Columnists
Surprise! The market's inefficient
By TIM WHITEHEAD
Put another nail in the coffin of market efficiency.
According to basic theory, the stock market is
efficient in that it immediately incorporates all of the available
information about a stock and reflects it in the stock's price.
Think of the stock market as a giant computer that takes all the
future projections, risks, discount factors and so on into account
and converts all that available information into a stock price. When
the stock's price changes, it is because the available information
has changed. This is known as the 'efficient market hypothesis' and
it is an article of faith. It is also violated on a regular basis.
The latest contrary evidence relates to how stock
prices react to earnings surprises. If Corporation X announces that
it earned 60 cents per share in the last quarter, compared to
analyst expectations of 40 cents, that would constitute a 'positive'
earnings surprise. Conversely, if X announced earnings of only 20
cents per share, that would be a 'negative' earnings surprise.
In paper titled "The Underreaction Phenomenon",
Professor Padma Kadiyala of Southern Methodist University and
Professor Raghavendra Rau of Purdue University looked at earnings
surprises and the market's reaction to subsequent corporate
announcements (new equity issue, stock repurchase or acquisition).
What they found is that the market reacts very differently depending
upon whether the earnings surprise was positive or negative.
Take, for example, the announcement of a share
buy-back. A company announces that it intends to buy back some
number or percentage of its own shares outstanding. Typically, the
corporation makes some statement about how the shares are
under-valued relative to the company's value or prospects. (Kadiyala
and Rau find that, in the stocks they studied from 1984 to 1994,
companies announcing buybacks had seen the price of the shares
decline by an average of 11 per cent in the six months prior to the
announcement.)
Will the price of the company's shares rise or fall
in the three years after that buyback announcement? Kadiyala and Rau
find that how the price responds depends, in part, on the nature of
the previous earnings surprise. If the earnings surprise was
positive - the company beat analysts' expectations - the stock
enjoyed an average extra return of 8.2 per cent over the next three
years after the announcement. If the earnings surprise had been
negative, however, the stock outperformed comparable stocks by only
2.8 per cent over the three years after the buyback announcement.
In both cases, stocks generally outperformed the
stocks of comparable companies after the buyback announcement. It's
just that the performance was significantly better for companies
that had been exceeding analysts' expectations prior to the buyback
announcement.
Kadiyala and Rau find similar results for corporate
announcements of new equity offerings, stock-financed takeovers and
cash-financed takeovers. In each case, the nature of the
corporation's previous earnings surprise - positive or negative -
made a difference to how well the market reacted to the announcement
over the next three years.
The conclusion is that the market doesn't fully
absorb the earnings surprise. When a company reports
better-than-expected results, the stock usually appreciates in
immediate reaction, but the results of Kadiyala and Rau imply that
the reaction is incomplete. It takes time for the market to fully
reward a company for a positive earnings surprise (or, conversely,
punish a company's stock for an earnings disappointment).
Kadiyala and Rau's results also suggest that this
under-reaction phenomenon is more pronounced for firms that few
analysts cover. This is consistent with the widespread belief that
market efficiency, where it does exist, applies least well to small
firms that don't have big followings on Wall or Bay Streets.
The brief synopsis is that the market under-reacts to
news, according to Kadiyala and Rau. That implies that the market is
at least somewhat inefficient. And that means that there is some
inefficiency for investors to exploit.
This means that, even after the initial surge in a
stock's price after a better-than-consensus quarter, there might be
more on the table for late investors to enjoy. Conversely, a poor
earnings result might see a stock's price slip immediately in the
market but that doesn't mean all the bad news has been factored into
the stock's price and so holders might consider selling.
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Economist/author Tim Whitehead
operates a consulting firm, Left Bank Economics Inc., near Paris,
Ontario.
