Wow  Facebook Inc. is all set for its initial public offering price range of between the high-$20s to the mid-$30s per share, The Wall Street Journal reported Thursday, citing unnamed sources. The social media company also seeks a valuation of $85 billion to $95 billion.

The above head line encourages me to write on the controversial topic  Market Efficiency. Capital markets are markets for trading in long-term financial instruments. Capital markets have two main functions: as primary market they provide the means whereby long-term funds can be raised; as secondary markets they provide the investors to sell their holdings of shares and bonds or to increase their portfolio by buying additional ones. Secondary market plays an important role in corporate financial management because by facilitating the ready buying and selling of securities, it increases their liquidity and their value. (Investors would pay less for a security that was difficult to dispose off.) The secondary market is also a source of pricing information for the primary market, increasing the efficiency with which new funds are allocated.

We have been talking about efficiency of markets for some time, now we must define an efficient market. Efficient market is one where the market price is an unbiased estimate of the true value of the investment. Market efficiency does not require that the market price be equal to true value at every point in time. All it requires is that errors in the market price be unbiased, i.e., that prices can be greater than or less than true value, as long as these deviations are random. It means that a market that is over pricing all assets has become inefficient. It also means that market efficiency can go up or down from time to time, this is most dramatically exhibited during market bubbles.)

The fact that the deviations from true value are random implies, in a rough sense, that there is an equal chance that stocks are under or over valued at any point in time, and that these deviations are uncorrelated with any observable variable. For instance, in an efficient market, stocks with lower PE ratios should be no more or less likely to be under valued than stocks with high PE ratios. Since the deviations of market price from true value are random, it follows that no group of investors should be able to consistently find under or over valued stocks using any investment strategy.

Market efficiency is a concept that is controversial and attracts strong views, pro and con, partly because of differences between individuals about what it really means, and partly because it is a core belief that in large part determines how an investor approaches investing. We will provide a simple definition of market efficiency, consider the implications of an efficient market for investors and summarizes some of the basic approaches that are used to test investment schemes, thereby proving or disproving market efficiency. 

At the outset, I would like to mention about an enduring pieces of evidence against market efficiency. It lies in the performance records posted by many of the investors who learnt their lessons from Ben Graham in the fifties. No probability statistics could ever explain the consistency and superiority of their records.

The question of whether markets are efficient, and if not, where the inefficiencies lie, is central to investment. If markets are, in fact, efficient, the market price provides the best estimate of value, then we need not bother to value any asset. Whatever price we pay shall be the true worth of the asset purchased. If markets are not efficient, the market prices deviate from the true values, investor will spend resources towards obtaining a reasonable estimate of this value. Thus, those who do valuation well be able to make ‘higher’ returns than other investors, because of their capacity to spot under and over valued securities. To make these higher returns, though, markets have to correct their mistakes – i.e. become efficient – over time. Whether these corrections occur over six months or six years can have a profound impact on time horizon that is needed to profit from the inefficiency.

Investors can also benefit from identifying segments where the market seems to be inefficient. They can then concentrate their efforts on finding undervalued stocks in such identified segments instead of hunting through whole universe of securities. For instance, some studies suggest that stocks that are ‘neglected’ be institutional investors are more likely to be undervalued and earn excess returns. A strategy that screens firms for low institutional investment (as a percentage of the outstanding stock) may yield a set of neglected firms, which can then be analysed, to arrive at a portfolio of undervalued firms. If the studies are correct the odds of finding undervalued firms should increase in this set.

Perfect Markets and Efficient Markets

There are many references to perfect markets and efficient markets in the financial theory. A perfect market should have the following characteristics:

  • Trading is costless. This means there are no taxes and transaction costs and entry and exit fro the market is free.
  • Information is costless and freely available to all the market participants
  • There are many buyers and no one investor is dominant

Clearly no stock market anywhere in the world is a perfect market. However we do not need capital markets to be perfect. We need capital markets to make fair prices so that we can make reasoned investments and financing decisions. From what has been stated above an efficient capital market will need to have the following features:

  • Operational efficiency, it means that the transaction cost should be as low as possible and that transaction should be quickly completed.
  • Pricing efficiency, it means that the prices of the capital market securities fully and fairly reflect all the information concerning the past events and all events that the market expects to occur in future.
  • Allocational efficiency, it means that the capital market through the medium of pricing efficiency allocates the funds where they are best used.

The efficient market hypothesis (EMH) is concerned with establishing the prices of capital market securities and states that the prices of the securities fully and fairly reflect all relevant information. Thus market efficiency also refers to the speed and the quality of the price adjustment to new information. The testing of market for efficiency has led to the recognition of three different levels or forms of efficiency. Will try to put different  forms of  market efficiency later.