What every financial manager needs to know about market efficiency
| by Dr Peter Atrill 24 Feb 2002 Diploma in Financial Management Relevant to Module B |
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What do we mean by capital market efficiency?
The term ‘capital market efficiency’ is used to describe the way in
which the market absorbs information. An efficient capital market is one in
which all the available information relating to a particular company is processed
quickly and accurately and reflected in the share price. Information relating
to a particular company is evaluated in a rational way and the price of its
shares is adjusted accordingly. This means that when new information is available,
which alters the expectations of investors about the future prospects of a company,
we should expect an instantaneous and unbiased reaction from the market in the
form of a revised share price. The kind of information that may alter investor
expectations can take various forms including profit warnings, dividend announcements,
board changes, strikes, new contracts won and so on.
If the market absorbs all information concerning a company quickly and accurately, this will mean that shares will be fairly priced. However, many investors find such a notion difficult to accept. In practice, many investors scour the market looking for shares that are mis-priced; that is where the market prices of shares do not reflect their ‘true worth’. For this reason, it is often said that the efficiency of capital markets is based on a paradox. In order for a market to be efficient, there must be a large number of investors who are prepared to examine the available information relating to a company in the hope of unearthing mis-priced shares. However, they will only do this if they believe that the market is inefficient. To illustrate this point, let us assume that investors are able to find an under priced share. They will want to buy the share in order to make a profit.
However, this will mean that demand for the share will rise and so its price will rise. Nevertheless, investors have an incentive to continue buying the shares until the price reaches the point that it corresponds to the ‘true worth’ of the share. That is, they will continue to buy until any market inefficiency has been eliminated.
It is important to recognise that ‘efficient markets’ are not the same as ‘perfect markets’. The term ‘perfect markets’, which is often used by economists, is based upon various assumptions that do not hold in the real world. These assumptions include information being freely available and individuals having perfect information about the future. Such limiting assumptions, however, do not apply to efficient markets, which are based on evidence collected about the behaviour of capital markets in the real world.
Three forms of efficiency
Three forms of market efficiency have been identified, which are as follows:
1 The weak form
This form of efficiency reflects the situation where share prices follow a ‘random
walk’. By this we mean that prices move up or down on a random basis without
regard to what has happened in the previous days. In other words, there is no
predictable pattern in share price movements, and so we cannot look at past
price movements to help us predict future share prices. The weak form of efficiency
suggests that current share prices fully reflect any information contained within
past share prices.
There are some investors who try to identify patterns occurring in share price movements (which is known as technical analysis). However, this type of analysis will not be profitable for investors in a capital market that has weak form efficiency. They will be wasting their time as there are no predictable patterns to detect.
2 Semi-strong form
The semi-strong form extends the notion of efficiency a little further and describes
the situation where any published information relating to a company will be
reflected in its share price. This means that investors who spend time poring
over company annual reports, company announcements, industry trends, economic
forecasts and so on (which is known as fundamental analysis) would not be able
to make superior returns on a consistent basis. They will be wasting their time
as this information has already been incorporated into the share price.
3 Strong-form
This form of efficiency is the ultimate form of efficiency in the sense that
it describes the situation where all relevant information, whether it is within
the public domain or whether it is outside the public domain, will be reflected
in the price of a share. This means that even access to ‘inside’ information
such as management decisions or intentions, would not enable investors to make
superior returns on a consistent basis.
These different forms of market efficiency represent a form of progression. Thus, a market that is efficient in the semi-strong form will also incorporate the features of the weak form (that is, random share price movements). A market that is efficient in the strong form will incorporate the features of the semi-strong form (rapid and unbiased price adjustment to published information) and will also incorporate the features of the weak form (random price movements). Thus, it would not be possible for a market to be efficient in the strong form but not incorporate the features of the semi-strong and weak forms.
Market evidence
You may wonder what evidence is available to support these various forms of
efficiency. The evidence supporting the existence of the weak form of efficiency
is really overwhelming. Tests have been conducted in many countries over many
time periods and the results almost always point to the existence of a random
pattern of share prices. The evidence supporting the existence of semi-strong
form of efficiency is less overwhelming, but nevertheless very convincing, at
least for the major world stock markets. Tests of the semi-strong form have
often involved an examination of price movements following the release of new
information, such as profit announcements, and the results have usually shown
that share prices re-adjust quickly and accurately to the new information. This
implies, of course, that investors cannot make abnormal gains by reacting quickly
to any new information.
Tests of the strong form have often involved an examination of the performance of investment fund managers. These fund managers are assumed to have access to a wide range of information, not all of which is in the public domain. The results show that despite this apparent advantage over private investors, fund managers are unable to generate consistently superior performance over time. However, the existence of the strong form of efficiency in major capital markets is a more contentious issue than the existence of the other two forms.
What are the lessons to be learned?
Having identified the various forms of market efficiency and the evidence in
support of each form, we need to be clear what the implications are for the
managers of a business. It can be argued that there are really four key lessons
that should be learned.
Lesson 1: Accept the market price
We have seen that the semi-strong form of efficiency indicates that new information
is quickly and accurately absorbed in share prices. This means that the price
of a share in the company will reflect its ‘true worth’. One important
implication for a manager is that there is no point in looking for undervalued
shares in other companies in the hope of finding a cheap takeover target. The
share price will faithfully reflect all the publicly available information relating
to the company. If the strong form of market efficiency exists then not even
‘inside information’ will be helpful in identifying cheap takeover
targets. Managers must, therefore, find more convincing reasons for taking over
another company, than simply that the shares are undervalued.
Lesson 2: Timing doesn’t matter
When a company is considering a new issue of shares, its managers may believe
that the timing of the new issue is of vital importance. If the market is inefficient,
then this could be true. It would not be a good idea, for example, to make a
share issue at a point when the shares are undervalued. However, if we accept
the semi-strong form of efficiency, the price of shares accurately reflects
their ‘true worth’ and so there is no ‘correct’ point in
time at which shares should be issued. Even if share prices are depressed, as
has been the case in the recent past, share prices will still reflect the market’s
view of future prospects and there are no economic laws that say prices will
rise in the future. Only if the strong form of efficiency did not exist and
the company had ‘inside information’ that would alter the price of
the shares, if released to the market, would the timing of a share issue be
important.
Lesson 3: You can’t fool the market
Some managers may believe that form is as important as substance when communicating
new information to the market. This may induce them to ‘window dress’
the accounts in order to provide a better picture of the financial performance
and position of the company than is warranted by the facts. The evidence suggests,
however, that the market is able to ‘see through’ any cosmetic attempts
to improve the financial picture. The market quickly and accurately assesses
the economic substance of the company and will price the shares accordingly.
Some managers may believe that a bonus issue of share will provide a ‘feel-good’ factor for investors that will be reflected in share prices. However, the market will not be fooled in this way. Investors will recognise that a bonus issue adds nothing to the value of the business and so there should be no change in share price following the issue. In some cases, share price movements have been observed following a bonus issue. However, it is not so much the bonus issue that provokes this movement but the signal that the bonus issue provides for investors. If, for example, it is expected that the dividend per share will remain unchanged following the bonus issue, this may be interpreted as signalling good news about future prospects. In this case, share prices may be expected to rise.
Lesson 4: The market decides the level of risk, not the company
The market will evaluate the risk associated with a particular investment and
will then accurately assess an appropriate level of return. (Remember that the
higher the level of risk, the higher the required return from investors.) There
is little that managers can do about the judgement imposed by the market. For
example, it would be futile to engage in financial strategies, such as the issuing
of particular types of shares or other securities, to try to reduce the required
rate of return. The market will deliver the same judgement, whatever kind of
financing strategy is adopted by managers.
Are the markets really efficient?
The view that capital markets, at least in the major industrialised countries,
are efficient is now part of the established wisdom of finance. However, there
is a growing body of evidence that casts doubt on the efficiency of capital
markets and this has re-opened the debate on this topic. Researchers have unearthed
regular patterns occurring in share price movements in some of the major stock
markets. This suggests an element of inefficiency as it would be possible for
an investor to exploit these patterns in order to achieve abnormal profits over
time. For example, there is fairly compelling evidence that, other things being
equal, small companies provide better returns. There is also some evidence that
investment timing may be critical. The choice of month, the choice of day and
even the choice of time of the day may be important when trading in shares.
For example, research shows that on Mondays there is a greater-than-average
fall in share prices. The clear implication is that by adopting the simple trading
rule of buying shares (but not selling shares) on Mondays, an investor can make
superior gains.
There is some debate as to the extent these findings of share price patterns and other anomalies really undermine the view that has prevailed for many years that the major stock markets are efficient. Some take the view that no theory is perfect and that we should not discard the idea of capital market efficiency because of a few imperfections. However, others believe that such price patterns show that the notion of efficient markets is fundamentally flawed.
Faced with the mixed messages coming from capital market researchers, the financial managers of a business may wonder how they should proceed. Well, the advice given by Brealey, Myers and Marcus (See reference at the end of the article) is as follows: “Although capital markets are not always 100 per cent efficient, smart financial managers generally start by assuming efficient capital markets. Financial traps and mirages are generally most easily seen from this vantage point. Of course, financial managers sometimes find opportunities in the wake of inefficiencies and imperfections. In that case they abandon the efficient-markets vantage point and adapt financial strategy accordingly”.
This is probably the best advice that can be offered until our understanding of stock market behaviour improves.
Conclusion
In this short article we have considered notion of stock market efficiency.
We have identified three forms of efficiency and have briefly mentioned the
kind of evidence accumulated to support the existence of the varying levels
of efficiency. Some of this evidence, particularly with regard to the strong
form of efficiency, runs counter to intuition but is, nevertheless, fairly compelling.
However, there is increasing evidence of share price patterns and other anomalies
that casts doubt on the degree of market efficiency that exists. This evidence
has re-opened the debate on market efficiency.
We have seen that an efficient stock market has important implications for the managers of a company. We have discussed four of the most important lessons: accept the market price, timing doesn’t matter, you can’t fool the market and the market decides the level of risk. These lessons must be learned by managers and should guide their decisions in an efficient market setting.
Reference
Fundamentals of Corporate Finance, R. Brealey, S. Myers and A. Marcus,
McGrawHill, 1995 Page 314.