1. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5 INEFFICIENT MARKETS AND CORPORATE DECISIONS Behavioral Corporate Finance by Hersh Shefrin

2. 1 Winner-Loser Effect  Stocks whose returns have been worst over a 3-year period have outperformed the market over the subsequent 5 years by about 30%.  Stocks whose returns have been best over a 3- year period have underperformed the market over the subsequent 5 years by about 10%.  On a cumulative basis, losers outperform winners by about 40% over 5 years.

3. 2 Momentum A portfolio formed by holding the winners from the past 6 months, and shorting the losers from the past 6 months earned more than 10% per year. Pattern is pronounced among small cap stocks.

4. 3 Post-Earnings- Announcement Drift  When a firm announces that its earnings have exceeded the consensus analyst forecast, the outcome is a positive surprise.  Negative surprise similarly defined.  Stock prices adjust slowly to surprises, exhibiting drift.

5. 4 Traditional Position  Overreaction and underreaction are the results of random variation consistent with market efficiency.  Fama pointed out that empirically, findings of overreaction occur about as frequently as findings of underreaction

6. 5 Limits of Arbitrage  Will smart investors quickly take advantage of mispricing caused by irrational investors, thereby rendering the mispricing small and temporary?  Mispricing can become worse before it gets better.  Therefore, smart investors might temper their trades, and as a result the inefficiencies might be neither small nor temporary.

7. 6 Limits of Arbitrage Pick a Number Game 1.Playing the game skillfully requires an understanding of the errors to which the other players are susceptible. 2.The appropriate course of action is different when the other players commit errors than when they do not. 3.Skilled play by the winner does not necessarily bring the outcome close to what would occur if few players committed errors.

8. 7 Do Managers Trust Prices?  Managers appear to behave as if they believe markets are inefficient.  Managers indicate that they would reject positive NPV projects if accepting those projects would lower their firm’s EPS.  Managers split their stocks, even though doing so has no value when markets are efficient.  Managers time IPOs to take advantage of hot issue markets.

9. 8 Earnings vs. NPV  Majority of CFOs view earnings rather than cash flows as the key variable upon which investors rely to judge value.  The majority of managers are willing to sacrifice fundamental value in order to meet a short-run earnings target. Over half of managers would avoid initiating a very positive NPV project if doing so meant missing analysts’ target for the current quarter’s earnings.  Example: Herman-Miller

10. 9 Stock Splits  Firms that decide to split their stocks tend to feature pessimistic coverage by analysts in respect to earnings forecasts.  Firms that announce stock splits are much less likely to experience a decline in future earnings, relative to firms with comparable characteristics.  The returns to stocks of firms that split exhibit price drift. Stocks earn an average abnormal return of 7.93% in the first year, and 12.15% in the first three years.

11. 10 IPOs: Hot Issue Markets and Initial Underpricing Exhibit 5.1

12. 11 Initial Underpricing Average First Day Returns 1.7% in the 1980s 2.15% in the 1990s 3.65% during the bubble period 4.12% in the post-bubble period

13. 12 Long-Term Underperformance Exhibit 5.2

14. 13 Money Left on the Table? Time Series of Table Scraps Why do managers leave money on the table? Exhibit 5.3

15. 14 Agency Conflicts  Investment banks that underwrite IPOs employ analysts.  Investment banks employing all-star analysts tend to gain underwriting market share.  Investment banks typically charge an underwriting fee that amounts to 7% of the gross offering.  Spinning, "Friends of Frank" accounts.