Corporate Valuation Introduction

FAIB Part BRational Benchmark and Behavioral LimitsDr. Oliver SpaltProfessor of Behavioral FinanceTilburg Universityo.g.spalt@uvt.nlwww.oliverspalt.com1FAIB Spring 2015EMH and Behavioral Finance2Purpose of this LectureMake you familiar with the fundamental difference between the Efficient Market View and the Behavioral Finance View of capital markets

Present key empirical and theoretical evidence on why it might be important to know Behavioral Finance

Establish a rational and behavioral benchmark for our other lecturesImplications for stock returns? (Lecture 2)Implications for investor behavior? (Lecture 3)Eugene Fama, Nobel Prize 2013The Efficient Market HypothesisFAIB Spring 2015EMH and Behavioral Finance3

Fama (1970): An efficient market is one where prices always fully reflect available information

If markets are efficient, they provide informative signals for investors. Hence, efficient markets make sure funds are allocated to their best useThe power of capitalism

EMH has lead to several first-order academic break-throughs that changed the world (for better or worse)CAPMOption pricingPassive investment industryThe Efficient Market HypothesisFAIB Spring 2015EMH and Behavioral Finance4The Efficient Market HypothesisFAIB Spring 2015EMH and Behavioral Finance5The central paradigm of academic finance in the last 50 years

Flavors of Efficient Market Hypothesis:

Weak form: at any point in time, prices contain all past information ( no predictable patterns in price data)Technical analysis does not work!

Semi-strong form: prices contain all publicly available information

Strong form: prices contain all information, public and private But insider trading is profitable!?Theoretical Justifications of the EMHAll investors are fully rational (Bayesian EU Maximizers)Some investors are less than fully rational, but their effect cancels out in the aggregateRandom mistakesNo price impactSome investors are non-rational in similar, correlated ways. However, rational arbitrageurs eliminate their influences on prices

Decreasingly strict assumptionsCommon misconception: EMH requires everybody is fully rational!Not true if arbitrage process works wellFAIB Spring 2015EMH and Behavioral Finance6Evidence consistent with EMH Example 1Annual returns US mutual funds 1963 1998It is very hard to beat the marketFAIB Spring 2015EMH and Behavioral Finance7

Source: Ross, Westerfield, Jaffee, and Jordan (2008) based on Pastor and Stambough (2002)Evidence consistent with EMH Example 2Abnormal returns around dividend omissions (event study)Information is often incorporated into prices quicklyFAIB Spring 2015EMH and Behavioral Finance8

Source: Ross, Westerfield, Jaffee, and Jordan (2008) based on Szewczyk, Tsetsekos, and Zantout (1997)Challenges to market efficiencyChallenges to the theory of efficient markets have come mostly on two fronts:

Based on observed market anomalies and sustained by a large literature on limits to arbitrageLectures 1 and 2

Based on systematic deviations from rationality in individual decision makingLecture 3FAIB Spring 2015EMH and Behavioral Finance9The Market-Based ChallengeRobert Shiller, Nobel Prize 2013FAIB Spring 2015EMH and Behavioral Finance10

Market anomalies (1) tech stock bubble (?)FAIB Spring 2015EMH and Behavioral Finance11

Market anomalies (2) housing bubble (?)FAIB Spring 2015EMH and Behavioral Finance12

Source: Robert ShillerEarly Formal Evidence: Excess VolatilityFamous early paper that challenges EMH formally: Shiller (AER, 1981)

Formally, EMH can be stated as: P(t) = Et[D(t) | (t)]At any point in time t, the price (P) is the best possible forecast of PV of future dividends (D), given available information ()Example: if we assume that dividend stays the same forever, and the discount rate is a constant r, then P = D1/r.

Pricing an asset is a forecasting exerciseKey principle of forecasting: the forecast cannot fluctuate more than the actual thing you want to forecastThink: weather forecastFAIB Spring 2015EMH and Behavioral Finance13Idea of the TestP(t) = Et[D(t) | (t)]

Property of optimal forecasts:D(t) = P(t) + (t), where (t) and P(t) are uncorrelatedThe PV of future dividends is the price plus an uncorrelated forecast error ()It follows: var(D) = var(P) + var()This implies: var(D) > var(P) (Key Testable Implication)

Why are (t) and P(t) uncorrelated?If (t) would have power to forecast dividends, then P(t) would not use all available information. It could then by definition not be the best available forecast.

FAIB Spring 2015EMH and Behavioral Finance14Excess Volatility (from Shiller (2003))

Stock prices vary more than discounted future dividends!FAIB Spring 2015EMH and Behavioral Finance15Evidence challenging assumptions of the EMHShillers findings came as a shock to the profession and sparked a huge debate about market efficiencyA lot of the following discussion centered around arcane statistical issuesNot 100% clear what the right approach is

Few dispute that Shillers analysis is very cleverIt provided the impetus for a whole new class of financial models trying to explain the excess volatility puzzle

But it did not settle the debate about efficient marketsCould also explain evidence by allowing discount rates to change systematicallyFAIB Spring 2015EMH and Behavioral Finance16Testing The EMH Using A Case StudyAll investors are fully rational (Bayesian EU Maximizers)Some investors are less than fully rational, but their effect cancels out in the aggregateRandom mistakesNo price impactSome investors are non-rational in similar, correlated ways. However, rational arbitrageurs eliminate their influences on prices

Cronqvist and Thaler (AER, 2004) provide an account of a large scale case study and argue that it calls into question central underpinnings of the EMH stated aboveFAIB Spring 2015EMH and Behavioral Finance17Testing The EMH Using A Case StudyRichard Thaler, Nobel Prize ???FAIB Spring 2015EMH and Behavioral Finance18

Cronqvist and Thaler (AER, 2004)In 2000, Sweden launched a partial privatization of their social security system

2.5% of payroll tax is contributed to individual savings accounts that are self-directed

The plan is pro-choice, i.e. gives participants a lot of freedom to make their own choicesGood thing if investors are rational (why?)Good thing for Sweden in aggregate if individual biases cancel out in the aggregateOr if individual biases are eliminated by the market mechanism

FAIB Spring 2015EMH and Behavioral Finance19Plan DetailsParticipants were allowed to form their own portfolios by selecting up to 5 funds from an approved list.

One fund was chosen (with some care) to be a default fund for anyone who, for whatever reason, did not make an active choice.

Participants were encouraged (via a massive advertising campaign) to choose their own portfolio.

Both balances and future contributions can be changed at any time, but unless some action is taken, the initial allocation determines future contribution flows.

FAIB Spring 2015EMH and Behavioral Finance20Plan Details (continued)Any fund meeting certain fiduciary standards was allowed to enter the system. Thus, market entry determined the mix of funds participants could choose from. As a result of this process, there were 456 funds to choose from.

Information about the funds, including fees, past performance, risk, etc., was provided in book form to all participants.

Funds set their own fees (except for managers included in the default fund, whose fees were negotiated).

Funds (except for the default fund) were permitted to advertise to attract money.FAIB Spring 2015EMH and Behavioral Finance21The Role of the Default FundIn the plan: A default is picked, but its selection is discouragedDefault fund ex ante sensible (well diversified, low fees)

We know from large body of research: if a fund is designated as the default fund, many participants will choose itGood reasons to believe that this is not always because individual preferences coincide with defaultE.g.: registered organ donators in Austria and Germany (99% vs. 12%)

Some reasons include:Status quo bias (Samuelson and Zeckhauser, 1988)Procrastination and lazinessImplicit endorsement by plan designers (possibly unintended)FAIB Spring 2015EMH and Behavioral Finance22Role of the Default FundInitial enrollment cohort (year 2000)The advertising campaign to encourage active choice worked. 66.9% formed their own portfolio. Those with more money at stake were more likely to form their own portfolio.Holding money at stake constant, women and younger workers were more likely to choose for themselves.

New enrollment cohorts (year 2003)No ad campaign to encourage active choiceIn the original sign-up period, 56.7% of those under 22 made an active choice, but only 8.4% of those joining in 2003 did soWithout ad campaign, default effect kicks in massivelyFAIB Spring 2015EMH and Behavioral Finance23Investments Made by Plan Participants in 2000FAIB Spring 2015EMH and Behavioral Finance24

Familiarity and Home BiasSweden is a small part of the overall world economyStill, almost half the invested money goes into Swedish stocks

This lack of international diversification is even more troublesome since most people work in SwedenValue of human capital positively correlated with Swedish economyShould diversify even more internationally

Some (behavioral) reasons for home biasTrust companies of your own country moreFeeling of competencePeople like to bet on things they feel knowledgeable aboutFAIB Spring 2015EMH and Behavioral Finance25Extrapolation BiasThe largest market share (aside from the default fund) went to Robur Aktiefond Contura which received 4.2 percent of the investment pool

This fund invested primarily in technology and health care stocks in Sweden and elsewhere

Its performance over the five year period leading up to the choice was 534.2 percent, the highest of the 456 funds in the pool

In the three years since, it has lost 69.5 percent of its value.

FAIB Spring 2015EMH and Behavioral Finance26Lessons from the Swedish ExperienceEconomists often think that the biases observed in psychologist and economist laboratories will be eradicated in open market settings

The Swedish experience reveals how just the opposite can happen.

Markets and advertising reinforced individual biases:Invest at home (familiarity)Chase returns (extrapolation)Active management rather than choosing default fund (overconfidence)

FAIB Spring 2015EMH and Behavioral Finance27Relation to EMHAll investors are fully rationalHard to argue Swedish investors made all rational choices

Some investors are less than fully rational, but their effect cancels out in the aggregateRandom mistakesMistakes were not random. Heavily distorted allocations (aided by marketing)

Some investors are non-rational in similar, correlated ways. However, rational arbitrageurs eliminate their influences on prices

FAIB Spring 2015EMH and Behavioral Finance28Preliminary ConclusionThe Cronqvist/Thaler study presents one case in which first two theoretical justifications for EMH are violatedThere exists a large body of additional evidence consistent with this viewWe will encounter more in the coming lectures

Implications for EMH in securities markets?Not much if arbitrage eliminates mispricing

Literature on the Limits to Arbitrage tests this directlyFAIB Spring 2015EMH and Behavioral Finance29Arbitrage DefinitionArbitrage is the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices (Sharpe and Alexander, 1990)

In efficient markets, arbitrage opportunities are so short lived as to be virtually non-existent

Arbitrage opportunities are like pieces of fresh meat that you put in a pool of hungry sharks (Stephen Ross)FAIB Spring 2015EMH and Behavioral Finance30

Arbitrage Strategy Simple ExampleSuppose the true fundamental value of Ford is 100.Arbitrageur observes that it trades at 99.

What will Arbitrageur do?Buy Ford stock. By doing so, he (and others who also see the opportunity) will bid up the priceUntil when? Until Ford trades at exactly 100

Practical problem: by simply buying a misvalued stock, the arb exposes himself to fundamental riskFord might go down instead of up because of new, not yet known, fundamental reasons (e.g., auto industry as a whole tanks tomorrow)Simply buying Ford is an unhedged bet: you only make money if Ford goes upFAIB Spring 2015EMH and Behavioral Finance31Arbitrage StrategyIf there are suitable substitutes, the arb can do much betterArb could sell (go short ) a close substitute, General Motors. Portfolio: Long 1 share in Ford & short 1 share of GMHence get $1 immediatelyNote: shorting: borrow security and sell. But need to give it back later.

If GM is a good substitute, this PF is hedged (i.e. largely immune) against auto risk!Auto stocks go down: lose on Ford, but win on shorting GMAuto stocks go up: win on Ford, but lose on GM

With perfect substitutes: can profit from the mispricing no matter what prices do, i.e., can eliminate fundamental risk completely

FAIB Spring 2015EMH and Behavioral Finance32Twin Shares: Royal Dutch/Shell ExampleFrom Froot and Dabora (1999):Royal Dutch and Shell are independently incorporated in the Netherlands and England, respectively. The structure grown out of 1907 alliance between Royal Dutch and Shell Transport by which the two companies agreed to merge their interests on a 60:40 basis while remaining separate and distinct entities. All sets of cash flows, adjusting for corporate tax considerations and control rights, are effectively split in these proportions. Information clarifying the linkages between the two companies is widely available. Royal Dutch and Shell trade on nine exchanges in Europe and the U.S., but Royal Dutch trades primarily in the U.S. and the Netherlands (it is in the S&P 500 and virtually every index of Dutch shares), and Shell trades predominantly in the UK (it is in the Financial Times Allshare Index, or FTSE). In sum, if the market values of securities were equal to the net present values of future cash flows, the value of Royal Dutch equity should be equal to 1.5 times the value of Shell equity. This, however, is far from the case.FAIB Spring 2015EMH and Behavioral Finance33Twin Shares: Royal Dutch/Shell Example

FAIB Spring 2015EMH and Behavioral Finance34This is a case with a perfect substituteStill large and very persistent deviation from theoretical pricesLimits To ArbitrageFAIB Spring 2015EMH and Behavioral Finance35This and other cases suggest arbitrage can be limited. Why?

Fundamental RiskNo perfect substitute available

Implementation CostsSome mispricing may persist if exploiting it would be too costly

Noise Trader RiskEven if perfect substitutes are available, mispricing may deepen in the short-run (see the RD/Shell graph)Markets can stay irrational longer than you can stay solvent (John Maynard Keynes)Relation to EMHAll investors are fully rational

Some investors are less than fully rational, but their effect cancels out in the aggregateRandom mistakes

Some investors are non-rational in similar, correlated ways. However, rational arbitrageurs eliminate their influences on pricesThe Royal Dutch / Shell case is one where arbitrage does not seem to work well

FAIB Spring 2015EMH and Behavioral Finance36Fundamental Line of Defense for EMHMilton Friedman (1953) argues that as long as there are some rational traders, irrational traders would be eliminated by selection

Irrational traders tend to buy and sell at the wrong times. This decreases their wealth.

Survival of the fittest in financial markets would imply that, in the end, all the wealth would be in the hands of the rational investors, and that the irrational investors could not survive.FAIB Spring 2015EMH and Behavioral Finance37

DeLong, Shleifer, Summers, and Waldman (1990)Friedmans argument sounds (and was long thought to be) brilliant but DSSW show that it is not generally true

DSSW present a model with limited arbitrage and correlated noise trader risk that illustrates three pointsHow noise traders can endogenously limit arbitrageHow mispricing can persistNoise traders can make money and need not die out

DSSW is the first paper that assesses the market impact of biasesA key paper in Behavioral FinanceFAIB Spring 2015EMH and Behavioral Finance38DSSW Key Assumptions (1)Economy with only two assets: one safe, one unsafes: price = 1; certain dividend r; perfectly elastic supplythe bond marketu: price = p; certain dividend r; fixed supplythe stock marketZero investment: Buy securities u for price p and sell p units of s (i.e., take out a loan)

Note: assets pay identical dividend for sure. With unlimited arbitrage those assets should sell at the same price

A key assumption is fixing the supply of asset uRealistic in may casesE.g.: RD/Shell shares are in fixed supply (at least in the short-run)FAIB Spring 2015EMH and Behavioral Finance39DSSW Key Assumptions (2)Overlapping generations model. In every period:m young agents and (1-m) old agents

Young set up a portfolio of safe and unsafe assets. Old receive the dividend of the claims they bought, need to pay back loan, and sell the asset back to the new young generationOptimization problem: how should a young agent optimally choose portfolio holdings (denote by ) in safe and unsafe assets to maximize utility when old?

Utility if old: constant absolute risk aversion (CARA)

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DSSW Key Assumptions (3)There are two types of young agents arbitrageurs, and (1-) noise tradersArbitrageur: correct beliefs about the expected price of asset uNoise Trader: incorrect beliefs (bullish/bearish for unmodeled reasons)Here: overestimate the expected price of u in t+1 by

Noise trader risk here is assumed to be the same for a given cohort, i.e. systematic. Cannot be diversified awayInvestors are bullish about internet stocks in generalInvestors have behavioral biases (overconfident, loss averse etc.)

For every new young cohort, sentiment is a draw from:

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DSSW Maximization Problem (1)Young in t maximize expected utility when old according to:

Expected wealth when old is normally distributed because:Noise traders: wt+1 = n[r + pt+1 + t - pt(1+r)]E(wealth) = dividend + exp. gain from selling stock pay back loanLinear function of normally distributed variables (verify later)Arbitrageurs: Same but without the mispricing termFAIB Spring 2015EMH and Behavioral Finance42

DSSW Maximization Problem (2)Based on previous slide, maximization problem for noise trader becomes:

Take derivative and setting to zero yields noise trader demand:

Demand of arbitrageurs a is the same except for last termFAIB Spring 2015EMH and Behavioral Finance43

Interpretation of demand functionsDemand for unsafe asset is a function of:(+) expected return [r + pt+1 - pt(1+r)](-) risk aversion (-) variance of return (p+1)2(+) overestimation of return (noise traders)

Noise traders hold more risky assets than arbs if they are bullish (>0) and vice versaFAIB Spring 2015EMH and Behavioral Finance44

Equilibrium pricesMarkets must clear: a + n = 1The equilibrium price pt for the unsafe asset u can be shown to equal (skipping some technical details):

Interpretation:Price equal to 1 if no noise traders ( = 0)Term 2: Variation in noise trader misperceptionTerm 3: Average noise trader misperceptionTerm 4: Compensation for noise trader riskFAIB Spring 2015EMH and Behavioral Finance45

Equilibrium pricesNote 1: Both arbs and noise traders at the same time believe that the asset is mispricedArbs think p=1; Noise traders think price is too low if > 0 and vice versa

Note 2: If average misperception and period t misperception is large enough (bullishness) price will trade above 1For example: internet stocks in the tech bubble

Note 3: There is zero fundamental risk in the modelMispricing comes solely from the unknown beliefs of tomorrows noise traders (= noise trader risk)Arbs cannot fully offset mispricing (why?)

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Equilibrium returnsCan show that difference in expected returns between noise trader and arbitrageurs in equilibrium is:

Return of noise traders can be higher (the above can be positive) if * > 0 but not if * 0

Noise traders do not necessarily lose money!

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DSSW The Big PictureDSSW show that there can be large mispricing even when there is no fundamental risk and no transaction costsNoise trader risk generates limits to arbitrage endogenously

Prices need not be equal to fundamental value if there are limits to arbitrage even if source of mispricing is known

It is not a foregone conclusion that noise traders will die out in the long run

Note 1: As always, this is a model. It is not the truthNote 2: Leaves open the source of the biases. Hence very flexible framework.FAIB Spring 2015EMH and Behavioral Finance48EMH Versus Behavioral View: A Recipe Two ingredients:Price Is RightPrice of an asset equals its fundamental valuePrices set by individuals with EU preferences that use Bayes lawNo Free LunchInvestors cannot get higher returns without accepting higher risk

Mix differently:EMH holds that both arguments are true. In fact they are equivalentBehavioral View:Agreed: If prices are right, then there would be no free lunchBut: it is not clear that prices are right (i.e., reflect fundamental value)No Free Lunch does not imply Price Is Right (e.g., DSSW)FAIB Spring 2015EMH and Behavioral Finance49

Where do we stand?In the 70s and 80s, EMH was accepted almost universally

Behavioral Finance has gained a lot of credibility since then, but it has not replaced the EMH (yet). Why?

One bad reason:BF lacks discipline (anything goes)Happy families are all alike; every unhappy family is unhappy in its own way. (Tolstoi, Anna Karenina)Not true. There is good and bad behavioral workBe not too harsh on BF: BF as a field is still youngIt has taken almost 200 years to get from Adam Smith (1776) to Fama (1970)BF is only a few decades oldFAIB Spring 2015EMH and Behavioral Finance50The Heart of the DebateAt the heart of the debate is what Fama (1970) calls the Joint Hypotheses Problem:

If you want to claim that the price of an asset differs from its true fundamental value, you need a model to determine that price.

Hence any test for mispricing is at the same time a test of the pricing model. Since we can never be completely sure that our model is right, we can also never be sure that there is mispricing.

In other words: observing something that looks like mispricing can simply mean that we need a better modelThat new model may well be a rational oneFAIB Spring 2015EMH and Behavioral Finance51ConclusionThe EMH is a stunningly powerful ideaTheoretically beautifulLed to major insights about how financial markets workLed to major innovations (derivatives, CAPM)

Behavioral Finance argues thatArbitrage can be limitedAssets can be mispriced

The power of those ideas might be equally greatBut we are still only beginning to understand these implicationsFAIB Spring 2015EMH and Behavioral Finance52