Financial Education

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.

Fundamental indexing strategies attempt to form benchmarks based on fundamental factors such as book value, dividends or earnings rather than market capitalization. Proponents claim that the fundamentals provide a less biased estimate of a security’s fair value, and thus explain the value premium. Detractors claim that the strategies are simply “value investing in a shiny new wrapper.”

In the January/February 2008 Financial Analysts Journal,  Kaplan argues both fundamental and market-cap weightings provide valuable information, and argues in favor of approaches that combine both.

The compound annual growth rate is a number that represents a steady level of growth from a beginning value to an ending value. It can be thought of as a way to smooth out uneven returns.

To calculate the CAGR of an investment over a period of n years, you would take the nth root of the total percentage return.

Consider a beginning investment of $100 and an ending investment of $161. 161/100 = 1.61. The fifth root of 1.61 is equivalent to 1.61 to the power of 1/5, or 1.1. Subtracting 1 (100% or the initial investment) gives 0.1, or 10%. The CAGR in this case is 10%.

Since the CAGR smooths out uneven returns, it fails to account for the risks taken to achieve the return.  Any series of returns that starts at 100% and ends at 161% five years later will have a 10% CAGR, such as the investments in column A and Column B below.

Column A actually grew at 10% per year. Column B had large positive gains in some years and large negative gains in others, but ended at the same value. Many investors would prefer the investment in Column A due to its greater predictability and equivalent terminal value.

The earnings yield is a company’s earnings per share divided by its price per share. Earnings yield has frequently been used to predict real return for stocks. Since earnings are not reported on a real basis, Stephen Wilcox presented a technique in the September/October 2007 Financial Analysts Journal to adjust earnings yield to better represent real return. Statistical tests show that this measure better predicts future real returns than other popular valuation measures.

There are two primary adjustments considered:

• An accounting adjustment to convert historical cost measures to current value
• An adjustment to liabilities to reflect the real cost of capital as principal values erode due to inflation

At the CFA Intstitute Efficient Market and Behavioral Finance conference in June 2007, Legg Mason’s Michael Mauboussin suggested that both market efficiency and behavioral anomalies could be explained by viewing the market as a complex adaptive system.

Under this model the only conditions required are that investors have diverse opinions, that there is an aggregation mechanism to bring information together, and that there are incentives for being right and penalties for being wrong.

The model explains breakdowns in market efficiency (bubbles and busts) as violations of one or more of the conditions. The most likely violation is diversity of opinion, and the occasional herding tendency of investors. It can also occur on a smaller scale when short-term noise is interpreted incorrectly as signal.

In the November/December 2007 Financial Analysts Jounal Fama and French break down the returns historically delivered by growth and value stocks into dividends and three components of capital gain: growth in book value, primarily through retained earnings; convergence in price/book ratios due to mean reversion in profitability and expected returns; and the general upward drift in P/B ratios experienced over the last century.

For value stocks, the capital gains arise primarily from convergence. P/B reverts to the mean (increases) and many of the companies that were cheap due to lack of profitability become more profitable.

For growth stocks, the growth in book value is the primary positive factor for returns and convergence is a negative one.

Drift has had a negligible effect on average returns, regardless of the growth or value profile.