Financial Markets, Corporate Governance and Efficiency or lack thereof

The untenable volatility of financial markets and fleeting nature of stock ownership on one side and corporate scandals, high-risk managerial whims and empire building attitudes of corporate managers on the other have rekindled a three-decade old debate on whether financial markets, especially stock markets hold efficient mechanisms for investment and resource allocation (Economist, October: 2003; Khachaturyan, 2003; Vitols, 2008; Coffee, 2005). And the recent Nobel prize (for the year 2013) awarded to Robert Shiller, Eugene Fama, and Lars Hansen for their research contributions with regard to functioning of financial markets and price evaluation of stocks has reinforced the importance of efficient resource allocations and the need to regulate stock-market to safeguard the interests of investors and corporations. For instance, the Aspen Institute’s Corporate Values Strategy Group (Aspen Institute, 2009) which has been working on promoting long-term orientation in business decision making and investing has issued a call to end the value-destroying short-termism in financial markets and create public policies that reward long-term value creation, which is endorsed by twenty-eight leaders representing business, investment, government and academia (including Warren Buffett - CEO of Berkshire Hathaway, Lou Gerstner - former CEO of IBM, Roger Ferguson - President of TIAA-CREF, and James Wolfensohn - former President of the World Bank).

(You can download full article from ssrn weblink:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2592843)

What is market? This is one of the most intriguing and often repeated “phrases” in almost all ‘walks of life’ and more particularly in business world for past four centuries.

"Market, however, is not an objective phenomenon; rather it is the random aggregation of demand and supply - created by a proportion of buyers and sellers – often ensuing without full awareness and complete knowledge about the means and methods of production, quality of assets or products and consequences of their usage".

The premises of ‘random aggregation by a proportion of buyers/sellers’ (that is demand for assets by a select group of buyers who are capable of and willing to pay and supply of assets by a select group of suppliers willing to sell) and ‘incomplete information or information asymmetry’ are quite central to the understanding the functioning of financial markets, especially stock market for the following reasons: First, it has been clearly established in economics literature that incomplete information or information asymmetry affects almost all business transactions (Bhide, 1993; Saxton & Anker, 2013). Second, it is quite evident that in almost all situations not all potential buyers or sellers participate in the stock transactions (Agglieta & Reberioux, 2005). In this context, whether financial markets - without systemic regulations and incentives controlling stock trades - can facilitate efficient resource allocation? Can they best serve the interests of investors, corporations and society-at-large?

In a classical review of studies on “efficient capital markets”, Fama (1970) presents the arguments for market efficiency contrasting 3 different models namely: (i) expected return or fair game model, (ii) sub-martingale model and (iii) and random walk model. The central underlying assumption in all three models - in support of the market efficiency argument is that – current stock prices are based on the information of expected return, and prices fully reflect all the information available to substantial number of investors. Fama further delineates the market conditions (as sufficient and not-as-necessary conditions though) that might help or hinder efficient adjustment of prices to information (Fama, 1970).

(1). There are no transaction costs in trading securities, (2). All available information is costlessly available to all market participants, and (3). All participants agree on the implications of current information on current price and distributions of future prices of each security. Fama further argues that these conditions are just sufficient and fortunately even unnecessary for market efficiency: for the reason, even in the presence of large transaction costs, if the sufficient number of investors have ready access to all available information, the market prices will ‘fully reflect’ all the information and result in market efficiency (Fama, 1970).

However, I would like to present the argument that Fama’s above conditions are not only necessary, they are even insufficient for meeting the ‘market-efficiency’ requirement, and further would like to differ on the efficiency argument with a contention that prices do not (and will not in most conditions) reflect the real value either based on current or future returns on the basis of following rationale: 1) First, even if sufficient number of investors have ready access to all the information and even if there are no transaction costs, the investors’ motive for buying an asset could be quite dissimilar. Some would like to buy the assets for long-term investment; some others may buy the asset for short-term returns. That is, the distance they would like to carry the asset could be different for each investor. In other words, even if all the transacting parties agree on current and future prices of the asset in question, the investment-horizon of each investor could be quite different. 2) Second, Even if the sufficient number of investors have ready access to all the information on current and future returns of the assets, the incremental or marginal jumps in stock prices could serve as a powerful motive for some investors to neglect the realistic potential of the asset and prompt them to focus on the marginal returns; Investors would be tempted to ask, why buy and hold? Rather buy and sell on a routine basis taking advantage of the incremental or marginal gains; such buys and sells (intra-day, daily, weekly or quarterly basis) may offer larger returns and indeed be less risky than keeping the stock for long-term, even if the stock’s future value is expected to be large. In the absence of regular dividends from corporations, long-term holding of a stock would even turn out to be irrational in contrast to short-term trading (Robert Shiller, the Nobel Laureate like to term speculative high-risk taking as “irrational exuberance”; given the nature of current stock market behavior, this rather transpires into a ‘rational business acumen’ ). 3) Third, the ‘differences in investor motives’ which is treated by proponents of market efficiency as ‘disagreements on information’ or ‘better evaluations by some investors’; but these may neither be disagreements nor better evaluations, rather sheer opportunism naturally tendered to investors with larger financial resources (not necessarily infinite resources - a condition demanded by martingale or sub-martingale models of market efficiency (Fama, 1970)). 4) Fourth, Investors also differ from each other in risk propensity. Even if accurate information about current or future returns of the asset is available to all the participants, the differences in risk propensity among investors could influence stock prices and thus can cause disconnect between intrinsic worth and price of an asset.

Above juxtapositions are with regard to the Fama’s notion of sufficient conditions for market efficiency which does not adequately address the investor motives. In light of the above reasoning, one could infer that even if there is agreement among substantial number of investors on information as well as the current / future prices of security, the demand fluctuations in “buys and sells of a stock” could induce high elasticity resulting in unrealistic prices, and thus would render the market inefficient.

Notwithstanding the effectiveness of information for agreement on asset values, there are market forces that would make the very conditions ‘insufficient’ to market efficiency. First, “like too much money chasing too few goods causing inflation”, huge demand for a stock in the market could result in unrealistically high prices inflating asset values; the ‘resulting high prices’ may have nothing to do with agreement or disagreement on either information or price, but a sheer demand induced by heavy investment flows in a market, lack of other investment choices to investors, mere popularity of firms, extensive investor-relations efforts, herd-behavior, irrational exuberance, insider-trading or attractive announcements (Shiller, 2005; Jiang & Zaman, 2007).

Consequently, high stock-demand for relatively a few companies resemble that of ‘most fans betting on a single horse in a race-track’ resulting in high betting prices for it. If that horse loses, everyone loses, and if it wins, the result would still be meagre gains to any investor. In a similar manner, the stock price of an asset can reach a point at which those who purchased the stock at higher price ranges (in terms of P/E ratios) would gain very little or nothing. Such scenario can tempt the investors to make short buy-&-sell thus inducing volatility and eroding gains to long-term investors. We have to keep in mind that firms are not like race-horses though; - most of the firms, if not all - would have potential to fetch reasonable returns to investors. To trace the possible reason for the high-stock-demand for relatively a small number of firms in recent decades, I would like to refer to the following data from Wall Street journal. This data points out that - despite the U.S. economy grew from $9 Trillion GDP in 1991 to $19 Trillion GDP in 2013 - the number of public firms listed in the United States decreased from 8000+ companies in 1991 to 5000+ companies in 2012 (Wall Street Journal, Feb: 2014; See the Figure 1).

In addition to mergers, bankruptcies, technological disruptions and global competition, firms inability to sustain their size and growth in saturated industry conditions is cited as reason for the decline in large number of public firms. The industry structure and performance of the manufacturing sector in the US economy attest to this change: despite stable economic growth over the last five decades, many large US firms could not sustain their market dominance and profitability due to rise in diseconomies of scale (Muthusamy and Dass, 2014; Panzar, 1989; Council of Economic Advisers, 1998; Fortune, 1995).

Figure 1: Decline in number of public-listed firms (1991 to 2012)

One can infer from these observations that, while the number of investment choices for investors have steadily declined in proportion over two decades despite increases in volume of market-investments; whereas, ‘the inflated stock prices with wide price-earnings ratio’ have placed untenable performance-demands on the corporate management of large-cap firms. The 75 year average P/E ratio of S&P 500 stocks is 16, whereas the current P/E ratio of most actively traded stocks in the United States are about 30+. Another study, in the same light, points out that small-cap and mid-cap stocks have outperformed large-cap stocks on an average by 2 times in terms of long-term ROE (over 3 decades from 1975 to 2005). Part of the reason for the low-yield from large-cap stocks - despite attracting huge investment flows - could be due to their price-inflation coupled with high-volatility and low dividend-yield (Morningstar Stock research, 2014). In the absence of regular dividends, even with stock-splits, the ‘investment risk to long-term investors’ in a large-cap stock increases to a greater extent.

Notwithstanding whether Fama’s conditions for market efficiency have been sufficient or not: greed, insider-trading (with monopolistic access to information), herd-behavior of markets and short-term orientation have caused disconnect between market prices and intrinsic-asset value. The hypothesis of the efficient market models that security prices at any point in time “fully reflect” all available information - as some earlier studies had provided agreeable results - might have worked in the early years of stock market evolution when the investment flows were not that high. But in recent decades, the demand for blue-chip and popular IPOs have been enormously high due to excessive investment flows.

At this juncture, it is important to ruminate the reason for high-rise in stock market investments: One of the primary reasons is that, the retirement savings of the larger-society being channeled into financial markets. Statistical data point to that nearly 50% of the stock ownership in fortune 100 companies are that of institutional investors, and more than 50% of the entire stock assets in the United States belong to that of larger population channeled through institutional investors. According to a recent report published in OECD Journal of financial markets (Celik and Isakkson, 2013), within OECD economies, the combined holdings of all institutions as of 2011 was to the tune of USD 84.8 trillion. Out of this, 38% (USD 32 trillion) was held in the form of public equity. The largest by far were investment funds, insurance companies and pension funds. Together they managed assets with a total value of USD 73.4 trillion, of which USD 28 trillion was held in public equity. In 1960s individual investors held 84% of all publicly listed stocks in the United States. Today they hold less than 40%. In Japan, the individual direct shareholdings are even smaller, and in 2011 only 18% of all public equity was held by individual investors and the remaining were held by institutions.

In a broader sense, the OECD economies are middle-class in character, that is: economies of the middle-class, by the middle-class, and for the middle-class primarily supported by the jobs, savings and investments of larger sections of the society.

Given these statistics, it is not an exaggeration to suggest that the float and liquidity of stocks are primarily rendered by the foundation provided by savings of larger public channeled through institutions (Celik and Issakson, 2013), and this data reinforces the importance of protecting the long-term interests rather than short-term exuberance witnessed in markets.

Given the high-elastic stock-demand caused by the investment flows, it does not matter whether speculation of asset prices would be a ‘fair game’, or whether price changes exhibit statistical independence with a random walk, the ‘buy and sell’ (either intra-day, daily, weekly or any short-term basis) is likely to beat ‘buy and hold’. Evidence for such trading schemes that counter the assumptions of ‘fair game’ and ‘independent stock price movements’ have been presented by several scholars including Fama himself (Filter tests of Alexander, Fama and Blume; Neiderhoffer & Osborne).

The volatility in stock prices and demand randomly aggregated by a small fraction of the investors in market – are the major source of anomalies, erosion in long-term returns, and inefficient resource allocations. Data suggests that, on any given day, 90% of the stocks traded in large exchanges belong to that of only top 200 large firms resulting in high concentration of investment flows to a small proportion of the entire population of public-listed companies. Consequently, the bias or anomalies that occur due to information asymmetry and differences in asset-evaluation among transacting parties in the stock market are much larger than that are witnessed in product or service markets. Because of differences in short-term and long-term orientation, biases in evaluation, and volatility in the volume of transactions (buyers/sellers), parties carrying and those expressing interest in an asset are likely to overprice or undersell. In other words, market aggregation arrived at by a fraction of buyers/sellers cannot be considered the true representation of market; whereas the participation of vast majority of investors trading like speculators on a daily basis would result in devastating volatility in the whole market.

Similar bias, exuberance or short-term speculation is quite frequently seen, when a new popular IPO is issued, with investors behaving like children in a candy-shop. See for example (Refer to following Figure 2), in one day (October 01, 2013), within just one extended trade fund (ETF) - Sigfig – how big an investment flow ($350 million) occurs – even from best performing stocks to an IPO from Tesla. (http://money.cnn.com/infographic/investing/tesla-stock-buying-selling). It is not an exaggeration to say that there is often ‘disconnect’ between the stock prices, firm performance and the rest of investment community carrying the asset in question. Thus, the aggregation and prices resulting from day-to-day speculation cannot be considered a resultant of market efficiency.

Also, take a look at the volatility in the stock price of Apple between September 2012 and June 2013, despite its superior sales and profit performance in the quarters and years before and after the downward swing in its stock price. The Price plummeted from $700 to $392 in this period: neither due to economic reasons nor due to company-specific reasons such as loss of most popular CEO in the industry (former Apple’s CEO Steve Jobs died in October 2011, and the firm performed extremely well under the new management team after his demise).

Interestingly, Apple had issued a small dividend after many years of multi-billion dollar profitability the previous quarters before this slump. What else would explain the volatility and the investors losing money due to the swings in stock price, other than short-term gambling attitude and an exceedingly soaring Apple’s stock Price (if not due to high P/E ratio) which might have triggered a high-risk condition. For 10 years from 2005 to 2014, Price to book value of Apple stock ranged from 3 to 7 approximately.

Those who purchased the Apple stock between price ranges $400 and $700, and sold it before it dropped to $390 or stock split in June 2014 would have lost their investment value due to $300 billion in value fluctuation. Only case by case analysis would reveal how much was totally lost in that downward swing given that on an average 40 Million + shares were traded on a daily basis between this range. One can only hope that the large institutional accounts did not make such risky buy and sell decisions, and that firms would implement some measures to protect long-term investor interests. After all, Apple’s equity structure includes more than 2000 institutional investors accounting for more than 70% of Apple’s holdings. Not surprisingly, even with a 7 to 1 stock split in 2014 (after this downward swing in 2013) the P/E ratio of Apple stock is around a high 17.

Figure 2: Investment flows to a new IPO Tesla within Sigfig’s ETF portfolio

"Overall, from the above observations, one can conjecture that stock markets neither ensure fair-game, nor carry the sub-martingale effect (that means;big fish will certainly eat small fish), nor follow random walk (statistical independence to reduce errors in asset pricing), beating all the assumptions of market efficiency."

Recent empirical studies have identified the sources of ‘bias’ and ‘volatility’ to factors such as information asymmetry, insider trading, playing-to-the-gallery attitude (attractive announcements), greed, fashion, fads, and bubbles, suggesting how market inefficiency occurs and why speculative prices do not sail along with either intrinsic value of assets or potential future returns. Scholars would like to call these sources and their consequences as anomalies of stock market. With the Nobel Prize in economics for the year 2013 awarded to the scholars who have juxtaposed the theories on efficiency and inefficiency of financial markets by reasoning disconnect and volatility in asset prices, these issues have regained global significance in the fields of economics, finance and management. I would like to draw following implications from the above observations that are of much significance to the whole economy as they are to individual investors.

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Senthil