Security Analysis and Efficient Markets

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Security Analysis and Efficient Markets
Where We Are Going
We will study the concept of efficient markets
and how efficient markets affect security
analysis
Chapter 2
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Security Analysis and
Efficient Markets
Security Analysis is

• The search for equity securities whose expected
  returns will exceed the overall market's return

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Goal of Security Analysis

• To increase the returns for a given level of risk
  that an investor is able to earn

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Efficient Market Hypothesis

• Earning superior returns requires that we select
  undervalued securities. However. . .
• The Efficient Market hypothesis argues that
  securities are always priced correctly

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Efficient Market Hypothesis Cont.
Still, there is hope
There is growing evidence of
"pockets of inefficiencies"
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What is an Efficient Securities Market?

• A market is efficient when prices incorporate all
  relevant information

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Information Sets

• A securities market is efficient with respect to
  a set of information if prices in the market
  reflect that information
• You can only talk about efficiency with respect
  to a particular information set

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Information Sets Continued

• Weak-form efficient
• Prices reflect all past stock price information

• Semistrong-form efficient
• Prices reflect all publicly available information
• Everything you can infer from that information

• Strong-form efficient
• Market prices reflect all information

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Famas Information Sets
Information reflected in Semistrong-form efficient
market prices
Information reflected in Weak-form
efficient market prices
Information reflected in Strong-form
efficient market prices
Market share
Trading volume Prior price patterns
Undisclosed dividend
increase
Management changes
Merger announcements
Prior stock price information
Undisclosed new product information
Earnings announcements
Legal issues
Private Information
Public Information
All Information, Public and Private
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An Implication of Market Efficiency is That . .
.

• Future price movements will appear to be random,
  but they are actually reflecting revisions in
  expectations for the future

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An Inefficient Market is . . .

• One that ignores relevant information
• Therefore, a market whose prices are unrelated
  to relevant information about the underlying
  values of securities, is not sustainable

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Market Paradox

• If markets are efficient, no one should invest in
  information. Prices would not be updated for new
  information, and the market would be inefficient

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Market Paradox Continued

• If markets are inefficient, astute investors will
  seek information to earn higher-than-normal
  returns. This would cause the market to become
  efficient

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Definition of Market Efficiency versus
Implications of Market Efficiency
The Coin Toss Example

• An implication of efficiency is that future price
  movements will be unpredictable that is, they
  will appear to fluctuate randomly

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The Coin Toss Example Continued

• However, price changes are not
  really random

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The Coin Toss Example Continued

• Consider a security that pays 1.00 for each of
  100 tosses that turns heads up
• The value at the end of the 100 tosses will be
  between 0 and 100, with an expected value of
  50

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The Coin Toss Example Continued
Toss One
Expected Value 50.00
Heads 50.50
Tails 49.50
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The Coin Toss Example Continued

• Prior to the first toss, it is impossible to
  predict how the price will change after the first
  toss
• Even though we could not predict the price
  movement before the toss, the price did not
  really fluctuate randomly

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The Coin Toss Example Continued
It reacted immediately to the information in the
first toss, which changed the value of the
security
54

53

52
. . . . . . . .
Dollars
51





50





49

48
0
5
10
99 100
Toss
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The Role of Investors in an Efficient Market
Information
Prices
Investors
Buy and Sell Orders
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Role of Investors in an Efficient Market
Continued

• Finding information
• Interpreting information
• Trading on information
• Happens only when
  it is profitable to do so

Cost of information lt Excess return
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Implication of Market Efficiency for Security
Analysis

• Future price movements are not predictable using
  known information

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Comparative Advantage

• Firms will operate in areas in which they have an
  advantage relative to others

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Security Analysis Will Be Done by . . .
Those who have some advantage
Faster access to data
Superior ability to analyze data
Lower transaction costs
Ability to keep trading rules proprietary
SEC Reg FD
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People Without Such Advantages Should Be . . .
Passive investors holding

• Mutual funds
• Index funds
• Diversified portfolios

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An Investors Beliefs about Efficient Markets . .
.
Affects his or her likely approach to investing
Market Efficiency Belief
Passive strategy
Market Inefficiency Belief
Active strategy
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Investor Beliefs and Security Analysis
Investor Beliefs
Markets are always efficient
Markets may be inefficient
Active Strategies
Weak-form inefficiencies exist
Semistrong-form inefficiencies exist

• Passive Strategies
• Buy and hold
• Indexing

Technical Analysis

• Fundamental Analysis
• Individual firm
• Cross sectional

Voodoo
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Summary

• Goal of security analysis
• Concept of efficient securities
• 3 levels of market efficiency
• Role of investors
• Comparative advantage in security analysis
• Investors' beliefs determine investment style

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Business Analysis
Prob. 2

• I.   Internal analysis
• 1.    mission
• 2.    products and services
• 3.   pricing structure
• 4.  marketing
• 5.  manufacture or purchased / long-term
  agreements with suppliers/ labor issues
• 6.    research and development group and how does
  this affect the future
• 7.    human resource issues
• 8.  management and plans for succession
• 9. distribution

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Business Analysis
I.   

• External Analysis
• Are there many competitors or few?
• Who are the firm's competitors?
• What are the barriers to enter ?
• Do we expect new competitors in the future?
• Identify competitors and get a description of
  each.
• Get financial information on the competitors.
• What might we expect from the competitors in the
  future?
• What are the growth prospects for this industry?
• Who are the firm's customers?
• Do we expect the customer groups to grow in the
  future?
• Do we expect the needs of the customer groups to
  change in the future?
• What are the major regulations that impact the
  Vermont Teddy Bear business?

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Financial Statement Analysis

• Prepare an accounting analysis of Vermont Teddy
  Bear. Evaluate how the company's estimates,
  accounting choices and levels of disclosure
  affect the reported numbers.
• Use the historical financial statements to learn
  about the company's profitability, growth and
  resource needs. Calculate ratios and trends for
  key financial information.
• Consider any business issues identified in the
  business analysis that may need financial
  analysis.
• Consider whether the results of the financial
  analysis identify any business issues. If so, do
  further business analysis on these issues.

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Prob. 4
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Quotes current as of 084500 CST, Thursday,
September 04, 2003.