Chapter 5 – Inefficient Markets and Corporate Decisions
Chapter Five
Inefficient Markets and Corporate Decisions
OVERVIEW
Chapter 5 describes the views of traditionalists and behaviorist on the degree to
which markets are efficient. The chapter explains the main issues that define the
controversy, describes the views of both traditionalists and behaviorists on these issues,
and discusses the implications for corporate decisions.
Managers perceive inefficiencies in the market, and take decisions in response.
The chapter describes three types of decisions. First, if managers perceive a conflict
between maximizing NPV and impacting short-term earnings adversely, they typically
refrain from maximizing NPV. Second, managers might split the stocks of their firms,
Chapter 5 – Inefficient Markets and Corporate Decisions
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initial underpricing, and long-term underperformance. In addition to behavioral
phenomena, agency conflicts also play a role in respect to IPO issues.
LEARNING OBJECTIVES
The main objective of this chapter is for students to demonstrate that they can identify the
psychological phenomena that obstruct market efficiency, and the associated implications
for managers’ behavior. After completing this chapter students will be able to:
2. Explain how the limits to arbitrage can interfere with market efficiency even in the
presence of smart money.
CHAPTER OUTLINE
Traditional Approach to Market Efficiency
Market efficiency has the following three forms: weak, semi-strong, and strong.
These reflect the degree to which past prices, public information, and all information
Chapter 5 – Inefficient Markets and Corporate Decisions
coincide with intrinsic value. However, he later noted that intrinsic value is very difficult
The Market Efficiency Debate
In the context of the market efficiency debate, anomalies are empirical pricing
phenomena that appear to be inconsistent with markets being efficient. Behavioral
economists contributing to this debate have studied how to measure sentiment, and how
to individual stocks and the Baker-Wurgler index. High sentiment beta stocks are prone
to have low returns after periods of high sentiment and periods of high returns after
periods of low sentiment.
Limits of Arbitrage
Traditionalists argue that arbitrage will quickly eliminate market inefficiencies.
Behaviorists contend that there are limits to arbitrage. Most importantly, investors who
Chapter 5 – Inefficient Markets and Corporate Decisions
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classroom. No reproduction or further distribution permitted without the prior written consent of
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seek to exploit market inefficiencies expose themselves to the risk that the inefficiencies
will become larger before they become smaller. The presence of these risks dampens the
willingness of smart money investors to take positions that fully exploit mispricing.
Market Efficiency, Earnings Guidance, and NPV
When markets are efficient, managers who maximize NPV also maximize market
value. However, when markets are inefficient, conflicts are possible between maximizing
Stock Splits
When markets are efficient, splitting a stock has at most a neutral impact on the
value of the firm. Moreover, if splitting entails transaction costs, then when markets are
efficient, splitting reduces the value of the firm.
Chapter 5 – Inefficient Markets and Corporate Decisions
To IPO Or Not To IPO?
There are three phenomena associated with IPOs: hot issue markets, initial
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might want to remind
students briefly what market efficiency entails, and indicate that many traditional
textbooks now include discussions about market inefficiencies and behavioral finance.
Instructors might make students aware of three points.
2. Regardless of whether the market is efficient or not, the evidence
3. It is important to understand how perceptions of inefficiency, whether
accurate or not, impact the decisions of corporate managers.
Chapter 5 – Inefficient Markets and Corporate Decisions
Below are suggestions for notes in respect to select slides.
Slides 9-11
Slides 9-11 introduces the concept “limits of arbitrage.” Instructors might
introduce this slide by reminding students that the traditional position holds that smart
Slide 12
Slide 12 summarizes a main finding about the momentum effect. After presenting
the contents of the slide, instructors might point out to students that although behaviorists
predicted long-term overreaction, they did not predict momentum. Instructors might ask
students if they think that the winner-loser effect and momentum are contradictory. The
answer is that they are compatible, in that the winner-loser effect is a long-term
phenomenon whereas momentum is a short-run phenomenon. Instructors can then
Chapter 5 – Inefficient Markets and Corporate Decisions
The behavioral explanation that students appear to have most difficulty
understanding is based on the combination of overconfidence and self-attribution error.
Instructors might be able to help students by asking them to consider an investor who
predicts that Microsoft’s future earnings will be larger than most investors are expecting.
If the investor turns out to be correct, then he becomes overconfident in his ability and
Slides 14-15
Slides 14-15 note that managers perceive that market value is driven by earnings,
not NPV, and are willing to sacrifice NPV to earnings if the two are in conflict. When
markets are efficient, maximizing NPV and maximizing market value are equivalent.
That equivalence is the basis for recommending that managers maximize NPV.
Chapter 5 – Inefficient Markets and Corporate Decisions
Instructors might wish to take students through the Behavioral Pitfalls box on
page 81, describing a situation that occurred at the firm Herman-Miller. Herman-Miller is
well known for its emphasis on processes to maximize intrinsic value. Yet even Herman-
Slide 18
Slide 18 deals with stock splits. Managers routinely split the stocks of their firms.
If the market is efficient, stock splits are essentially pointless exercises, unless the stock
price becomes extremely high or extremely low, in which case there are transaction cost
and liquidity issues. For years, traditional textbooks used an event study from the 1960s
about stock splits to make the point that markets are efficient. In line with market
Slide 20
Slide 20 is the first of several slides dealing with IPO phenomena. The slide
describes the first two of these phenomena, hot issue markets and initial underpricing.
Chapter 5 – Inefficient Markets and Corporate Decisions
The slide depicts Exhibit 5-2, showing the time series of two variables between 1980 and
the middle of 2015, the number of IPOs per year and the average first day returns per
year.
Instructors might wish to ask their students about a quip made by Amgen’s former
CEO George Rathmann, who advised that when at a party and the hors d’oeuvres come
around, take them whether you are hungry or not. In the context of hot issue markets,
instructors can ask students what they think that Rathmann means by this quip? To
Slide 21
Slide 21 summarizes the average first day returns for four subperiods. Instructors
Slide 22
Slide 12 displays Exhibit 5-3, contrasting the performance of firms that have gone
IPO and firms matched by size and book-to-market equity that have not gone IPO. The
exhibit clearly shows that the matched firms have outperformed the firms that have gone
IPO. Instructors might ask students what kind of traditional and behavioral explanations
Chapter 5 – Inefficient Markets and Corporate Decisions
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classroom. No reproduction or further distribution permitted without the prior written consent of
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might explain why this is the case? Traditional explanations might focus on IPO firms
being less risky than matched firms. Behavioral explanations would focus on market
inefficiency, with the equity of IPO firms being overpriced.
Slide 23
Slide 23 pertains to managers appearing to leave money on the table in connection
with initial underpricing. The slide displays Exhibit 5-4 showing the time series of money
left on the table between 1980 and 2003. Instructors might ask students how they would
If time permits, instructors can go more deeply into the reasons for initial
underpricing, contrasting the risk-based traditional explanation and the behaviorally
based psychological explanation. In this case, instructors can ask students how they
answered Concept Preview Question 5.2, taking them through the two key learning points
associated with that question. First, a particular loss is experienced in the context of other
The behavioral issues can be illustrated in an example, the IPO of firm VA Linux.
This example is particularly striking in that VA Linux set a record for first day returns.
Time permitting, instructors can ask students to open their books to page 86, and take
them through exhibit 5.4 to show them what would have happened to the original
Chapter 5 – Inefficient Markets and Corporate Decisions
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classroom. No reproduction or further distribution permitted without the prior written consent of
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investors’ ownership shares, including that of CEO Larry Augustin, had there been no
initial underpricing.
Slide 24
Slide 24 discusses the role of agency conflicts in initial underpricing. There are
two issues involved. The first issue is the manner in which firms pay for star analyst
coverage. Because the formal fee is a percentage of gross offering, firms appear to pay
nothing for analyst coverage, star or not. However, managers appear to value coverage by
star analysts, and pay for it by permitting initial underpricing.