Efficient Capital Markets

According to Fisher, in perfect capital markets where ownership is divorced from control, the separation of corporate dividend-retention decisions and shareholder consumption-investment decisions is not problematical. If management select projects using the shareholders' desired rate of return as a cut-off rate for investment, then at worst corporate wealth should stay the same. And once this information is communicated to the outside world, share price should not fall.

Of course, the Separation Theorem is an abstraction of the real world; a model with questionable assumptions. Investors do not always behave rationally (some speculate) and capital markets are not perfect. Barriers to trade do exist, information is not always freely available and not everybody can borrow or lend at the same rate. But instead of asking whether these assumptions are divorced from reality, the relevant question is whether the model provides a sturdy framework upon which to build.

Certainly, theorists and analysts believed that it did, if Fisher's impact on the subsequent development of finance theory and its applications are considered. So much so, that despite the recent global financial meltdown (or more importantly, because the events which caused it became public knowledge) it is still a basic tenet of finance taught by Business Schools and promoted by other vested interests world-wide (including governments, financial institutions, corporate spin doctors, the press, media and financial web-sites) that:

Capital markets may not be perfect but are still reasonably efficient with regard to how analysts process information concerning corporate activity and how this changes market values once it is conveyed to investors.

An efficient market is one where:

- Information is universally available to all investors at a low cost.

- Current security prices (debt as well as equity) reflect all relevant information.

- Security prices only change when new information becomes available.

Based on the pioneering research of Eugene Fama (1965) which he formalized as the "efficient market hypothesis" (EMH) it is also widely agreed that information processing efficiency can take three forms based on two types of analyses.

The weak form states that current prices are determined solely by a technical analysis of past prices. Technical analysts (or chartists) study historical price movements looking for cyclical patterns or trends likely to repeat themselves. Their research ensures that significant movements in current prices relative to their history become widely and quickly known to investors as a basis for immediate trading decisions. Current prices will then move accordingly.

The semi-strong form postulates that current prices not only reflect price history, but all public information. And this is where fundamental analysis comes into play. Unlike chartists, fundamentalists study a company and its business based on historical records, plus its current and future performance (profitability, dividends, investment potential, managerial expertise and so on) relative to its competitive position, the state of the economy and global factors.

In weak-form markets, fundamentalists, who make investment decisions on the expectations of individual firms, should therefore be able to "out-guess" chartists and profit to the extent that such information is not assimilated into past prices (a phenomenon particularly applicable to companies whose financial securities are infrequently traded). However, if the semi-strong form is true, fundamentalists can no longer gain from their research.

The strong form declares that current prices fully reflect all information, which not only includes all publically available information but also insider knowledge. As a consequence, unless they are lucky, even the most privileged investors cannot profit in the long term from trading financial securities before their price changes. In the presence of strong form efficiency the market price of any financial security should represent its intrinsic (true) value based on anticipated returns and their degree of risk.

So, as the EMH strengthens, speculative profit opportunities weaken. Competition among large numbers of increasingly well-informed market participants drives security prices to a consensus value, which reflects the best possible forecast of a company's uncertain future prospects.

Which strength of the EMH best describes the capital market and whether investors can ever "beat the market" need not concern us here. The point is that whatever levels of efficiency the market exhibits (weak, semi- strong or strong):

- Current prices reflect all the relevant information used by that market (price history, public data and insider information, respectively).

- Current prices only change when new information becomes available.

It follows, therefore that prices must follow a "random walk" to the extent that new information is independent of the last piece of information, which they have already absorbed.

- And it this phenomenon that has the most important consequences for how management model their strategic investment-financing decisions to maximise shareholder wealth

Activity 2

Before we continue, you might find it useful to review the Chapter so far and briefly summarize the main points..

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