bad performers tend to outperform good performers
• Supported by arbitrage strategies
 Explained by our inability to forecast and model

accurately?
Behavioral Finance:
Other Behavioural Issues
 Mental Accounting
 Influence of “framing” in buy/sell/hold decisions
• Focus on performance of single account or stock instead of total
wealth
• Similar to Prospect Theory
 Momentum Investing
 Investors tend to buy stocks that are going up
 Buying pushes price higher causing “Momentum”
 Herding
 Tendency of investors to copy each other’s strategies
 More prevalent among institutional investors
Technical Analysis
Lecture 2
Technical Analysis
 Examines prior price and volume data and other market-related

indicators to determine past trends believing they may help to
forecast future trends
 Emphasis on charts and graphs of internal market data
 Less (or no) emphasis on fundamental factors
 Exploits timing considerations and market imperfections
Technical Analysis:
Basic Assumptions
1. Market value determined solely by interaction of demand and

supply
2. Although there are minor fluctuations in the market, stock
prices tend to move in trends that persist for long periods
3. Reversals of trends are caused by shifts in demand and supply
4. Shifts in demand and supply can be detected sooner or later in
charts
5. Many chart patterns tend to repeat themselves
Technical Analysis:
Most Significant Assumptions
The lag between the time a technical analyst

perceives a change in the value of a security and
when the investing public ultimately assesses this
change provides a profit opportunity to the
chartist.
The Use of Charting
 Often linked to the development of the Dow Theory in

the late 1890s by Charles Dow
 Generally believed successful in signaling the market

crash of 1929
Essential Elements of the Dow Theory
 3 major movements in the market:
1. Daily fluctuations
2. Secondary movements
• two weeks to a month
3. Primary trends
• long term
• May be bullish or bearish in nature
Presentation of the Dow Theory:
Example of use to analyze a trend
 Chart shows positive

primary trend despite
two secondary
downward trends
 Bullish primary trend is
confirmed by the
increases in the levels of
secondary lows and
highs
 Pattern assumed to
persist long-term but
ultimately to end
Presentation of the Dow Theory:
Market reversal and confirmation
Ultimate end of a bullish trend

detected by a new pattern:
• Recovery fails to exceed previous
high (Abortive recovery) +
• New low penetrates a previous
low +
• New pattern confirmed by
subsequent movement in Dow
Jones Transportation Average
Support and Resistance Levels
 Chartists attempt to define trading levels where price

movements might face a challenge or barrier.
 This assumes the existence of:

 Support levels (lower ends of trading ranges) and
 Resistance levels (upper ends of trading ranges)
 Support may develop each time stock price falls to lower level as
investors who previously passed up buying opportunity now act
• Resistance may develop when stock price rises to high side of
normal trading range as investors take profit or try to get even
after having bought at previous high
•Support – at a sufficiently low price,
the quantity demanded of a security
increases keeping the price from
falling further
•Resistance – at a sufficiently high
price, the quantity supplied of a
security increases keeping the price
from rising further
Note that the analyst is looking just at the patterns here and is
not really concerned with any fundamentals behind them.
•Breakout – the security price

moves out of the previous trading
range (breaching the resistance or
support level) suggesting a new
consensus and new trading levels
Volume
 The volume of trading supporting a given market

movement is considered significant.
 A stock price making a new high on heavy trading
volume is viewed as bullish
 A stock price making a new low on heavy trading
volume is viewed as very bearish
 A stock price making a new high or low on light trading
volume may indicate a temporary move likely to be
reversed
Chart Evaluations
Market technicians carefully

evaluate charts – looking for
what they perceive to be
significant patterns of
movement.
Charts
The problem in reading charts:

Analyzing patterns in such a fashion that they
truly predict stock market movements before
they unfold.
Key Indicator Series
A number of technical indicator series may be watched

for bearish ( )and bullish ( ) trends
 Contrary opinion rules
 Smart money rules
 Overall market indicators
dundee.ac.uk
BU52042 Security Analysis and Equity Valuation by Dr Murat Mazibas CFA FRM

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BU52042

Security Analysis and Equity

 Lecture 1: Introduction: Financial Securities and Security markets.

 Lecture 2: Market Efficiency: Technical analysis, fundamental analysis,

 Lecture 3-6: Analysis & Valuation of Equity Securities:

 Workshop: Security Analyst Report presentations

 Efficient Markets and Anomalies

“All securities are correctly priced at any point in time”

 Implies neither fundamental analysis nor technical analysis work to profitably

 The Efficient Market Hypothesis (EMH) is stated

 No relationship exists between past and future prices

 Has been tested in two ways:

 The serial correlation between stock prices over

 Test based on the frequency and extent of runs in stock price

 Try to determine whether given trading rules based on

 Simulates conditions under which a given trading rule

 Stock price moves up 5% or more, “buy”

Since stock prices move randomly, such rules do not

 Any trading rule that relies on historical data and

 Security prices do appear to be independent over time,

 Prices move independently over time

 Past trends cannot be used easily to predict the future

 Charting/technical analysis may have limited value

 No exceptional returns can be earned using investment

 All public information is already impounded into the

 No learning lag in the dissemination of public

 Tests of this form of the EMH attempt to see if

 Assume a stock goes up 15% and the stock is 20%

 Assume the overall market rises by 10%.

 On a risk-adjusted basis, the stock would need to go up

 Since the stock rose by more than 12%, it is said to

 Tests examining the effects stock splits, stock dividends, and

 Almost all of the market impact of a stock split appears to occur

 Tests indicate that investors see through changes in accounting

 Fundamental analysis cannot be used to determine whether a

 Anomalies or deviations from the basic proposition that the

 Stock prices fully reflect all information, public, non-

 No group of investors has a monopoly on access to any

Test results of strong form EMH do not support its existence

 Specialists on security exchanges have been able to earn

 Corporate insiders consistently earn higher returns than would

 Gains beyond what the market would normally provide

 Often referred to as “Anomalies”

 Transactions costs must be included when determining

1. Mergers and Acquisitions

 Premiums for Acquired Company

 Acquiring Company Performance

Merger price premium = Offer price/share

 Does not support an efficient market

 Approximately 2/3 of price gain appears to benefit only the

 Golden parachutes for the executives of the acquired

 Mandelker study indicated no abnormal gain for the

 Clash of management philosophies

 IPO (initial public offering)

 IPO price may not fully reflect the true value

 Best time to buy is on initial distribution from

 IPOs are not that good of an investment for (average) investors

 An exchange is a market where securities,

 Securities accepted for trading purposes by regulated exchanges

 Strong upward movement associated with securities to be listed

 Strong sell-off after listing has occurred

 Delisting has strong negative effect on security

 Repurchase by a firm of its own shares