1. The Efficient Market Hypothesis
(Covered in Chapter 14)

2. Capital Market Efficiency
Statement: Markets are “Information Efficient”
Market participants processes new information as it “arrives”
Prices adjust to new information and constantly find a new equilibrium
Background: Why do security prices change?
In other words: What causes the returns that we observe?
For example: Small Stocks have high expected returns
with high s
In general the price of a stock is:
P0 = D1/(1 + R) + D2/(1 + R)2 + …
But these are really expected D’s: E(D1), E(D2)…

3. Market Efficiency Continued: P0 = E(D1)/(1 + R) + E(D2)/(1 + R)2 + …
As new information becomes available
About the Economy, Industry, Company…
People update their expectations about future CF’s
They also change their required return (R)
New information causes prices to change
As Expected D’s and R’s change
New information arrives at random times
The “Direction” of the information is random (good news or bad news)
The Magnitude of the information is random
So the prediction is that prices changes are random
At least that’s the theory
And for the most part, it’s actually a pretty good theory

4. Prices Reflect Information
The Efficient Market Hypothesis (EMF)
Prices Reflect Information
When new information becomes available:
Market participants analyze the information
Then they buy or sell securities until prices equal the new “equilibrium value”
If there are more buyers than sellers at $50, then the price goes up
If there are more sellers than buyers at $55, then the price goes down

5. The Efficient Market Hypothesis (EMH)
So what does the EMH predict?
In other words:
“What should we observe if the EMH holds?”
Reaction to new information is swift
Prices adjust to the new information
No over reaction or delayed reaction
Securities are correctly priced
You get what you pay for
So you can’t beat the market
Or maybe you can’t easily beat the market?
(What does beat the market really mean?)
Let’s look at the two EMH Predictions 

6. 1. Reaction to New Information is Swift
A firm announces a new project with NPV = $40

7. 2. Securities are Correctly Priced
What does correctly priced mean?
The price of a security equals the risk-adjusted present value of it’s expected CF’s:
P0 = CF1/(1 + R) + CF2/(1 + R)2 + …
0 = -P0 + CF1/(1 + R) + CF2/(1 + R)2 + …
0 = -CF0 + CF1/(1 + R) + CF2/(1 + R)2 + …
(Note that the right-hand side is the calculation for NPV)
Correctly priced securities are zero NPV investments
You get what you pay for
So can you find mispriced securities?
Or do prices correctly reflect information?
First let’s talk about what’s meant by information 

8. Forms of the Efficient Market Hypothesis
1st Idea: “Prices Reflect All Information”
We know this not strictly true since prices react to announcements.
Like an earnings announcement
Before the announcement, this information is know by the accountants, but prices don’t react until the after the announcement
2nd Idea: “Prices Reflect All Available Information”
Or all “Public” information
If this is true, then securities analysts can’t find mispriced securities
Without inside (illegal) information
Is this true?
Can analysts spend time & money to find mispriced securities?
Does the evidence support this?
3rd Idea: “Prices Reflect All Easily Available Information”
Or all “cheap” information
If this is true, maybe market participants can’t predict securities prices using just past prices
Can people without superior information or superior market access find mispriced securities?

9. Forms of the EMH (Continued)
Each idea represent a different “form” of the EMH:
Strong Form:
“Prices Reflect All Information”
Semi-Strong Form:
“Prices Reflect All Available Information”
Weak Form:
“Prices Reflect All Easily Available Information”

10. Evidence Supporting or Contradicting the EMH
EMH predicts that you can’t find mispriced securities
The implication is that you can’t “beat the market”
But what does it mean to beat the market?
People often mean a return greater than the S&P 500
The “Large Stocks” we category from the beginning of this chapter
What is the historic mean return for large and small stocks?
Category Mean
Large stocks 11.7%
Small Stocks 16.4%
So all I had to do to “beat the market” is buy small stocks!
Does that count as beating the market?
Remember small stock are more volatile (more risk)!
So a claim of market-beating returns must be risk-adjusted
There are many ways to adjust for risk
One way is to compare to returns to the same “style” index
Small, Mid-cap, Large Cap vs. Value, Balanced and Growth
We’ll do this for mutual funds

11. EMH Evidence Can professional managers beat the market?
Not a lot of evidence that they can
Although maybe they are not trying to beat the market
Maybe they just want to keep their jobs
Can you look at a single manager’s performance?
Maybe. Maybe not. (coin flips)
1,000 people flip a coin get heads…
Look at all Active mutual fund managers:
Professional managed funds that must report performance
Compare funds to the appropriate style index
See tables from SPIVA Report
The full SPIVA report is on the Course Web site

12. But First We’ll Consider Types of Companies
As a way to account for risk
Types of company can mean:
Big, Middle or Small companies
Companies in different industries
Companies currently at the high end of the range of PE and Market-to-Book ratios – called Growth companies
Companies currently at the low end of the range of PE and Market-to-Book ratios – called Value companies
What have the returns been in the past for these types of companies?
What about the return on bonds?

13. Stock Categories: A common way to categorized stocks
In order to account for know risk factors:
Market Value aka Market Cap
Categories are Large, Mid and Small
Multiply the price per share by number of shares
This is what is costs to buy the company
The relative position of the company in the range of PE and Market-to-Book ratios
Categories are Growth, Balanced, Value
Are you buying a company’s stock because
You expect it to grow or because it has current profits?
These two factors (3x3) create nine categories (called “styles”)
Represented by “Style Boxes”

14. Indices and ETF tickers that Track Each Style:
Value
Balanced
Growth
Large
S&P 500 Value
(IVE)
S&P 500
(IVV)
S&P 500 Growth
(IVW)
Mid
S&P 400 Value
(IJJ)
S&P 400
(IJH)
S&P 400 Growth
(IJK)
Small
S&P 600 Value
(IJS)
S&P 600
(IJR)
S&P 600 Growth
(IJT)

15. Can professional managers beat the market?
SPIVA Scorecard, Year-End 2010
Report 1: Percentage of U.S. Equity Funds Outperformed by Benchmarks
Fund Category
Comparison Index
One Year
Three Year
Five Year
All Domestic Equity Funds
S&P Composite 1500
49.31
51.68
57.63
All Large Cap Funds
S&P 500
65.72
57.65
61.83
All Mid Cap Funds
S&P MidCap 400®
73.75
83.90
78.19
All Small Cap Funds
S&P SmallCap 600®
53.42
70.11
63.02
All Multi Cap Funds
63.90
60.84
66.28
Large Cap Growth Funds
S&P 500 Growth
49.86
78.67
82.00
Large Cap Core Funds
76.25
60.83
63.20
Large Cap Value Funds
S&P 500 Value
71.30
31.44
34.67
Mid Cap Growth Funds
S&P MidCap 400 Growth
83.65
94.89
82.14
Mid Cap Core Funds
S&P MidCap 400
87.18
83.64
Mid Cap Value Funds
S&P MidCap 400 Value
57.73
71.72
71.76
Small Cap Growth Funds
S&P SmallCap 600 Growth
61.63
83.59
72.68
Small Cap Core Funds
S&P SmallCap 600
59.27
65.78
60.21
Small Cap Value Funds
S&PSmallCap 600 Value
39.52
52.94
51.81
MultiCap Growth Funds
S&P Composite 1500 Growth
47.37
85.28
78.79
MultiCap Core Funds
70.67
56.16
61.22
MultiCap Value Funds
S&P Composite 1500 Value
68.63
50.96
59.35
Real Estate Funds
S&P BMI United States REIT
75.71
72.57
68.83

16. EMH Evidence Conclusion: Can you beat the market?
Really: Can you beat the market on a risk-adjusted basis?
There are lots of studies
Conclusion:
With knowledge and hard work you can find mispriced securities
But there does not appear to be an easy way to do so
This would support the Weak-Form of the EMH
So can you find mispriced securities often enough to continually beat the market?