Page 207 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes
Example: Consider a merger between two firms. Normally, a merger or an acquisition
is known about by an ‘inner circle’ of lawyers, investment bankers and firm managers before
the public release of the information. When these insiders violate the law by trading on this
private information, they may make money. They also make it to the SEC’s wall of shame.
Figure 7.4: Stock Valuation during Mergers

Unfortunately, stock prices typically move up before a merger, indicating that someone is
acting dishonestly. The early move indicates that the market has a tendency towards strong-
form efficiency, i.e. even private information is incorporated into prices. However, the public
announcement of a merger is typically met with a large price response, suggesting that the
market is not strong-form efficient. Leakage, even if illegal, does occur, but it is not fully
impounded in stock price. By the way, until recently, insider trading was legal in Switzerland.

Is the Stock Market Semi-strong form Efficient?

The most obvious indication that the market is not always and everywhere semi-strong form
efficient is that money managers frequently use public information to take positions in stocks.
While there is no evidence that they beat the market on a risk-adjusted basis, it is hard to believe
that an entire industry of information production and analysis is for naught. It seems likely that
there is value to publicly available information. However, there are probably degrees to which
information really is public knowledge. What is surprising is that recent studies have shown
some evidence that excess returns can be made by trading upon very public information. These
tests usually take the form of ‘back-testing’ trading strategies. That is, you play a “what-if” game
with past stock prices, and pretend you followed some rule, using information available only at
the time of the pretend trade. One common rule that seems to perform well historically is to buy
stocks when the dividend yield is high. This apparently has made money in the past, even
though the information about which stocks have high yields and which have low yields is
widely available. Another rule that generates positive excess returns in back-tests is to buy
stocks when the earnings announcement is higher than expected. This seems simple, since
current announcements and even forecasts are widely available as well.
Does this mean that it is easy to become rich on Wall Street? Hardly! The profitability of these
simple trading rules depends upon the liquidity of the stocks involved, and trading costs
(‘frictions’). Sometimes the costs outweigh the benefits. While many investment managers explain
that they pursue a strategy of buying ‘value’ stocks (such as low P/E firms) few of these managers
have consistently superior track records.

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