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