Financial Education

The value premium refers to the well-documented outperformance of value stocks (those with high book value relative to market value) over gorwth stocks (those with high market-book ratios.) This outperformance is not explained by systematic Beta as defined in the CAPM, though it does represent one of the three/four factors used in the Fama-French model.

In the March/April 2008 Financial Analysts Journal, Phalippou finds that the value premium is driven by stocks with low institutional ownership - a group that represents just 7% of the total stock market capitalization. Since individual investors may be less sophisticated than institutional investors, such stocks may have a higher tendency to be mispriced. The low institutional ownership may also signal that the mispricing opportunities are difficult to arbitrage.

In a strong-form efficient market no group of investors should be able to generate excess risk-adjusted returns. Technical analysis, fundamental analysis, and even inside information will provide little value once the information is known.

Tests of the strong form efficient market hypothesis have generally examined the performance of four groups of investors.

1. Corporate insiders
2. Stock exchange specialists
3. Security analysts
4. Professional money managers

Studies of insider buying and selling have provided mixed support for the EMH. At one time, insiders and public investors following insider trades experienced excess risk adjusted returns. However, more recent studies have indicated that public traders can no longer profit after adjusting for transaction costs.

Stock exchange specialists have monopolistic access to certain market data such as unfilled limit orders. Data suggests that specialists are able to earn excess risk-adjusted returns due to their access to this data.

There is some evidence that certain analysts may possess superior information, and that following the recommendations of these analysts may permit excess returns. Often these anomalies appear to be incorporated, which would support the EMH. For example, the Value Line timeliness rating was considered enigmatic as it appeared to consistently predict returns. However, changes in rating are now incorporated in stock prices within a day or two, and transaction costs may limit any usefulness of the anomaly.

In general, tests of professional investors have supported the EMH. On average, such investors do not enjoy superior risk-adjusted returns.

The strong-form efficient market hypothesis assumes that stock prices reflect all information, whether public or private. As such, it encompasses both the weak-form EMH and the semistrong-form EMH. If a market is strong form efficient, it is also weak- and semistrong-form efficient.

In a strong-form efficient market no group of investors should be able to generate excess risk-adjusted returns. Technical analysis, fundamental analysis, and even inside information will provide little value once the information is known.

In essence, the strong form efficient market assumes a perfect market in which all information is cost-free and universally available to all market participants simultaneously.

The momentum anomaly refers to the fact that a strategy of buying past winners and selling past losers produces returns that are not explained by the Capital Asset Pricing Model framework. Proponents of the efficient market hypothesis (EMH) attribute the momentum anomaly to risk factors that are not captured in Beta, while opponents point to the anomaly as evidence against the EMH.

In the October 2007 Journal of Finance, Avromov et. al. find that the influence of momentum is limited to a small sample (4% of market capitalization) of companies with high credit risk. This study offers support to the efficient market hypothesis and the argument that the excess returns are attributable to a risk factor (in this case, credit quality.)

When a company has issued securities that can be exchanged for common shares, converting the securities into common shares would potentially dilute the ownership stake of existing shareholders. When calculating earnings per share, companies must consider the potential dilution.

For securities that pay a dividend or periodic interest payment, the after-tax payments would be added back to earnings (since those payments would no longer be necessary if the securities were converted.) Then, the number of shares into which the securities are converted is added to the shares outstanding.

Diluted EPS = (Earnings + After tax payments on convertible securities)/(Shares outstanding plus shares issued on conversion)

In some cases, securities would be antidilutive, or increase earnings per share if they were assumed to be converted. Such securities are not included in the diluted EPS calculation, as it is intended to represent the maximum possible dilution.

If the semistrong form of the efficient market hypothesis holds, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

There are two types of studies frequently used to test the semistrong form of the EMH:

1. Return prediction studies attempt to predict the future rates of returns for the market or individual stocks using public information such as valuation, dividend yield, or risk premium. Another type of return prediction study is event studies, which examine abnormal returns immediately following a major announcement to determine whether returns predictably persist or reverse.
2. Cross-sectional return prediction studies test whether variables such as valuation to predict the relative returns of all stocks in a sample.

Return prediction studies have generally shown little success in predicting short-term returns. However, they have successfully been used to predict long-term returns. For example, high dividend yields, high default spreads and high term structure spreads all tend to predict higher long-term returns for stocks.

Studies have also demonstrated that markets do not rapidly process the information related to earnings surprise, or unanticipated changes in earnings. If markets are semistrong efficient such information should be reflected on the day of the earnings announcement. However, as much as half of the total change in stock price can occur in the 90 days following the day of the announcement.

Cross-sectional studies have demonstrated several anomalies that appear to contradict the efficient market hypothesis. On a risk adjusted basis: low P/E stocks tend to outperform high P/E stocks; small stocks tend to outperform large stocks; stocks with low price/book ratios outperform stocks with high price/book ratios.

Event studies of stock splits, IPOs (after issuance), accounting changes and corporate finance events generally support the efficient market hypothesis in that the news of such items is quickly and fully incorporated into the market price.

The semistrong form of the efficient market hypothesis assumes that security prices adjust rapidly to all publicly available information. Such information includes market based information and thus the semistrong EMH encompasses the weak form EMH (if markets are semistrong efficient, they are also weak form efficient.)

In addition to market information, other public information includes earnings and dividend announcements, financial ratios, accounting practices, stock splits, and economic and political news. If markets are semistrong efficient, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

On the income statement, accounting standards encourage separate treatment of operating and non-operating items. Operating items are those relating to the day-to-day management of the enterprise: sales, cost of sales, selling, general and administrative expense, research and development costs, etc. Often the net of these items is presented as a subtotal, operating income.

Non-operating items include investing and financing activities, which are reported separately from operating income (unless pertaining to a financial services firm, for which such items are operational.) Non operating items include the interest, dividends and profits on investments made in the securities of other companies; interest expense; etc.

Some investments in other companies are made for strategic reasons, such as access to raw materials. In these cases, investors and analysts may wish to classify the investments as operating.

While taxes are a normal operating expense, they are also affected by non-operating items. Often, analysts will adjust operating profit by the tax rate to arrive at NOPAT (net operating profit after tax.)

The weak form of the efficient market hypothesis assumes that current stock prices fully reflect all security market information. Security market information includes historical price and volume data, as well as other market-generated information such as odd-lot trades and short interest.

If the weak-form EMH holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Working capital items such as inventory, accounts receivable and accounts payable represent the day-to-day financing requirements a company faces. Without inventory there can be no sales, etc. Most of the activity ratios focus on these working capital needs.

However, simply having working capital is not enough. Wal Mart could have all the inventory in the world, but without the store to put it in it would still have no business. Although the store does not constantly have to be replaced, it is essential to conducting business and requires ongoing support in the form of renovation, repairs, etc.

The final activity ratios measure how efficiently a company puts these longer-term assets to use. In other words, how much sales can the company generate given a certain amount of assets in place. The resulting ratio, asset turnover, can be expressed using solely long-term assets or by using total assets. The latter measure incorporates working capital efficiency as well. In either case, the numerator is sales and the denominator is the average asset value (long-term or total) during the period being measured.

Below is the data used to calculate both long-term asset turnover and total asset turnover for Plantronics, Inc.