5 inefficient markets

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Chapter 5INEFFICIENT MARKETS AND

CORPORATE DECISIONS

Behavioral Corporate Finance byHersh Shefrin

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights

reserved.


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Winner-Loser EffectStocks whose returns have been

worst over a 3-year period have

outperformed the market over thesubsequent 5 years by about 30%.

Stocks whose returns have been best


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over a 3- year period have

underperformed the market over the

subsequent 5 years by about 10%.

On a cumulative basis, losers

outperform

winners by about 40% over 5 years.1


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MomentumA portfolio formed by holding the

winners from the past 6 months,

and shorting the losers from the


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past 6 months earned more than

10% per year.Pattern is pronounced among small

cap stocks.2


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Post-Earnings- Cumulative Abnormal Returns for Different Earnings

Surprises

6.00

-100 -50 4.00 2.00

0.00

-2.00 0 -4.00

50 100

Announcement Drift-6.00-8.00


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When a firm announces that

its earnings have exceeded theconsensus analyst forecast, the

outcome is a positive surprise.

Negative surprise similarly

defined. Stock prices adjust

slowly to surprises,

exhibiting drift.

31.


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Traditional PositionOverreaction and

underreaction are the results of

random variation consistent with


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market efficiency. Fama

pointed out that empirically,findings of overreaction occur

about as frequently as findings

of underreaction4


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Limits of ArbitrageWill smart investors quickly take

advantage of

mispricing caused by irrationalinvestors, thereby rendering the

mispricing small and temporary?


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Mispricing can become worse before

it gets

better. Therefore, smart

investors might temper their

trades, and as a result the

inefficiencies might be neither smallnor temporary.5


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Limits of Arbitrage Pick

a Number Game1. Playing the game skillfully requires

an


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understanding of the errors to which

the other players are susceptible. 2.

The appropriate course of action is

different

when the other players commit errors

than when they do not. 3. Skilled playby the winner does not

necessarily bring the outcome close

to what would occur if few players

committed errors.6


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Do Managers Trust

Prices?Managers appear to behave as if

they believe


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markets are inefficient.

Managers indicate that they would

reject

positive NPV projects if accepting

those projects would lower their firms

EPS. Managers split their stocks, even though doing

so has no value when markets are

efficient. Managers time IPOs to

take advantage of hotissue markets.7


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Earnings vs. NPVMajority of CFOs view earnings

rather than

cash flows as the key variable uponwhich investors rely to judge value.


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The majority of managers are willing

to

sacrifice fundamental value in order

to meet a short-run earnings target.

Over half of managers would avoid initiating

a very positive NPV project if doing so

meant missing analysts target for the

current quarters earnings. Example:

Herman-Miller

8


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Stock SplitsFirms that decide to split their

stocks tend to

feature pessimistic coverage byanalysts in respect to earnings


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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 splitexhibit

price drift.

Stocks earn an average abnormal return of

7.93% in the first year, and 12.15% in the

first three years.

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5 inefficient markets

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