What Really Drives the Market?

Despite the recent popularity of the “behaviorist” view, analysis indicates that, on the whole, investors make rational investment decisions based on their view of future cash flows.

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The principle that financial markets accurately reflect the underlying value of traded stocks has been widely accepted in the investment world since the 1960s. It is predicated on the assumption that investors make buy or sell decisions based on a rational view of a company’s future cash flow: that is, they consider all the relevant information, and markets allocate capital to companies efficiently.

How stocks are valued is critically important to corporate managers. If the promise of future cash flow is what attracts investors, then it makes sense for managers to pursue strategic moves that generate the most cash. And it follows that a manager will evaluate different investment options by comparing their discounted cash flows.

Recently, however, the rational view has been under attack from adherents of behavioral finance. “Behaviorists” suggest that irrational investor decisions on the part of many can strongly influence the market value of companies. Since the publication of Werner DeBondt and Richard Thaler’s 1985 Journal of Finance article “Does the Stock Market Overreact?” a number of finance academics and practitioners have jumped into the fray, arguing that stock markets do not reflect economic fundamentals as well as people think. More specifically, they maintain, there are instances when stock market valuations can and do make significant and lasting deviations from the companies’ intrinsic value.

For managers who have been taught that there are proven and incontrovertible methods for weighing strategic options — and that picking the best option would sooner or later have a positive effect on the value of the company — the behaviorist critique is unsettling, to say the least. Does this mean that managers should stop relying on DCF to make choices? In a word, no.

According to our analysis, significant discrepancies between market value and intrinsic value are rare. What’s more, markets and individual share prices that are out of sync with economic fundamentals usually come back into proper alignment relatively quickly. This happened during the late 1970s, when inflation-conscious investors pushed stock valuations too low. Even during the “bubble” of the late 1990s, it was only a small subset of stocks in telecommunications, media and high tech (with large market capitalizations and extremely high price-earnings ratios) that sent the market soaring. Although the average S&P 500 price-earnings ratio in 1999 was about 30, most of the companies in the index were trading at 22 times earnings or lower. Market values returned to a more reasonable alignment with intrinsic values of around 17 times earnings by 2001. The market value ultimately reverted to levels justified by the underlying economic fundamentals. Nevertheless, the behavioral approach to market valuation provides managers with some useful insights — chief among them, that markets are not always right, because “rational” investors cannot always correct the mispricing by “irrational” investors in the short term.

When Markets Deviate

Behavioral finance economists have suggested that market valuations can deviate from economic fundamentals when all three of the following conditions are present: Large numbers of investors behave irrationally; the irrational investor behavior is not random but “systematic”; and there are limits on the ability of rational investors to take arbitrage positions that would correct any deviation from intrinsic value.

Irrational Investors

Investors behave irrationally if they fail to process all the available information correctly when forming their expectations of a company’s future performance. For example, as academic research shows, individual investors may attach too much importance to recent events and stock market results, causing them to over-value companies with strong recent performance. Conversely, investors may be slow to revise their expectations in the light of new information and thus undervalue stocks of companies that have, for example, recently released positive news, such as strong earnings.

Systematic Behavior

If the irrational behavior by investors were totally random, share prices would not move away from the intrinsic value set by rational investors: Overvaluation would be as likely to occur as undervaluation, so they would essentially cancel each other out. But academic studies show that irrational investor behavior can also be systematic. In other words, large groups of investors tend to follow the same patterns of irrationality: They overreact to bad news and are over-confident about good news in the same way.

Limited Arbitrage Opportunity

Systematic irrational behavior by large groups of investors can prevent share prices from reflecting their intrinsic value, at least for some of the time and for some of the stocks. However, the deviations would not be sustainable if rational investors exploited them by taking arbitrage positions: “going short” on stocks they thought were overvalued (borrowing stocks from a broker and selling them at once in hopes of pushing the price down, paying back the broker with the lower-priced stocks and pocketing the difference) or “going long” on (buying up) stocks they believed were undervalued. However, in reality, the cost, complexity and risk involved in setting up such positions are sometimes beyond what individual investors can justify. Indeed, if share prices don’t return to the fundamental value before it is time to pay back the broker, investors would experience a loss.

When all three conditions apply, behavioral finance predicts that pricing deviations will occur. But when we examined some well-known recent cases where market deviations have occurred, we found that the above conditions were not fully in place, suggesting that the market deviations could not be both significant and persistent. This, in fact, turned out to be the case.

Reversal and Momentum

Consider the much-studied phenomenon of “reversal,” when high-performing stocks of several years become low-performing stocks in subsequent years. Behavioral finance argues that reversal comes from investors first extrapolating a company’s recent success into the future, driving up its share price; then adjusting their expectations when the company fails to meet these projections, bringing the price down. The opposite phenomenon —“momentum” — occurs when positive returns on stocks over the past several months continue, even after new information appears that is less encouraging. Behaviorists suggest that this trend is based on systematic underreaction: Investors underestimate the true impact of, for example, missed earnings targets, so share prices are slow to adjust downward.

But academics in finance are divided as to whether irrational investors alone are responsible for reversal patterns in returns over the long term. Some believe that such patterns are actually the result of rational risk premiums based on a company’s size or its market-to-capital ratio (the ratio of a company’s equity and debt to the amount of capital invested). Rational investors may see such factors as indicators of liquidity risk (for example, smaller companies are more risky because they are more likely to go bankrupt during an economic recession).

Nor is there a clear consensus on whether investor irrationality is the main cause of short-term momentum patterns. In reality, the potential trading profits from exploiting these patterns are typically so small (after transaction costs) that most investors do not try to exploit them. Therefore, small momentum patterns could exist even if all investors were rational.

Persistent Mispricing

Still other deviations suggested to support the validity of behavioral finance are the way the market values a carved-out subsidiary or a single company listed on two markets (a dual listing).

A classic example is the experience of 3Com Corp., which in March 2000 floated 5% of its Palm Inc. subsidiary in anticipation of a full spinoff nine months later. Immediately after the initial spinoff, Palm’s market capitalization skyrocketed above the market value of 3Com. Given 3Com’s size and its profitability, this was clearly mispricing. Why didn’t “rational” investors exploit the mispricing by taking short positions in Palm shares and long ones in 3Com shares? Because the number of available Palm shares after the carve-out was extremely small: 95% of the shares were still held by the parent. As the share supply increased via short sales over the following months, rational investors stepped in and the price differential gradually decreased.

Another well-known example is past mispricing of the shares of the Royal Dutch/Shell Group and the Shell Transport & Trading Co. These are separately traded on both the Amsterdam and London stock markets, although they are shares in the same combined Shell group. In an efficient market, one would expect that the two stock prices would strictly reflect the proportion of the group’s dividends allocated to them. However, the actual share-price relationship has been known to deviate by as much as 30%. Why? For some reason, possibly because of taxes, large groups of investors prefer one share over another — and other investors are wary of stepping in to arbitrage the difference. Recent research suggests that attempting to arbitrage the difference is, in fact, quite risky — and potentially costly. Even if the price difference is significant, investors have little reason to be confident that the price gap will narrow in the near term. In fact, it could even widen. However, over time this particular price gap narrowed, and since the announcement of the Royal Dutch/Shell share unification in October 2004, it has practically disappeared.

What do these examples say about the rationality of markets? Do they mean that investors are willing at times to tolerate blatant inefficiencies? We don’t think so. Both examples underline our belief that mispricing is an uncommon and temporary phenomenon, one that occurs only under special circumstances. As soon as those circumstances disappear, rational investors will step in to drive share prices back to intrinsic values.

Implications for Corporate Managers

So what does all this mean for corporate managers? History shows that, eventually, the pricing level for a company’s shares, for a sector or for the market as a whole, does not escape economic reality. Sooner or later, the markets will reflect real values because investors need to see cash flows and dividends. For managers, DCF tools will continue to be important.

However, history also shows that on occasion market valuations can and do deviate. Corporate managers can attempt to put these deviations to use. For example, when prices are overvalued, they can issue additional shares, spin off assets or buy other companies using their own stock; when prices are undervalued, they can repurchase company shares.

This is not to suggest that major corporate decisions should be triggered entirely by whether or not there is a gap between the market value and the intrinsic value. First and foremost, they need to make sense strategically and be able to generate value for shareholders. Nor should managers be too quick to believe that their share price offers opportunities they can take advantage of. Our experience suggests that many suspected market deviations turn out to be insignificant or even nonexistent. Those that do exist tend to be rare and short-lived.

Despite the well-publicized exceptions, the traditional assumption that investors make rational investment decisions on the basis of their view of future cash flows is as valid today as it ever was. On the whole, financial markets value investments efficiently — even if some people invest irrationally some of the time. Although managers may occasionally find ways to take advantage of short-term discrepancies, they can benefit that way only if they understand the real underlying values. Regardless of what the market is saying, they need to keep their eyes on discounted cash flow.

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