Is the market always right?

Companies and investors do not need capital markets to be perfect; but to be efficient and to offer fair prices so they can make reasoned investment and financial decisions (Watson, 2013). In the recent past, there has been much debate questioning the notion that stock markets are efficient. To add to this debate, in 2013 two economists with completely opposing interpretations of the ways markets behave were jointly awarded the 2013 Nobel memorial prize for economics (BBC, 2014). How can two opposing theorists win the same prize?

Market efficiency research goes back to 1900 when Louis Bachelier published his idea that government bonds followed a random course. He understood that if it was obvious that a share would be worth more next week, then surely the price would already have risen in anticipation of that? Correct! Predictable moves have already happened, because the market is efficient – and all that is left are unpredictable surprises.

In the 1960’s, Eugene Fama wasn’t satisfied with Bachelier’s theory as there wasn’t “an economical model behind it”. Fama’s theory established the prices of capital market securities and stated that the prices of securities fully and fairly reflect all relevant available information’. Market efficiency therefore refers to both the speed and the quality of the price adjustment to new information (Watson, 2013). If I was a new investor entering the market, the main consequence of the market being efficient, is that the market would always be one step ahead of me. If this is the case, I would be much better off investing broadly and diversifying my portfolio of shares, to increase my chances of higher returns. This is the concept that underpins Markowitz’s (1952) portfolio theory.

Fame (1970) identified three forms of efficiency:

Weak form efficiency: current share price reflects all past movements, which implies that if I carried out a ratio analysis on a company, it would immediately be out of date. Share prices will change as new information arrives on the market and, since new information arrives at random, share price movements will also be random (Samuelson, 1965). This supports the ‘Random Walk Hypothesis’ theory by Kendal (1953) that there is no systematic link between one price movement and subsequent ones, therefore a share prices at any one time reflects all known information. Because of the nature of the news, when it arrives it is unknown if it will be good or bad.

Semi-strong efficiency: share prices reflect all historic and publicly available information and react quickly and rationally to new information. This means that you can’t make abnormal returns by studying publicly available information, as the market has already adjusted to the news. 

I believe the UK stock market is semi-strong efficient. To support my statement I have created a graph to show Twitter’s share price during the first week of February 2015 (see diagram 1). On the 6^th February, Twitter’s Chief Executive announced that the social media company saw a 97% increase year on year for revenue growth. Based on Fama’s theory, this means that as soon as the news was released, share prices should have immediately reflected this new information. This is exactly what is illustrated by diagram 1.  

Diagram 1: Twitters share price during the first week of February 2015

Strong form efficiency: reflects all information, whether it is publically available or not. Investors cannot make abnormal returns from share dealing, not even investors who act on ‘insider information’. Capital markets clearly do not meet all the conditions for strong form efficiency as prosecutions for this offence has taken place.   

As an investor I might as well behave as though the market is efficient and that nothing is therefore underpriced. The market quickly and rationally integrates new information, as supported by the Twitter example, which therefore means that abnormally high returns can only be made where there is access to information that is not yet published (insider information) or by chance.    

So the market is always right. Or is it?

In 1981 Robert Shiller a challenger to the efficient market hypothesis arrived on the scene. His argument was ‘market volatility is too high for the efficient markets theory to be true’. He believed that investors’ behaviour cannot be fully based on rationality and must acknowledge the role played by psychology (Malkiel, 2003). In the 1980’s, he showed that stock prices tend to fluctuate more than corporate dividends. This should not happen if investors were fully rational, since stock prices forecast future dividends (Financial Times, 2013). His idea was that markets have a tendency to overreact to news, or to react to non-news. 

By using share price data, I have constructed a graph to show the change in Apple’s share price throughout February 2015 (see diagram 2). In two instances during the month, ‘rumours’ circulated within the news about potential new products and release dates. Although no official announcements had been made by Apple, share prices increased even though the news could potentially be ‘non-news’, demonstrating Shiller’s theory that the market overreacts, and in this case to ‘non-news’.

Diagram 2: Apple’s share price over February 2015

Shiller went on to write a best-selling book called Irrational Exuberance, and applied his insights to the US housing market, which he believed was overvalued. He claimed that behaviour of house prices was driven by excessive optimism over future valuations (Shiller, 2007). This finding was proven to be remarkably prescient when the market crashed in 2007.  

In his book, Shiller explained that stock analysts commonly look at how company profits, or earnings, compared to their share price. What Shiller and his colleague John Campbell investigated was the longer-term view of this price earnings ratio. They compared the share price to the average earnings for the past 10 years. This long-term price-earnings ratio showed a sharp peak in 1929, just before the great Wall Street crash. And the peak in the late 1990s was even bigger (The Economist, 2014). So why didn’t investor spot these irrational booms? Stiller compared it to the expression “no-one should shout fire in a crowded theatre”. Earnings were increasing and so were prices. Everything looked positive!

So, is the market always right? As identified in this blog, I expressed that I believe that the U.K's stock market is semi-strong efficient, as demonstrated by the Twitter case when information is released, the market reacts appropriately. On the other hand, Shiller also has a strong argument as the Apple case illustrates that markets do overreact to news, or react to non-news. By applying the two opposing theories to real life events, it is understandable why both theorist were awarded the nobel prize. I believe that both methods will continue to be standard tools in academic research, and provide guidance for the development of theory as well as for investment practice. 

References 

BBC News (2013) Are markets ‘efficient’ or irrational? Retrieved from  http://www.bbc.co.uk/news/magazine-24579616

Malkiel, B. G. (2003). The efficient market hypothesis and its critics. Journal of economic perspectives, 59-82

Shiller, R. J. (1981). The Use of Volatility Measures in Assessing Market Efficiency*. The Journal of Finance, 36(2), 291-304.

Shiller, R. J. (2000). Irrational exuberance. Princeton University Press. 

The Economist (2014) Rational or not? Retreived from http://www.economist.com/blogs/buttonwood/2014/03/equity-markets

The Financial Times (2013) Fama, Hansen and Shiller win Nobel Prize for economics. Retrieved from http://www.ft.com/cms/s/0/6f949e8c-34c1-11e3-8148-00144feab7de.html

The Guardian (2015) Twitter shares soar after sharp revenue increase but growth still slowing. Retrieved from http://www.theguardian.com/technology/2015/feb/05/twitter-shares-soar-revenue-increase-growth-slowing

The Independent (2015) Apple could be planning virtual reality headset. Retrieved from  http://www.independent.co.uk/life-style/gadgets-and-tech/news/apple-could-be-planning-virtual-reality-headset-10053916.html?origin=internalSearch

The Independent (2015). New Apple watch expected to launch. http://www.independent.co.uk/life-style/gadgets-and-tech/news/apple-event-on-9-march-apple-watch-expected-to-launch-10073354.html?origin=internalSearch

Watson (2013) Corporate finance: principles and practice. 6^th Ed.

Diagram 1 - Yahoo Finance (2015) Apple share price figures. Retrieved from https://uk.finance.yahoo.com/q/hp?s=AAPL

Diagram 2 - Yahoo Finance (2015) Twitter share price figures. Retrieved from https://uk.finance.yahoo.com/q?s=TWTR

Will the Tesco turnaround plan create long term shareholder value?

Maximising shareholder value is fundamentally maximising shareholders purchasing power, which implies that the ultimate measure of a company’s success is the extent to which it enriches shareholders. This is seen by increasing a company’s share price over the long term and through paying out dividends. Jensen and Meckling (1973) argued that the singular goal of a company should be to maximise the return to shareholders. Similarly, Arnold (2013) states Value Based Management is a managerial approach in which the primary purpose is long term shareholder wealth maximisation. However, in comparison, Arnold (2013) brings together the way in which shares are valued by investors, with the strategy of the firm, its organisational capabilities and the finance function. Based on the recent revelations of Tesco’s poor performance, in this blog I will highlight the flaws in Tesco's previous strategy and how the concepts proposed by Arnold (2013) underpins the turnaround plans for Tesco. 

In my opinion, if investors are using indicators such as Earnings Per Share (EPS) to assess the performance of a company, and form expectations as to how the company is likely to perform in the future, it is by no surprise that management feel the need to focus their attentions on the future rather than what really matters; their current position and their stakeholders. With such an emphasis on EPS, unsurprisingly in 2009, Tesco announced in its annual reports ‘the best way of enhancing shareholder value is to grow earnings while maintaining a sustainable level of Return on Capital Employed’ (ROCE). The results on the other hand were very different (see Figure 1).

If Tesco truly believed in their strategy, then why do the results illustrate a decreasing ROCE and a rapidly increasing EPS? Research suggests that there was inadequate cash to both invest and pay out dividends; however this problem was covered by the proceeds of the sale of fixed assets.This example demonstrates that it is possible for a company to generate a rising EPS at the same time as it is employing increasing capital at inadequate rates of return. In other words, Tesco was destroying shareholder value as it was increasing its earnings (Financial Times, 2015).

Figure 1 – Tesco: the Leahy Years (Financial Times, 2014)

This unsustainable resource of cash led to Tesco borrowing the money, demonstrating that they lacked one of the main elements of shareholder value creation – finance. Furthermore, in 2014, the BBC News reported that Tesco had predicted profits of £1.1 billion for the first half of 2014. However, due to accounting errors there had been a £250 million overestimation in its forecasts. As this news hit the headlines in September 2014, shares plunged to an 11-year low, closing at 202.75p, and then continued to fall overnight hitting a trough of 191.08p - see figure 2. This rapid decrease in share price illustrates that the market was of semi-strong efficiency (Fama, 1970), as the news was rationally being integrated into the public domain as it hit the headlines. 

Figure 2 - Share Price of Tesco during September 2014

More recently, Denning (2012) argued that pursuing the goal of maximising shareholders value produces less shareholder value than a specific focus on delighting the customer. His research concluded that shareholder value is a result, not a strategy. Denning explained that in order to rescue companies from bad habits, a phase stage is required whereby it rethinks the very basis of a corporation and the way the business is conducted. If you take care of your customers, shareholders will be drawn. With a focus on customers, there is an opportunity to build a brand for the long term rather than to exploit short term opportunities. This theory was support by the research carried out by Hillman & Keim (2001), which concluded that stakeholder management leads to improved shareholder value creation. Working for customers produces focus and motivation for organisations – enter Dave Lewis!

In order to increase long term prospects, Dave Lewis has recently been appointed the new Chief Executive of Tesco, who is determined to give Tesco a ‘cultural cold bath’ by implementing back-to-basic strategies, which supports the research of Denning and Hillman. He plans to get Tesco back to what it does best: selling a wide range of items at low prices. The previous Chief Executive’s first error was promising investors that he could sustain an operating margin of 5.2% in the U.K (The Guardian, 2015). Lewis has made no medium-term financial pledges because restoring competitiveness is his top priority. He is also ensuring that short term profits associate with an increase in the long term value of the company. In creating a clear strategy to support long term prospects, he has planned to close 43 unprofitable stores, cut back on new store openings and seek to rationalise the business by cancelling dividends and ending the company’s defined benefit pension scheme, which has a deficit of £3.4 billion (The Guardian, 2015). In the past, Tesco’s product range has arguably become over diversified, resulting in a decline in profits. Lewis has planned to sell the Tesco Broadband and movie streaming service Blinkbox to TalkTalk for an undisclosed sum. In addition, to help implement the changes, a new UK Operations Director (arrival from Halfords) and Finance Director (M&S) have also been appointed. By employing three external candidates for top management roles, I believe this will introduce a fresh perspective into the business whilst also bringing much needed experience, knowledge and a wider skill set, which in turn will strengthen the organisations capabilities of fulfilling Lewis’ Tesco Turnaround vision.

Based on the new plans, Tesco is set to report a rise in profit next year of 2%, followed by an increase of 23% in the following financial year (Yahoo Finance, 2015). If achieved, this will demonstrate a strong growth, which should change the markets view on the company and lead to a higher share price over the medium term. The results published by The Financial Times on 8^th January 2015, illustrates that shareholders are feeling optimistic about the turnaround plan as share price has increased by 15% since December (The Guardian, 2015).

I believe this turnaround plan demonstrates the strong connection between the three elements of creating shareholder value. A clear strategy, implemented by the correct people can drive success, which in turn will increase shareholder value. The proposed plans by Dave Lewis already look to deliver strong results based on the recent increase in share price - see figure 3.