Is the stock market efficient? The case of BT and EE

I briefly mentioned in my previous that when the announcement of Tesco's profit over-statement hit the headlines the share price plummeted - this concept is going to be the focus of this blog - stock market efficiency. 

In an efficient market place all known information is reflected within the share price which will essentially rise when good news is released and fall if bad news is released - but is this currently being achieved in reality? A current example which I am going to use to answer this question is the BT and EE acquisition. It was confirmed last week that BT, the UK’s largest telecoms and broadband network, had acquired Britain’s largest mobile phone network EE. The £12.5bn deal was completed on Thursday (5th February) following several weeks of speculation as to whether a move was going to take place (Financial Times, 2015).

The Efficient Market Hypothesis (EMH) implies that a company’s share price will fully reflect all available information, such that when new information is released it is incorporated into a share price rapidly and rationally (Basu, 1977). This therefore implies that investors undertaking statistical analysis into stock prices, in no way can “beat the market” and make higher returns as everyone has access to all current information and this is immediately reflected in the share price.

So was the market efficient in incorporating BT's announcement of the EE acquisition into the share price?

 

Figure 1: Share price reactions to information announcements (Arnold, 2013)

As shown in Figure 1, in a perfectly efficient market as soon as BT’s announcement of the EE acquisition was made, the share price would change rapidly, either rising or falling depending as to whether investors perceived this as good or bad news. This therefore suggests investors make quick and rational decisions. However in reality this is generally not the case and there are a number of reactions which could happen (lines 1-4). So what reaction did the market take for BT? On 24th November 2014 BT's share price (Figure 2) rose suggesting that investors anticipated that BT was going to make a move which they perceived as a good decision for the company - this follows line 2 in the above figure. This was due to speculation within the news that BT could potentially be acquiring either EE or 02. This explains why following the official announcement last week the share price did not change significantly - the market had already anticipated this information and so it was already incorporated into the share price. This suggests that the market is not perfectly efficient and therefore goes against the EMH.

Figure 2: BT’s Share Price (London Stock Exchange, 2015)

Kendal's (1953) theory of “random walks” suggests that share prices reflect all known information, they changed in a completely random fashion and consequently past performance cannot be used in any way to predict the future performance of a company (Agwuegbo et al, 2010). Looking at BT’s share price I agree with Kendal's theory as following the speculation of an acquisition in November the share price increased. Prior to this information being released I believe it could not have been predicted as to what direction the share price would have moved in. Likewise, news is completely random - how can people predict what is coming and consequently whether the share price would rise or fall?

However a challenge to Kendal's theory is that currently there are very highly paid jobs - chartists, for example, who aim to forecast future stock market trends based on past share price movements. Is this the case or it is simply just luck?!

Fama (1970) extended the random walks theory and identified three forms of efficiency; weak (past information), semi-strong (past and publically available information) and strong (all information - both public and private) form. The most likely and most justified form of efficiency for the UK market is semi-strong form which is where share prices efficiently adjust to reflect all information which is publically available as well as information from the past. It also suggests that investors react quickly and rationally to new information and so there is no benefit in analysing public information after it has been released (Fama, 1970). I believe semi-strong efficiency has been demonstrated from the BT share price as when the information of a possible acquisition was released in November the share price increased rapidly and significantly to reflect this information.

It has been identified however that there are anomalies in the stock market which suggests that there are occasions where it can be predicated, thus at these time it is inefficient. For example, the time of the day and month effect where at particular times it has been found that investors can achieve abnormal returns despite information being already publically available.

Furthermore, one of the key criticisms of the EMH is that occasionally investors make errors which may result in share prices deviating significantly from its true value - this is behavioural finance. The EMH implies that investors are rational however behavioural finance suggests they are not. For example, in reality emotions can influence how an individual acts and because of this do not always make rational decisions. An example of this is when investors are overconfident which can lead to an overreaction. This could explain the early rise in BT’s share price before the official announcement was made. It could be argued that investors were overconfident as they invested purely based on speculation – it was not certain that BT were going to acquire one of the companies and if they did there was no indication that it was going to work out well. It will be interesting to reflect on this in a few years time to determine whether it was a good thing that they were overconfident - is it working well? Are investors getting returns? Because of these anomalies and behavioural finance it is difficult to argue that stock markets are perfectly efficient and therefore challenges the EMH.

As discussed in my previous blog, shareholder owned companies generally follow the guiding objective of maximising shareholder wealth where executives should act with this in mind and therefore make decisions in order to achieve this. However, if the market is inefficient and shareholders act irrationally then this objective is unachievable and pointless - how will managers know what decisions they have to make to increase shareholder wealth? The rise in BT's share price suggests investors were rational and implies the goal of shareholder wealth maximisation is achievable. Additionally, the increased share price suggests the acquisition has maximised shareholder wealth and therefore appears to be a good decision made by the executives. I believe shareholders will take the view that the company is getting into a new market with a well-known and established company who already has the knowledge of what it takes to succeed. Furthermore there is potential to grow, for example BT can now sell packages which include mobile, and maximise the long-term value of the company. 

In summary, I believe the stock market cannot be predicted and share price movements are completely random. This is because news cannot be predicted and therefore you can never truly know how the share price will change until news is released. For BT I think the market is of semi-strong form as the share price rose indicating that investors reacted promptly and rationally. Whilst there was an early reaction, which at first could have been interpreted as investors beating the market or being overconfident, this was due to the speculation that something was going to happen. Because of this and in answer to the question I posed at the beginning - is an efficient market achieved in reality? - Whilst I believe the stock market is far from inefficient, it is not perfectly efficient - and after all, we don't live in a perfect world!

References

Agwuegbo, S. O. N., Adewole, A. P. & Maduegbuna, A. N. (2010). A random walk model for stock market prices. Journal of Mathematics and Statistics, 6(3), 342-346. doi:10.3844/jmssp.2010.342.346

Arnold, G. (2013). Corporate financial management. (5th ed.). Harlow: Pearson

Basu, S. (1977). Investment performance of common stocks in relation to their price-earning ratios: A test of the efficient market hypothesis. The Journal of Finance, 32(3), 663-682. Retrieved from http://web.a.ebscohost.com/ehost/search/

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. doi:10.1111/j.1540-6261.1970.tb00518.x

Financial Times (2015). BT seals £12.5bn deal to buy EE. Retrieved 10^th February 2015, from http://www.ft.com/cms/s/0/9a74a0ec-ac6c-11e4-9aaa-00144feab7de.html#axzz3RL5gLwDx

London Stock Exchange (2015). BT.ABT GROUP PLC ORD 5P. Retrieved 10^th February 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB0030913577GBGBXSET1

Will the Tesco turnaround plan maximise shareholder wealth?

The assumed primary objective or sole guiding principle in a shareholder owned company is shareholder wealth maximisation, that is, to act in a way which is in the best interests of its owners (Loderer et al, 2010). In my opinion this is perfectly logical given the fact that shareholders have incomplete contracts and so bear the risk that something could go wrong within the company and for this they should be rewarded. However, considering Tesco's situation over the past few months it appears they have most definitely not been following this principle. In September it was unveiled that the supermarket giant had overstated profits for the period by £263m (Financial Times, 2014). By doing this, clearly, they are not acting in the best interests of their shareholders, but what drove the executives to do this?

Agency theory is the assumption that the interests of the agents (the executives) and the interests of the owners (the shareholders) deviate from one another (Hill, 1992). Therefore there is a separation between ownership and control. This can result in managers making decisions for their own benefit to maximise their own utility rather than acting in the best interests of the shareholders by making decisions which create value. It could be argued that the executives at Tesco manipulated profits with the desire of gaining their bonuses or because they were under pressure to appear to be doing a good job and have 'rising' profits after a bumpy, poor performing couple of years. Either way, it destroyed shareholder value as shares crashed to an 11-year low and the end of year dividend was scrapped following the announcement. Clearly this overstatement was not made with shareholder wealth maximisation in mind and demonstrates how there is significant scope to destroy shareholder value through the agency problem.

But are the executives the only ones to blame? Tesco announced that at the time there was no CFO appointed after their current officer had resigned and was not due to start until December. It could be argued that the company was not being run correctly and there are potentially governance issues as well as auditor problems. However Jensen (2010) suggests that the problem lies with governments by not effectively setting rules and regulations for companies to follow to avoid these issues (Jensen, 2010), therefore suggesting Tesco are not the only ones to blame. 

So what are Tesco's plans to turn the company around and generate shareholder value?

It is only now that we are beginning to see the real effects this has had on Tesco and what they are planning to do to regain investor confidence and steps they are taking to create value.

In January, Dave Lewis, the companies CEO of five months was presented with the challenge of turning Tesco around. Lewis revealed plans to 'beef-up' their corporate finance department who will concentrate on investment opportunities, portfolio reviews and disposals in order to strengthen the balance sheet (Financial Times, 2015). Following this, plans were announced to make cost cuts of £250m which will begin by closing 43 unprofitable stores and cancelling plans for 49 new stores. Is this creating long-term shareholder value? Arguably not as they are not investing in the future of the organisation and new store openings are vital to the success of supermarkets. However I believe it is likely that shareholders will recognise that this is the only option available to Tesco given September's events and the generally poor performance of the company. Closing the unprofitable stores is an action consistent with point three of the value action pentagon which suggests that one way to create value is to divest assets from operations with a negative performance spread in order to utilise this capital more efficiently elsewhere (Arnold, 2013). This will allow capital which was previously tied up in unprofitable stores to be employed more productively. A further example of how Tesco is doing this comes after the announcement that they are closing their e-book selling service after posting a pre-tax loss of £2m on sales of just £70,000 in 2013. This business appears to have been a value-destroyer from the start for the company. Whilst they have been unable to find a buyer for this business, it further demonstrates how the company is making decisions to prevent any further damage as capital which would usually been spent within these units can now be invested more efficiently elsewhere.

However it was announced today (3rd February 2015) that Tesco are paying out £2.2m in severance pay to the former chief executive and finance director (BBC, 2015). The company suspended the payments while the scandal was investigated, however after seeking legal advice it was made clear that Tesco cannot withhold these payments. This is a further dent in shareholder value as a result of the scandal where otherwise the money could have been efficiently invested within the business to maximise shareholder returns.

Whilst some may argue that Tesco are beginning to turn their current situation around, I was shocked when I came across the below graph (Figure 1). The graph shows an increase in Tesco's EPS – great for shareholders right? WRONG. It shows that whilst EPS is rising, more capital is being employed to achieve this at ever lower returns suggesting that returns on new investments were inadequate and in most cases possibly negative. Whilst it only shows up until 2011, looking at the general trend over those 13 years I believe it is unlikely to have changed considerably. This is clearly destroying shareholder value as the capital is not being invested efficiently and is a further example of agency theory as the company is not acting in the best interests of the shareholders. It also demonstrates how one figure can make it appear that a company is performing well whilst on further investigation other figures suggest otherwise. This is why many academics acknowledge that shareholders should not solely rely on EPS to determine a company's performance as it does not always show the true picture (Rappaport, 2006).

Figure 1: Tesco's EPS and ROCE 1998-2011 (Financial Times, 2014)

 

Figure 2: Tesco PLC Share Price (London Stock Exchange, 2015)

Although it has been a very bumpy past few months for Tesco and its shareholders, looking at the company's share price (figure 2) it appears the market is regaining some confidence - shares jumped by 20% in January after the "turnaround" plan was announced. I believe the only way is up for Tesco and given the plans they have revealed, I think they are focusing on turning the company around and creating value for shareholders in the process to some extent. I think it is also worth noting that the other three supermarkets, which along with Tesco are referred to as the "big four", are also delaying expansion plans with some even closing stores. Whilst I believe Tesco is without doubt in the worst position I believe investors will gain some comfort knowing that competitors are struggling too. Nevertheless the ROCE figure over past years provides significant worry. It will be interesting to see how Tesco performs over the coming year and what further actions they take and whether they are ones which truly maximise shareholder wealth.

References

Arnold, G. (2013). Corporate financial management. (5th ed.). Harlow: Pearson
 

BBC (2015). Tesco's ex-boss and finance officer to share £2m payout. Retrieved 3rd February 2015, from http://www.bbc.co.uk/news/business-31122025
 

BBC (2015). Tesco to close 43 stores despite better Christmas sales. Retrieved 3rd February 2015, from http://www.bbc.co.uk/news/business-30712762
 

Financial Times (2014). How investors ignored the warning signs at Tesco. Retrieved 4th February 2015, from http://www.ft.com/cms/s/0/8f866d16-3280-11e4-93c6-00144feabdc0.html?siteedition=uk#axzz3QiBvu91J
 

Financial Times (2014). Tesco reveals it overstated first-half results by £250m. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/67fb8db4-421e-11e4-9818-00144feabdc0.html#axzz3QiBvu91J
 

Financial Times (2015). Tesco to beef up corporate finance department. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/07ed51ec-a31b-11e4-bbef-00144feab7de.html?siteedition=uk#axzz3QiBvu91J
 

Financial Times (2015). Tesco to close ebook-selling service. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/48e6c4b4-a567-11e4-ad35-00144feab7de.html#axzz3QiBvu91J
 

Hill, C. W. L. (1992). Stakeholder-agency theory. Journal of Management Studies, 29(2), 131-154. doi:10.1111/j.1467-6486.1992.tb00657.x

Loderer, C., Roth, L., Waelchli, U., & Joerg, P. (2010). Shareholder value: Principles, declarations, and actions. Financial Management, 39(1), 5-32. doi:10.1111/j.1755-053X.2009.01064.x

London Stock Exchange (2015). TSCO TESCO PLC ORD 5P. Retrieved 3rd February 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB0008847096GBGBXSET0

Rappaport, A. (2006). 10 ways to create shareholder value. Harvard Business Review, 84(9), 66-77. Retrieved from http://web.b.ebscohost.com