Are Dividend Payments a Waste of Money?

Dividend policies have long been scrutinised by investors  and make up a crucial element in any investment decision. However, some of the world’s most successful companies have a dividend policy where they don’t pay a dividend! Why on earth would you invest in them? Which companies don’t reward their shareholders? And why?

Some of the companies that choose not to pay a dividend include:

Google – Who has never paid a dividend despite currently holding around $35bn in surplus cash;

Apple – Withheld dividend payments for the last decade, despite declaring a $95bn cash figure on the books;

Berkshire Hathaway - Run by Warren Buffet who traditionally recommends stocks with a solid dividend payment history. Despite this, his own company doesn’t pay a dividend even though the company currently has sufficient cash enough to pay $20,000 per share. Yes, enough cash to pay over $20,000 per share...

First, lets analyse the reasons why most companies traditionally pay a regular dividend. One of the primary reasons for paying a dividend to shareholders is to reward shareholders for their investment. Dividends are little packets of reassurance to investors that the company is using their money to generate more money, and the company’s future is stable. When shareholders feel their investments are safe they tend to keep their money invested within the same company, keeping demand for the company’s shares up and therefore keeping the share price high. A clear example of supply and demand. Dividend payments also act as a signal to the markets. Companies with a solid dividend policy attract new investors who believe they will see return on investments and are convinced the stability of the company. This again, increases demand which pushes share prices up. Another reason for companies paying dividends is that it spreads return payments over a significant time period, for personal tax reasons shareholders prefer this method. By paying small regular amounts, shareholder can take advantage of the dividend tax relief that is currently enjoyed in the UK and US.

After reading the previous paragraph, it would seem that dividend payments are highly beneficial to shareholders. So, why do some of the world’s most successful companies not pay a dividend?

Figure 1 – Google, Apple and Berkshire Hathaway Share Price (14/05/12)

The primary reason companies do not pay a dividend is to retain cash, and, within today’s market, it is usually a sign that a company is struggling and needs the capital. However Google, Apple and Berkshire Hathaway certainly are not struggling companies. We need to analyse the reasons behind why these companies don’t pay a dividend and if this has any bearing on why they are successful. It could be seen that paying a dividend signals that the company has run out of investment projects, and as an easy option dumps the money on shareholders. When a company runs out of investments to spend cash on, it could show they are lacking creativity or being too risk adverse. The sole reason companies exist is to build on shareholder value and releasing cash out of the business and into the pockets of shareholders only reduces the earning potential of the company. There is a strong argument that paying dividends hinders the company’s ability to generate more shareholder wealth. Similarly companies that prefer to return cash to shareholders than potentially invest in a project with potentially high returns may be acting as a competitive disadvantage to the company and could find themselves falling behind competitors. As discussed above, dividends can be preferential to shareholders to minimise their tax liabilities. However, looking at Google, Apple and Berkshire Hathaway, their shares are valued at; $600, $53 and $120,000 respectively (See figure 1).  Therefore, any dividend payments are marginal when compared to the price of the shares, making the dividend payments almost irrelevant to shareholders.

After analysing each side of the argument for dividend payments, I believe that a company’s primary objective is to build shareholder value and, therefore, money is better invested within a business and within projects rather than returned to shareholders. Shareholders should realise that dividend payments are in the short term very attractive but there are no returns or wealth construction once the money leaves the business. If shareholders truly believed in their company’s future then surely the money is best being utilised within the company, with the majority of wealth being generated from the sale of the shares in the future, rather than a set of short term payments.

CDO and CDS – what are these? And how did they cause a global recession?

There are two acronyms that are at the heart of the recession talk, the CDO and CDS. But very few people know what they are and how they had such a pivotal role in the current recession.

CDS -

So what do the acronyms stand for? A CDS is a credit default swap. The loan seller can purchase a CDS , for this the loan seller pays a fee and in return if the loan is defaulted upon the CDS seller pays out compensation (usually the face value of the loan). As a financial instrument it’s highly effective at spreading risk without diversification of the loan seller’s portfolio. So, for example, banks can sell loans to homeowners or small businesses and not need to balance the risk in the portfolio with more secure loans sold to more established businesses. The advantage of this is that loans to small businesses and homeowners have higher interest rates attached and therefore are more profitable, so by loading the portfolio with these with CDS taken out makes for a highly profitable and low risk portfolio.

CDO -

The second acronym is the CDO, which is a collateralised debt obligation. Again, in its basic form this is a collection of loans that have been packaged together. By packaging loans together it reduces the risk of the package and also allows them to be sold on. There are three main advantages to banks for selling CDOs. Firstly its shifts the risk of loan defaults onto the investor. Secondly it turns small monthly payments that would normally be received from the loan repayments, into a large capital payment from the investor buying the CDO, which gives the bank more capital to give out as new loans. Finally by increasing loans and profits made from CDOs it boosts the financial performance, which results in increased share prices and boosts manager’s bonuses.

Why did they rise in popularity?

Both options sound great, they reduced risk and increase the debt capital available to the market, which should be a self supporting cycle of growth. However loans are highly dependent on interest rates. And the US interest rate had been consistently low since the early 90’s.

With interest rates being low over such a long time it encouraged everyone to borrow more and more. Banks were happy to lend as they were shifting the risk by selling all these loans as CDOs and reducing risk with CDSs as well as receiving cash from selling them, which again increases the amount of loans they can sell. Banks had so much cash they were struggling to lend it all out, so they increased the amounts they were giving out, in some cases offering 140% of the value of property loans and 6 or 7 times annual salaries of the receivers.  But look what happens when interest rates increase slightly.

Many loans start to be defaulted upon, but banks think they are covered with the CDS and CDOs that they took out. But they didn’t realise the extent to which CDOs and CDSs had flooded the market and the amount of companies whose balance sheets were loaded with these instruments that were so sensitive to changes in interest rates. The results of these errors are well documented and this blog doesn’t aim to discuss the results but to questions who was at fault for allowing it to get this far.

Who is to blame for the CDO and CDS issue?

Ok, so let’s line the main groups up who played some part in this over saturation of CDOs and CDSs. Firstly there is the US governments for consistently low interest rates. Secondly there are the homeowners taking loans they couldn’t afford. Thirdly, banks for offering loans that were up to 140% of property values and 6 or 7 times annual salaries. And finally the credit rating agencies that managed to rate CDOs incorrectly.

US Government to blame?

The US government kept interest low to encourage growth in the economy, however should they have realised growth is never expediential? And surely they saw the public debt levels increasing and should have stepped in by increasing interest rates to deter the public taking out more debt. It seems the American government became ‘blinkered’ and only saw the growth benefits of low interest rates. But because interest rates are low does it give other people and institutions the right to exploit that?

US homeowners to blame?

The US homeowners used the low interest rates to take out mortgages, which is great when the mortgage is manageable. The low interest rate would have enabled millions of young family’s gain the first step on the housing ladder and secure their futures. However greed kicked in and people took mortgages that were on the limits of their financial capabilities. It seems there was an over confidence of the public and as a result they didn’t try and ‘keep up with the Jones’, they bought the Jones’ house! It depends how harsh you want to be on the average American family, on one hand you could say it’s their entire fault for being so greedy, but personally I think the average American family is unlikely to understand the complex economics or the financial instruments that are involved when they take out a mortgage. Therefore they trusted the banks.

The banks to blame?

Should they have trusted the banks? Well, yes. The banks have the financial and economic knowledge and it was indeed the banks selling CDOs and taking out the CDSs, so they were in the best position to understand the extent to which the markets were exposed.  The banks also chose to lend huge sums of money to low earning families, it could be called predatory in some cases. However the banks thought they were spreading the risk, they believed they were being safe. You must understand that everyone believed that these CDOs and CDSs were truly safe and therefore you can’t land all the blame at the banks door step. Why did the banks think they were safe?

Credit rating agencies to blame?

The banks thought they were safe instruments because they are banded in terms of risk. Credit rating agencies rank CDOs from AAA to C or D.

The three main credit rating agencies (Moody, Standard & Poor and Fitch) were effectively fooled when it came to CDOs. Somehow they managed to band secondary CDOs into the same categories as primary CDOs. This in turn fooled the market into buying CDOs that were far more risky than they were labelled. The markets are so reliant on these ratings that if errors occur at this stage, the consequences can be catastrophic. It seems unbelievable that such a small error can have such large impacts, and errors that were made by the ‘experts’. The era of bank bashing began as soon as the financial crisis hit the headlines, but it seems that the error was made by the credit rating agencies and maybe instead of slashing the bonuses of the banking executives a little more digging should be done into the salaries of the rating agencies...

Glenstrata - A Damaging Super Merger?

Last week I discussed foreign direct investment and how that can benefit the company and inevitably the shareholders. But this week is centred around companies merging together or a company acquiring a company. Mergers and acquisitions (M&As).

So what’s the difference between a merger and an acquisition? Well the difference isn’t clear in the business world as sometimes it can be called a merger when really a company is taking over another or vice versa. But the simple way to think of a merger is two companies agreeing to combine into one. And an acquisition is a company buying another. For the purpose of this blog we can use merger and acquisition interchangeably.

There are several different types of M&As all of which have recent news stories to give real context to the theory. Firstly there is a horizontal merger, this can be seen in the recent news surrounding the two mining and commodity giants Glencore and Xstrata who are companies in similar lines of activities, which I will discuss in detail later. Another type of merger is the vertical merger, which means buying up parts of the supply and production chain, Greggs is a good example of this, they own the bakeries that supply their retail stores. The advantages being it can reduce costs for Greggs, it also allows greater degrees of product control and faster product alterations, which should give Greggs a competitive advantage over other rival retailers, boosting shareholder wealth. The final type of merger is when a conglomerate is formed, where the two companies are unrelated in their activity but see some commercial gains in merging.

The deal between Glencore and Xstrata hasn’t gone through yet but they would form a giant $90billion company that would have huge power in the commodity and mining markets.

So what are the main benefits for the companies and their shareholders? Well the companies sell a lot of their products such as copper, zinc and aluminium to China for manufacturing purposes. Merging creates less competition in the market which allows prices to rise, and if they charge more money, they make more money! The idea of synergy is also key when discussing a merger of this size, the shareholders and managers should be expecting the combination of the two sets of assets to produce “gains” which is extra value from the same asset base.  Other synergy benefits would possibly include tax bill reductions (which have been discussed in one of my previous blogs). The economies of scales the two companies could benefit from could be immense, by sharing suppliers they could negotiate even larger discounts, which would be eye watering for the supplier but would decrease costs for Glencore and Xstrata. Other than the obvious economical reasons for the merger, why else would the executives make this move? Business men like large businesses and want to be the biggest and the best! The idea of empire building is a reality, fuelled with a dangerous mix of status, hubris and power struggles of the top executives and if the opportunity arises to combine to make the world’s largest company, do you think the power hungry execs could turn it down?

Is this merger really going to be the perfect synergy, or will it all end in tears? No matter how rose tinted your glasses are, you must realise that this merger won’t be as simple as plugging the two companies together and value will instantly be created. The steps involved in merging are huge and ridiculously expensive, a company will have to broker the deal and they will be taking between 2-5% of the deal which is over $4billion. Which is $4billion instantly wiped off shareholder value. The ability for the two management teams to fuse together is critical to the mergers success, if they don’t resolve cultural, dominance and personal differences at the top of the firm it will quickly destroy the merger as they management will tear the companies apart from the inside. There is also the question as to whether anyone other than the management and shareholder benefit from this deal? If the merger happens successfully, I’m sure the executives will be very happy with their increased salaries and bonuses and the shareholders will be very happy with an increase in dividends and share prices, but what about the rest of the stakeholders? Will society actually benefit from this? As consumers would a company with the ability to control commodity prices be good? Probably not, because any increase in price will be passed on directly to us. As a driver for the company, would you be pleased when they manage to reduce transportation costs by 10% causing you to lose your job? Probably not. As a supplier would you be pleased when Glenstrata knock on the door demanding a 20% drop in price? Probably not. M&As can be great for shareholders and executives but do the largest really help anyone other than the select few?



British Brands Gone - FDI.

There have been several cases of high profile UK brands being snapped up by foreign companies recently. American based Kellogg’s recently bought Pringles for £1.7bn, Kraft bought Cadbury’s for £11.5bn and most recently Muller have bought Scottish based milk producer Robert Wiseman Dairies for a more modest £300m.



What is foreign direct investment?

Any company that takes managerial control over a company or assets outside of its domestic boarder can be identified as foreign direct investment (FDI). All three cases above are acquisitions, where the company has bought the shares of the foreign company to take managerial control. There are two other methods of FDI, greenfield and joint venture.

Greenfield investment is when companies literally buy a field and build from the ground up. Greenfield investments are popular within the car industry, for example Hyundai started construction in 2006 of a plant in the Czech Republic to supply is European operations. The advantage for Hyundai is a purpose built, state of the art production site that is specifically designed for their products. Greenfield investments have advantages for both the company and the local economy, and often governments offer financial support packages to attract large greenfield projects. The main advantage to the company is the complete control they have over the project, usually 100% owned they have no diluted of returns for shareholders. However they do require large capital investment and the planning and construction period mean it’s the slowest method to market, which are all risk factors to shareholders money.

Many companies also chose to enter into a joint venture, usually choosing to work with an established company to make use of their existing assets and infrastructure. For example Marks and Spencer bought a 51% stake in the Indian retailer Reliance for £29m to take advantage of its store locations. The advantage of entering into a joint venture is the knowledge transfer and experience the companies can share. Usually a large company enters into a JV with smaller company to take advantage and enter the market quickly, the smaller company is usually happy for the investment and the economies of scale the large investor brings. JVs are usually the cheapest method into a foreign location, however they do have disadvantages, there can be issues sharing technology and trade secrets that can potentially reduce competitive advantage. There can also be management and culture synergy issues, again which could potentially damage shareholder wealth if the project fails.

Is FDI the only way to generate sales abroad?

There are other options available to generate sales in a foreign market, such as exporting or licensing. Exporting offers one of the fastest routes to market but must be balanced with the costly transportation. Exporting is the only option for some companies that are restricted by resource location, such as diamond mines. Also exporting is seen as the only option for companies who rely on location branding benefits such as Barbour, Bentley and Aston Martin, who all use the UK production as part of their brand image.

Licensing is the process of granting the rights to sell a product under a specific brand. Again this is a fast entry to market with little capital required, however the loss of control of the brand can be potentially damaging in the long term. There can also be issues with loss of control over technology and trade secrets, effectively reducing competitive advantage.

Management must consider all of the above methods when considering FDI. The company must be aware of the potential risks of each method and select the option that will result in the greatest shareholder wealth production.

 Source: UNCTAD, UNCTADstat

FDI – The rich helping the rich?

There is no doubt FDI has major economical benefits for both parties involved, however the latest figures show the majority of FDI is still between developed countries. On one hand it makes sense you would aim to sell your products in the developed world, where disposable incomes are higher, but at the same time the developing countries would benefit from major FDI the most. Huge capital investment and job creation would create a self supporting spiral of wealth for the developing countries, but companies just aren’t willing to take the risk. Yet.



Legally Managing Your Company Tax Bill & Currency Management

The UK’s Tax Avoidance Deficit

To put the discussion of tax avoidance into context we must first look at the figures. The HRMC released figures quoting revenue losses of £6.3billion as a result of tax avoidance, although other sources states figures between £3 billion and £13billion. Either way, at the outset it appears that huge amounts of money are being snatched away from the treasures’ coffers. But let’s put this into context further, the FTSE 100 companies alone have a market capitalisation of £1.8trillion and profits (after tax!!) of over £75billion, and that’s just the top 100 companies. So it seems they pay a fair amount anyway?
 

International Corporations Managing Tax Bills

Who is getting away with this £6.3billion and how? Well, the simple answer is most companies with the ability to hire top accountants. But looking specifically at Diageo, the owner of many brands, for example Guinness, Smirnoff, and Jonnie Walker, has employed a few clever accounting tricks to lower its tax bill. Diageo is listed on the London Stock Exchange and has its headquarters in London and therefore, it should be paying corporation tax of 28%. Between 2005 and 2008, inclusive, Diageo averaged a tax bill of 18%. Over that time frame the corporation tax rate was 30% and Diageo should have paid a total of £2,478million. Diageo only paid £1,454million during this time. This is brilliant news if you’re a shareholder: by reducing the tax bill there is an extra £1billion floating around for either wealth building projects or dividends. Then again, is it not the purpose of a corporation to build as much value for shareholders as possible? The great economist Adam Smith would have taken great delight in such shareholder wealth generation.

So how do they manage their tax bill to save money? It’s fairly simple really; Diageo splits each of its brands into subsidiaries located in different countries, and any profits arise abroad rather than in the UK. This is called transfer pricing. As an example, Guinness is based in Ireland and benefits from a lower tax rate of 12.5% on any profits made from the sales of that brand. This means that Guinness’ tax bill is reduced by over half when compared to the UK. A further way Diageo ensures ensure tax efficiency is by ownership transferring. Diageo has transferred the legal ownership of UK based brands such as Jonnie Walker to a Dutch company called Diageo Brands BV. The Dutch corporation tax for Diageo would normally be 25.5%, however, there is an exemption clause that means Diageo can reduce that to 0% (See link below for details of ownership trading). This means that tax efficiency is achieved as Diageo is not paying any tax on their profits. These two methods ensure sales based in the UK and around the globe are being diverted into countries like Ireland and the Netherlands, so any profits are subject to reduced taxes. Diageo has structured its organisation in a tax advantageous position.

Currency Risk Management

Diageo, as a multinational organisation, has to manage the risks that are associated with any transactions that are between currencies. Diageo recently announced its commissioning of a new brewery is Tanzania at a cost of $55million. Diageo had to consider the financial risk posed by the exchange rate between US dollars and Kshs (Tanzanian Shilling) between committing to purchase the plant and actually paying for it. This time frame creates risk, as any fluctuation in either currency can make the plant either more expensive or cheaper than originally planned. There are several basic techniques that can be used such as leading or lagging payments for reducing transaction exposure. Netting or matching payments is also an option when dealing between subsidiaries and third parties. There is always the option to simply do nothing and hope the currency markets balance out your transaction costs over time. Alternatively, there are some basic hedging techniques used to reduce risk, for example forward market, money market, futures or currency option hedging. All these techniques have their individual benefits that must be assessed by the finance manager and will usually depend on the size of the transaction to the company.

Another currency risk that Diageo has to manage is the translation of its subsidiaries values into UK sterling to form part of its annual report. It is important to differentiate between transaction exposure, which is a pure cash loss, and translation exposure, which is loss of book value and does not involve any loss of cash. Each subsidiary (under the old UKs IAS 27 and current IFRS 3) must be included in the consolidates accounts, meaning Diageo has to convert its North American, European, Asian and International companies results into British Sterling. Again, any negative fluctuations in currency can destroy the value of foreign subsidiaries and thus destroy shareholder value. Therefore, it is important for managers, at least, to consider managing the exposure through hedging, especially when the values of subsidiary companies are relatively large to the company.

How Diageo restructured its company to place brands into Dutch corporations:
http://www.guardian.co.uk/business/2009/feb/02/tax-gap-diageo-johnnie-walker.

References:

http://www.hm-treasury.gov.uk/press_46_10.htm

http://www.ftse.com/Indices/UK_Indices/Downloads/FTSE_100_Index_Factsheet.pdf

http://www.guardian.co.uk/business/interactive/2009/feb/02/tax-database

http://www.actionaid.org.uk/doc_lib/addicted_to_tax_havens.pdf

http://www.diageo.com/Lists/Resources/Attachments/640/Diageo_AR10_full_report.pdf

http://www.guardian.co.uk/business/2009/feb/02/tax-gap-avoidance

http://www.telegraph.co.uk/finance/migrationtemp/2802209/FTSE100-companies-see-profits-double.html

http://www.guardian.co.uk/business/tax-gap-blog/2009/feb/13/diageo-taxavoidance

http://www.diageo.com/en-sc/investor/Pages/resource.aspx?resourceid=1135

http://www.eabl.com/inner.asp?pcat=mediacentre&cat=newspressreleases&sid=492

http://www.guardian.co.uk/business/2009/feb/02/tax-gap-diageo-johnnie-walker

We need cash!! – When a loss isn’t a loss.

Cash, money, investment, funds, capital, whatever you want to call it, companies need it to survive and grow. There are three methods by which companies can raise money, retained earnings, equity capital and debt capital. It’s the job of the finance manager to make the decision of which option to choose, and which option is the best for the business.

Firstly we can look at a company that had a long history of using retained profit, Greggs PLC. They were one of very few companies on the FTSE to have no long term debt on their balance sheet at all, that was until 2009, which we will discuss later. Greggs’ growth had always been funded through profit, which to most companies is a dream come true, with retained profit the cost of capital is zero! Any return made on retained earnings is pure profit!

In 2009 Greggs appointed a new chairman, who took over when cash was running low due to dwindling sales figures in light of the recession. With no cash, expansion would grind to a halt. McMeikan was had to raise capital using one of the other methods, and he chose to take a loan from the government, which sits in the long term liabilities as debt. The advantage of taking on debt is obviously it injects cash when it’s otherwise not available, and also there is no dilution of control, the company gets cash and doesn’t release any shares. However the debt will come with interest rates attached, which reduces the rate of return. Greggs needed to ensure the investments were now making higher returns and so when negotiating property leases, they squeezed landlords to retain their margins and significantly slimmed their product range to reduce costs.

An option that Greggs didn’t choose to raise finance was through the issuing of shares. Companies can issue a batch of shares, which have to be offered to current shareholders first, and then to the mass market. Facebook, although it’s an initial public offering  (IPO) rather than a share issuing procedure, are soon to be floating the company to raise money, and it certainly will raise significant amounts of money! The advantage to Facebook is there are no monthly payments or any obligation to pay back the capital raised or even to pay a dividend, which does lower the cost of capital. However it will come at a price to them, they will be losing a significant amount of control of the company and will be under increasing pressure to make returns for the shareholders. To issue shares or float a company is also very costly involving consultants, brokers and underwriters all taking a cut amount to between 10-12% of the finance raised.

Whichever option is chosen, only one thing is important! Return on the investment!! The option chosen should (usually) be the one that eats into the rate of return the least. Companies can calculate the cost of capital for each method and the expected cash flows (usually discounted as well) over the predicted life of the investment. Companies should then look to choose the project that pays the highest return. Seems simple enough, accept or reject projects. So why do companies take on projects that make a loss??

The internet is full of heavily discounted products that are clearly making losses such as airlines offering 99p flights. There are even sites such as Groupon that offer companies a marketing platform for low margin promotions. Surely the finance manager punches the numbers into the calculator and halts the project before a penny is ever invested? So why do they do it?



Sony’s Playstation has been entangled in a console war with Microsoft and Nintendo over the last decade, and has sold over 41 million of its Playstation 3 model (dated 11/05/11) but made a loss of £2bn on these!!  However, making a loss on the consoles was all part of the plan for the Sony bosses. Playstation took the decision to install a blu-ray play in its consoles, which created a point of difference compared to the X-box and Wii, but even if they were sold at cost price they would price themselves out of the market. The decision was made to sell it at a loss to gain market share, which worked exceptionally well and PS3 sales overtook X-box 360 sales early 2011, and as the blu-ray market has continued to grow so has the sales of PS3. The gain in market share was vital to grow sales in the games market as well, margins are smaller on games but customers purchase more frequently and total PS3 games sales recently passed 500 million mark, helping boost Sony’s third quarter net profit to $559.7m. Proving projects that make a loss don’t always make a loss.

 References:

Riley, A & Boome, A., Sex, religion and gossip fuels superbrands. BBC. Available at: http://www.bbc.co.uk/news/business-13416598 [Accessed February 19, 2012].

http://www.guardian.co.uk/technology/gamesblog/2011/apr/05/ps3-overtakes-xbox360

http://www.ft.com/cms/s/0/22ba711e-2f6e-11e0-834f-00144feabdc0.html#axzz1mqTNC5zY



EMH / Random Walk / Behavioural or a Mix Of All Three??

With the huge availability of information these days, why aren’t we all high flying city traders? Surely if we can follow a company’s progress continuously we can see their profits coming and buy shares with a click of a mouse! Well unfortunately it’s not that easy, and there are several theories on why it’s more difficult than we first thought.

Fama (1970) developed the Efficient Market Hypothesis, which stated that markets react to information instantly and settle at their efficient level until more news becomes available. Specifically in this blog we will be looking into the EMH with respect to share prices, as there is a wealth of information regarding company’s shares and company news.

Efficient Market Hypothesis (EMH) states two fundamental principles. Firstly, nobody can continually beat the market. Secondly, all prices are based on rational information. So if a company reports good news such as increased dividends or profits then surely the price will rise? And if a company releases reduced profits and starts cutting dividends then prices tumble?

Rio Tinto wrote down 8.9 billion dollars worth of its aluminium stock, over 10% of its total market cap, after it cut its losses on its 2007 Alcan project (The FT 2012). This would be considered bad news by most shareholders, however Rio Tinto shares actually finished up 13p on the day!

(Image: Rio Tinto share price 08-02-2012)

Another strange case was Google reporting a 27% rise in profits in its final quarter. When a company can report profits of $2.7bn and shares still fall by a massive 10% then surely this is great news for shareholders? (BBC 2011) Well apparently not! How does this fit with EMH?

When you dig a little deeper into the EMH, three levels of efficiency appear; weak, semi-strong and strong. Weak form efficiency states that current share prices reflect all past movement, which could be true for Rio Tinto. No matter what the bad news is, if Rio Tinto reported very solid share prices over the past ten years then maybe it’s ok to lose $8.9bn this time, because their track record is pretty good. Or semi –strong efficiency might apply to Google, which uses all past movements and all publicly available information to set the share price. Based on Google’s short history on the market and the public information that is available that shows investors expected higher profits than were reported, then maybe this is why share prices fell.

So if we can’t truly rely on information to correctly balance out market efficiencies, then what’s the alternative? Random walk theory (Kendall, 1953) posits that there is no fixed relationship between share price and time. There is no point looking at past information because it has no influence on the future information and therefore future share price. So maybe we would be better throwing our investment pot randomly over several companies and hope to get lucky? Well if you believe random walk theory then maybe you could apply this to the two cases above?

However, personally I would strongly recommend you don’t start throwing your cash around just yet. There is also behavioural finance theory to take into account. This does not rely on past information but has a much more irrational nature. Because the shares are traded by humans, we can’t simply look at the numbers and make a decision, we are affected by other factors such as regret and confidence, amongst other things. This can create a herd mentality amongst traders and drive prices up or down for no reason, look at Black Monday of 1987. There seems to be no reason for these wild swings in the market but they certainly do happen.

It’s not entirely clear how the stock markets work, or we would be the high flying city traders as mentioned previously, but it is clear EMH, Random Walk and Behavioural Finance theories can all be applied to cases in the market.

But if you think you can beat the market then sign up to Yahoo finance Fantasy Trader and then see which theory you believe...

Click here: Yahoo Trader

 References:

http://www.ft.com/cms/s/3/a9596aee-52ff-11e1-8aa1-00144feabdc0.html#axzz1mCXjfJbG

http://www.ft.com/cms/s/2/260cc4d6-9048-11df-ad26-00144feab49a.html#axzz1mCXjfJbG

http://www.bbc.co.uk/news/business-16642925

http://www.ft.com/cms/s/2/260cc4d6-9048-11df-ad26-00144feab49a.html#axzz1mCXjfJbG