banner
August 15, 1999
STRATEGIES

How Dot-Com Makes a Company Smell Sweet
Related Articles
  • The New York Times: Your Money

    Forum

  • Join a Discussion on Investing
    By MARK HULBERT

    A new academic study may finally put to rest the notion, once widely held, that the financial markets efficiently price all securities, all the time. Given the recent carnage in Internet-related stocks, it seems appropriate that the study's case rests on the behavior of a group of stocks whose issuers may have tried too hard to take advantage of Internet mania.

    It was not so many years ago that the doctrine of market efficiency, the so-called efficient-markets hypothesis, was the prevailing orthodoxy among this country's finance professors. Accepting the hypothesis means accepting that all money managers' attempts to beat the markets are doomed.

    Though many people have grown skeptical of the theory, a surprising number of believers still devote a lot of energy to explaining away any evidence of market inefficiencies.

    But this new study, "A Rose.com by Any Other Name," by Michael J. Cooper and P. Raghavendra Rau, assistant professors of finance at Purdue University in West Lafayette, Ind., and one of their graduate students, Orlin Dimitrov, provides evidence of inefficiency that even the most die-hard believers in efficient markets should find hard to dismiss.

    Cooper and his co-authors studied 63 companies that from the beginning of 1998 to March 26 of this year changed their names to include Web-oriented designations like ".com," ".net" or the word "Internet."

    On average, over the two weeks after their name changes were announced, the companies saw their shares gain 125 percent more than those of their peers, the study said. The authors were careful to filter out companies whose gain could be attributed to other causes, like a good earnings report or merger rumors.

    It is very difficult to explain away this result. A name change has nothing to do with the profitability of the company. But believers in market efficiency are not likely to give up without a fight.

    The main argument Cooper anticipates is that the new names may in fact reflect a major shift in business -- that the companies were becoming more involved with the Internet. The rise in their stock prices thus would have nothing to do with the name changes per se but would instead reflect the market's judgment about the profitability of their future Internet business. Because this judgment is not obviously wrong on its face, the market's behavior cannot be used to prove market inefficiency.

    But the study -- available on the Web at www.mgmt.purdue.edu/mcooper/newpapers/dotcom.pdf -- was designed to pre-empt this argument. It isolated companies in the group whose core businesses have nothing to do with the Internet and then compared their performances with those of the companies in the group whose core businesses were Web-related.

    If the market was efficient in setting the prices of Internet stocks, the companies with no Internet association should have experienced smaller gains after their name changes.

    Cooper found no such pattern. On the contrary, there was no difference in the performances of these two groups of rechristened companies. The only possible explanation is that investors have been willing to throw their money at almost anything that claimed an Internet link.

    Evidence that markets are inefficient, however, doesn't mean that beating them is easy. From the fact that the market is sometimes inefficient, you can't conclude that it is always so. In fact, the markets remain quite efficient, especially for the stocks and bonds of the biggest and best-known companies.

    Most of the stocks in the study were relatively little known and had small market capitalizations, the kind of stocks for which one would expect the market to be least efficient.

    Still, the Internet examples, though extraordinary, are not unique. The study's authors found examples of the phenomenon dating back several centuries. Because beating the market requires identifying pockets of inefficiency, it is heartening to receive rigorous statistical evidence that such pockets exist.

    Mark Hulbert is editor of The Hulbert Financial Digest, a newsletter based in Alexandria, Va. His column on investment strategies appears every other week. E-mail: strategynytimes.com.