[silk] Do fundamentals—or emotions—drive the stock market?

[Udhay Shankar N]

http://www.mckinseyquarterly.com/article_page.aspx?ar=1593&L2=5&L3=7&srid=297&gp=0
Do fundamentals—or emotions—drive the  stock market?

Emotions can drive market behavior in a few 
short-lived situations. But fundamentals still rule.

Marc Goedhart, Timothy Koller, and David Wessels

2005 Special Edition: Value and performance

There's never been a better time to be a 
behaviorist. During four decades, the academic 
theory that financial markets accurately reflect 
a stock's underlying value was all but 
unassailable. But lately, the view that investors 
can fundamentally change a market's course 
through irrational decisions has been moving into the mainstream.

With the exuberance of the high-tech stock bubble 
and the crash of the late 1990s still fresh in 
investors' memories, adherents of the behaviorist 
school are finding it easier than ever to spread 
the belief that markets can be something less 
than efficient in immediately distilling new 
information and that investors, driven by 
emotion, can indeed lead markets awry. Some 
behaviorists would even assert that stock markets 
lead lives of their own, detached from economic 
growth and business profitability. A number of 
finance scholars and practitioners have argued 
that stock markets are not efficient—that is, 
that they don't necessarily reflect economic 
fundamentals.1 According to this point of view, 
significant and lasting deviations from the 
intrinsic value of a company's share price occur in market valuations.

The argument is more than academic. In the 1980s 
the rise of stock market index funds, which now 
hold some $1 trillion in assets, was caused in 
large part by the conviction among investors that 
efficient-market theories were valuable. And 
current debates in the United States and 
elsewhere about privatizing Social Security and 
other retirement systems may hinge on assumptions 
about how investors are likely to handle their retirement options.

We agree that behavioral finance offers some 
valuable insights—chief among them the idea that 
markets are not always right, since rational 
investors can't always correct for mispricing by 
irrational ones. But for managers, the critical 
question is how often these deviations arise and 
whether they are so frequent and significant that 
they should affect the process of financial 
decision making. In fact, significant deviations 
from intrinsic value are rare, and markets 
usually revert rapidly to share prices 
commensurate with economic fundamentals. 
Therefore, managers should continue to use the 
tried-and-true analysis of a company's discounted 
cash flow to make their valuation decisions.
When markets deviate

Behavioral-finance theory holds that markets 
might fail to reflect economic fundamentals under 
three conditions. When all three apply, the 
theory predicts that pricing biases in financial 
markets can be both significant and persistent.

Irrational behavior.
Investors behave irrationally when they don't 
correctly process all the available information 
while forming their expectations of a company's 
future performance. Some investors, for example, 
attach too much importance to recent events and 
results, an error that leads them to overprice 
companies with strong recent performance. Others 
are excessively conservative and underprice 
stocks of companies that have released positive news.

Systematic patterns of behavior.
Even if individual investors decided to buy or 
sell without consulting economic fundamentals, 
the impact on share prices would still be 
limited. Only when their irrational behavior is 
also systematic (that is, when large groups of 
investors share particular patterns of behavior) 
should persistent price deviations occur. Hence 
behavioral-finance theory argues that patterns of 
overconfidence, overreaction, and 
overrepresentation are common to many investors 
and that such groups can be large enough to 
prevent a company's share price from reflecting 
underlying economic fundamentals—at least for some stocks, some of the time.

Limits to arbitrage in financial markets.
When investors assume that a company's recent 
strong performance alone is an indication of 
future performance, they may start bidding for 
shares and drive up the price. Some investors 
might expect a company that surprises the market 
in one quarter to go on exceeding expectations. 
As long as enough other investors notice this 
myopic overpricing and respond by taking short 
positions, the share price will fall in line with its underlying indicators.

This sort of arbitrage doesn't always occur, 
however. In practice, the costs, complexity, and 
risks involved in setting up a short position can 
be too high for individual investors. If, for 
example, the share price doesn't return to its 
fundamental value while they can still hold on to 
a short position—the so-called noise-trader 
risk—they may have to sell their holdings at a loss.
Momentum and other matters

Two well-known patterns of stock market 
deviations have received considerable attention 
in academic studies during the past decade: 
long-term reversals in share prices and short-term momentum.

First, consider the phenomenon of 
reversal—high-performing stocks of the past few 
years typically become low-performing stocks of 
the next few. Behavioral finance argues that this 
effect is caused by an overreaction on the part 
of investors: when they put too much weight on a 
company's recent performance, the share price 
becomes inflated. As additional information 
becomes available, investors adjust their 
expectations and a reversal occurs. The same 
behavior could explain low returns after an 
initial public offering (IPO), seasoned 
offerings, a new listing, and so on. Presumably, 
such companies had a history of strong 
performance, which was why they went public in the first place.

Momentum, on the other hand, occurs when positive 
returns for stocks over the past few months are 
followed by several more months of positive 
returns. Behavioral-finance theory suggests that 
this trend results from systematic underreaction: 
overconservative investors underestimate the true 
impact of earnings, divestitures, and share 
repurchases, for example, so stock prices don't 
instantaneously react to good or bad news.

But academics are still debating whether 
irrational investors alone can be blamed for the 
long-term-reversal and short-term-momentum 
patterns in returns. Some believe that long-term 
reversals result merely from incorrect 
measurements of a stock's risk premium, because 
investors ignore the risks associated with a 
company's size and market-to-capital ratio.2 
These statistics could be a proxy for liquidity and distress risk.

Similarly, irrational investors don't necessarily 
drive short-term momentum in share price returns. 
Profits from these patterns are relatively 
limited after transaction costs have been 
deducted. Thus, small momentum biases could exist 
even if all investors were rational.

Furthermore, behavioral finance still cannot 
explain why investors overreact under some 
conditions (such as IPOs) and underreact in 
others (such as earnings announcements). Since 
there is no systematic way to predict how markets 
will respond, some have concluded that this is a 
further indication of their accuracy.3
Persistent mispricing in carve-outs and dual-listed companies

Two well-documented types of market deviation—the 
mispricing of carve-outs and of dual-listed 
companies—are used to support behavioral-finance 
theory. The classic example is the pricing of 
3Com and Palm after the latter's carve-out in March 2000.

Two types of market deviation—the mispricing of 
carve-outs and of dual-listed companies—are used 
to support behavioral-finance theory

In anticipation of a full spin-off within nine 
months, 3Com floated 5 percent of its Palm 
subsidiary. Almost immediately, Palm's market 
capitalization was higher than the entire market 
value of 3Com, implying that 3Com's other 
businesses had a negative value. Given the size 
and profitability of the rest of 3Com's 
businesses, this result would clearly indicate 
mispricing. Why did rational investors fail to 
exploit the anomaly by going short on Palm's 
shares and long on 3Com's? The reason was that 
the number of available Palm shares was extremely 
small after the carve-out: 3Com still held 95 
percent of them. As a result, it was extremely 
difficult to establish a short position, which 
would have required borrowing shares from a Palm shareholder.

During the months following the carve-out, the 
mispricing gradually became less pronounced as 
the supply of shares through short sales 
increased steadily. Yet while many investors and 
analysts knew about the price difference, it 
persisted for two months—until the Internal 
Revenue Service formally approved the carve-out's 
tax-free status in early May 2002. At that point, 
a significant part of the uncertainty around the 
spin-off was removed and the price discrepancy 
disappeared. This correction suggests that at 
least part of the mispricing was caused by the 
risk that the spin-off wouldn't occur.

Additional cases of mispricing between parent 
companies and their carved-out subsidiaries are 
well documented.4 In general, these cases involve 
difficulties setting up short positions to 
exploit the price differences, which persist 
until the spin-off takes place or is abandoned. 
In all cases, the mispricing was corrected within several months.

A second classic example of investors deviating 
from fundamentals is the price disparity between 
the shares of the same company traded on two 
different exchanges. Consider the case of Royal 
Dutch Petroleum and "Shell" Transport and 
Trading, which are traded on the Amsterdam and 
London stock markets, respectively. Since these 
twin shares are entitled to a fixed 60-40 portion 
of the dividends of Royal Dutch/Shell, you would 
expect their share prices to remain in this fixed ratio.

Over long periods, however, they have not. In 
fact, prolonged periods of mispricing can be 
found for several similar twin-share structures, 
such as Unilever (Exhibit 1). This phenomenon 
occurs because large groups of investors prefer 
(and are prepared to pay a premium for) one of 
the twin shares. Rational investors typically do 
not take positions to exploit the opportunity for arbitrage.

Thus in the case of Royal Dutch/Shell, a price 
differential of as much as 30 percent has 
persisted at times. Why? The opportunity to 
arbitrage dual-listed stocks is actually quite 
unpredictable and potentially costly. Because of 
noise-trader risk, even a large gap between share 
prices is no guarantee that those prices will converge in the near term.

Does this indict the market for mispricing? We 
don't think so. In recent years, the price 
differences for Royal Dutch/Shell and other 
twin-share stocks have all become smaller. 
Furthermore, some of these share structures (and 
price differences) disappeared because the 
corporations formally merged, a development that 
underlines the significance of noise-trader risk: 
as soon as a formal date was set for definitive 
price convergence, arbitrageurs stepped in to 
correct any discrepancy. This pattern provides 
additional evidence that mispricing occurs only 
under special circumstances—and is by no means a 
common or long-lasting phenomenon.

Markets and fundamentals: The bubble of the 1990s

Do markets reflect economic fundamentals? We 
believe so. Long-term returns on capital and 
growth have been remarkably consistent for the 
past 35 years, in spite of some deep recessions 
and periods of very strong economic growth. The 
median return on equity for all US companies has 
been a very stable 12 to 15 percent, and 
long-term GDP growth for the US economy in real 
terms has been about 3 percent a year since 
1945.5 We also estimate that the 
inflation-adjusted cost of equity since 1965 has 
been fairly stable, at about 7 percent.6

We used this information to estimate the 
intrinsic P/E ratios for the US and UK stock 
markets and then compared them with the actual 
values.7 This analysis has led us to three 
important conclusions. The first is that US and 
UK stock markets, by and large, have been fairly 
priced, hovering near their intrinsic P/E ratios. 
This figure was typically around 15, with the 
exception of the high-inflation years of the late 
1970s and early 1980s, when it was closer to 10 (Exhibit 2).

Second, the late 1970s and late 1990s produced 
significant deviations from intrinsic valuations. 
In the late 1970s, when investors were obsessed 
with high short-term inflation rates, the market 
was probably undervalued; long-term real GDP 
growth and returns on equity indicate that it 
shouldn't have bottomed out at P/E levels of 
around 7. The other well-known deviation occurred 
in the late 1990s, when the market reached a P/E 
ratio of around 30—a level that couldn't be 
justified by 3 percent long-term real GDP growth 
or by 13 percent returns on book equity.

Third, when such deviations occurred, the stock 
market returned to its intrinsic-valuation level 
within about three years. Thus, although 
valuations have been wrong from time to time—even 
for the stock market as a whole—eventually they 
have fallen back in line with economic fundamentals.

Focus on intrinsic value

What are the implications for corporate managers? 
Paradoxically, we believe that such market 
deviations make it even more important for the 
executives of a company to understand the 
intrinsic value of its shares. This knowledge 
allows it to exploit any deviations, if and when 
they occur, to time the implementation of 
strategic decisions more successfully. Here are 
some examples of how corporate managers can take 
advantage of market deviations.

    * Issuing additional share capital when the 
stock market attaches too high a value to the 
company's shares relative to their intrinsic value
    * Repurchasing shares when the market 
under-prices them relative to their intrinsic value
    * Paying for acquisitions with shares 
instead of cash when the market overprices them 
relative to their intrinsic value
    * Divesting particular businesses at times 
when trading and transaction multiples are higher 
than can be justified by underlying fundamentals

Bear two things in mind. First, we don't 
recommend that companies base decisions to issue 
or repurchase their shares, to divest or acquire 
businesses, or to settle transactions with cash 
or shares solely on an assumed difference between 
the market and intrinsic value of their shares. 
Instead, these decisions must be grounded in a 
strong business strategy driven by the goal of 
creating shareholder value. Market deviations are 
more relevant as tactical considerations when 
companies time and execute such decisions—for 
example, when to issue additional capital or how 
to pay for a particular transaction.

Second, managers should be wary of analyses 
claiming to highlight market deviations. Most of 
the alleged cases that we have come across in our 
client experience proved to be insignificant or 
even nonexistent, so the evidence should be 
compelling. Furthermore, the deviations should be 
significant in both size and duration, given the 
capital and time needed to take advantage of the 
types of opportunities listed previously.

Provided that a company's share price eventually 
returns to its intrinsic value in the long run, 
managers would benefit from using a 
discounted-cash-flow approach for strategic 
decisions. What should matter is the long-term 
behavior of the share price of a company, not 
whether it is undervalued by 5 or 10 percent at 
any given time. For strategic business decisions, 
the evidence strongly suggests that the market reflects intrinsic value.

About the Authors

Marc Goedhart is an associate principal in 
McKinsey's Amsterdam office, and Tim Koller is a 
principal in the New York office. David Wessels, 
an alumnus of the New York office, is an adjunct 
professor of finance at the Wharton School of the 
University of Pennsylvania. This article is 
adapted from Tim Koller, Marc Goedhart, and David 
Wessels, Valuation: Measuring and Managing the 
Value of Companies, fourth edition, Hoboken, New 
Jersey: John Wiley & Sons, 2005.

Notes

1For an overview of behavioral finance, see Jay 
R. Ritter, "Behavioral finance," Pacific-Basin 
Finance Journal, 2003, Volume 11, Number 4, pp. 
429–37; and Nicholas Barberis and Richard H. 
Thaler, "A survey of behavioral finance," in 
Handbook of the Economics of Finance: Financial 
Markets and Asset Pricing, G. M. Constantinides 
et al. (eds.), New York: Elsevier North-Holland, 2003, pp. 1054–123.

2Eugene F. Fama and Kenneth R. French, 
"Multifactor explanations of asset pricing 
anomalies," Journal of Finance, 1996, Volume 51, Number 1, pp. 55–84.

3Eugene F. Fama, "Market efficiency, long-term 
returns, and behavioral finance," Journal of 
Financial Economics, 1998, Volume 49, Number 3, pp. 283–306.

4Owen A. Lamont and Richard H. Thaler, "Can the 
market add and subtract? Mispricing in tech stock 
carve-outs," Journal of Political Economy, 2003, 
Volume 111, Number 2, pp. 227–68; and Mark L. 
Mitchell, Todd C. Pulvino, and Erik Stafford, 
"Limited arbitrage in equity markets," Journal of 
Finance, 2002, Volume 57, Number 2, pp. 551–84.

5US corporate earnings as a percentage of GDP 
have been remarkably constant over the past 35 years, at around 6 percent.

6Marc H. Goedhart, Timothy M. Koller, and Zane D. 
Williams, "The real cost of equity," McKinsey on 
Finance, Number 5, Autumn 2002, pp. 11–5.

7Marc H. Goedhart, Timothy M. Koller, and Zane D. 
Williams, "Living with lower market 
expectations," McKinsey on Finance, Number 8, Summer 2003, pp. 7–11.


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((Udhay Shankar N)) ((udhay @ pobox.com)) ((www.digeratus.com))