INVESTMENT MANAGEMENT

UMAD5X-15-3

EFFICIENT MARKET
HYPOTHESIS 1

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 What you are learning today
Random walks

Definition of an Efficient Market

Three forms of the Efficient Market Hypothesis

(EMH)

The implications of EMH for Investment

Management
 Efficient Market – the academic view
In 1965 Eugene Fama wrote
“An efficient market has large numbers of rational
investors actively competing with each trying to predict
future market values of individual shares, and where
important current information is almost freely available
to all participants”.

In October 2013 he was one of three

academics who shared the Nobel prize
for Economics
 Efficient Market – the market view
In the words of Warren Buffett

“I’d be a bum on the streets with a

tin cup if markets were efficient”.

Buffett is chairman of Berkshire Hathaway (BH) and the most

successful investor ever with a net worth of over $58 billion. Since
1965 BH shares have produced an annual return of 20.5% as
compared to 9.7% for the S&P 500 Index.
BH owns shares in Coca-Cola that were bought for $1.3 billion and
at February 2019 had a market value of $18.9 billion. BH is the
largest shareholder in American Express where its shares are worth
$14.5 billion as compared to $1.3 billion when originally purchased.
 What is a Random Walk?
Price changes are random
Maurice Kendall (1953) – expected to find regular price cycles for
shares and commodities, but found that prices followed a random
walk

Random Walk - the movement of share prices from day to day DO

NOT reflect any pattern

Statistically speaking, the movement of share prices is random,

(skewed positive over the long term)
 Random Walk with Positive Trend
Share
Prices

the positive trend line is

there because firms
invest in +NPV projects on
average
Positive trend is related to
expected return

Deviations from the trend

should be unpredictable.
Time
 Random Walks and the EMH
Closely related to the EMH is the concept that
share prices should follow a random walk
That is, price changes should be random and
unpredictable
Why?
Under EMH, prices reflect all information. So what
causes the price to change is the release of new
information or news
Flow of new information is unpredictable and thus
price change is random
 Why is efficiency important?

Market efficiency based on the idea that share

prices fully reflect information
Investors can trust that market prices reflect fair value
of assets
Do not have to conduct own research
Objective for companies is clear: maximise share price
will maximise shareholder wealth
A clear benchmark for corporate decision making
Capital and resources are allocated in sectors that
would generate most benefits for society
 Three Forms of the EMH
Depending on the information set, you can have
weak, semi-strong or strong form EMH

Weak form EMH

The relevant information is historical prices and other trading
data such as trading volume

If the markets are weak form efficient, use of this

information provides no benefit at all

Share prices reflect fully all information in past price

movements
 Three Forms of the EMH
Semi-strong form EMH

– The relevant information is "all publicly available

information, including past price and volume data"

– If the markets are semi-strong form efficient, then

studying past price and volume data, or studying
earnings and growth forecasts provides no net
benefit in predicting price changes at the margin

– Share prices reflect fully all publicly available

information
 Three Forms of the EMH
Strong form EMH
– The relevant information is all information both public and
private or “inside” information.

– If the markets are strong form efficient, use of any information,

public or private, provides no benefit at the margin

– SEC Rule 10b-5 limits trading by corporate insiders (officers,

directors and major shareholders). Insider trading must be
reported.

UK version is Section 118 FSMA

Market Abuse Directive (EU)
Relationships between EMH forms

Note that semi-strong efficiency implies that a market

is weak form efficient – but not vice versa

Strong form efficiency would indicate that both weak

and semi-strong forms
Implications of the EMH

Technical analysis

Fundamental analysis

Active versus passive investment

Portfolio management
Technical Analysis

The idea is that pattern

repeats itself (or the trend
would continue)

If you can identify them,

you can predict future
price movement
 Relationship to the EMH
Technical Analysis
Technical Analysis or TA is using past prices and
volume information to predict future price changes

– If the markets are weak form efficient will technical

analysis be able to consistently predict future price
changes?

– In practice, chartists don’t believe in efficient

markets
 Fundamental Analysis
Fundamental analysis (FA) assumes that share prices
should be equal to the discounted value of the expected
future cash flows the share is expected to provided

Techniques of FA generally focus on

Forecasting the firm's future dividends or earnings

Discounting those future cash flows by the required

rate of return (usually obtained from the CAPM) and

Comparing the resulting estimated price with the

current share price
 Fundamental Analysis
If the estimated price or intrinsic value is ______ than
the current price an investor should ___ the share since
it is ___________ and since its price should ________ to
the "true" or "fundamental" value uncovered by the
analyst

If the estimated price is ____ than the current price the

share should be ____ because the share is currently
__________ by the market

In either case if the analyst is correct the investor should

receive an _______________
 Fundamental Analysis
If the estimated price or intrinsic value is greater than the current
price an investor should buy the share since it is undervalued and
since its price should increase to the "true" or "fundamental"
value uncovered by the analyst

If the estimated price is lower than the current price the share
should be sold because the share is currently overvalued by the
market

In either case if the analyst is correct the investor should receive

an abnormal return
Abnormal return refers to return in excess of that required for
the risk being undertaken
 Relationship to the EMH
Fundamental Analysis
Using economic and accounting information to
predict stock price changes
– If the markets are weak form efficient (or semi-strong form
efficient or strong form efficient) will fundamental analysis be
able to consistently predict price changes?
– Answer:

If the markets are only weak form efficient?

Fundamental Analysis CAN predict price changes
If the markets are semi-strong or strong form efficient?
Fundamental Analysis CANNOT predict price changes
 Research findings on TA and FA
Technical Analysis
Most technical trading rules do not generate
abnormal profit after adjusting for transaction costs
Fundamental Analysis
To add value, your forecast must be better than the
consensus forecast (it is not sufficient to identify a
good company)

Strong competition makes it difficult for Fundamental

Analysis to produce net benefit after costs
 EMH Implications for Investment Management

Active Management

Security analysis Assumes inefficiency,

Timing strategies use technical and/or
fundamental analysis
Investment newsletters
to select securities
Passive Management

Buy and Hold portfolios Consistent with semi-

Index Funds strong efficiency
Market Efficiency and Portfolio Management

Even if the market is efficient a role exists for

portfolio management

– Identify risk appetite and choose appropriate mix

of risky and risk free assets
– Tax considerations
– Other considerations such as liquidity needs or
diversify away from the client’s industry
 Summary
EMH says prices reflect all information

Far reaching implications for investors,

companies, regulators and industry policy

Three forms of EMH: weak, semi-strong and

strong
Weak form EMH implies TA is useless
Semi-strong form EMH implies FA is useless
Tutorial Week 6
 Exercise 1
Explain why the following statements are
true/false/uncertain.
 
• a. With all else held constant, a firm will have a
higher P/E ratio if its beta is higher.
• b. P/E ratio will tend to be higher when ROE is
higher (assuming retention is positive).
• c. P/E ratio will tend to be higher when the
retention rate is higher.
 Answer
• False - Higher beta means that the risk of the firm is higher and the
discount rate applied to value cash flows is higher. For any expected
path of earnings and cash flows, the present value of the cash flows,
and therefore, the price of the firm will be lower when risk is higher.
Thus the ratio of price to earnings will be lower.
 
• True - Higher ROE means more valuable growth opportunities.
 
• Uncertain - The answer depends on a comparison of the expected rate
of return on reinvested earnings with the market capitalization rate. If
the expected rate of return on the firm's projects is higher than the
market capitalization rate, then PE will increase as the retention ratio
increases.
 Exercise 2
• a. Computer shares currently provide an expected rate
of return of 14%. MBI, a large computer company, will
pay a year-end dividend of $4 per share. If the share is
selling at $80 per share, what must be the market’s
expectation of the growth rate of MBI dividends?
 
• b. If dividend growth forecasts for MBI are revised
downward to 4% per year, what will happen to the
price of MBI shares? What (qualitatively) will happen
to the company’s price–earnings ratio?
 Answer
Hence we use the constant growth version of the DDM model as
shown below
Use P0 = D1 / (k-g) so $80 = $4/(0.14 – g) and hence (0.14 –g) = 0.05
Thus g = 0.09 or 9.0% growth in dividends
If the growth were reduced to 4% then using P0 = D1 / (k-g) we have
P0 = $4/ (0.14 – 0.04) = $4/0.10 = $40.00
The price falls in response to the more pessimistic forecast of dividend
growth. The forecast for current earnings, however, is unchanged.
Therefore, the PE ratio decreases. The lower PE ratio is evidence of
the reduced optimism concerning the firm's growth prospects.
Exercise 3
 Answer
• MRP = 10% Rf = 3% Beta = 0.9 and hence
k = 3% + 0.9*10% = 12.0%
• Long term growth rate estimated by analyst is
too large, so use alternative as terminal
growth rate g = 4.3%
• The required intrinsic value is the sum of all
PV’s = 5.44
 Answer
b) Two reasons why terminal growth should not equal to
14.21%
• 1) It is greater than k

• 2) It is estimated that the long run growth potential for UK

GDP is about 2.3%. Adding the inflation target of 2%, UK firms
should not have terminal growth rate far higher than 4.3%.
This is consistent with 140 years of US aggregate earnings
figures which suggest US aggregate earnings were growing at
about 3.8%. Based on the above, it is inconceivable for a
major blue chip to have 14.21% as terminal growth rate.
 Answer
  Pros Cons

DDM 1) PV of future cash flow is consistent with financial 1) A number of parameters to estimate
theory 2) Sensitive to parameter values
2) Accommodate different growth rates
3) Can avoid bubbles

PE 1) Simple to use 1) Does not allow for multiple growth rates

2) Make use of comparables’ prices 2) Earnings quality problem
3) Cannot avoid the risk of bubbles