Does an efficient stock market exist?

In my first blog post I touched briefly on stock market efficiency, this blog will compare the effects of a profit announcement on two company’s share prices; Balfour Beatty in 2015 and Moneysupermarket.com in 2013.

Pricing efficiency in stock markets has divided opinions among academics and investors, this concept dictates that all security prices fully and fairly reflects all information regarding both past and future events in the marketplace, therefore they are fairly priced (Watson and Head, 2013).  Fama (1970) identified three forms of market efficiency

Weak form effeciency: share price fully reflects information in historical prices
Semi strong effeciency: share price fully reflects all information that is publicly available
Strong form effeciency: share price fully reflects all information that is publicly and privately available

 

On March 25^th 2015 construction company Balfour Beatty reported a pre-tax loss of  £304m, the total shrank to £59m once profits from discounted operations including the sale of its US business Parsons Brinckerhoff were included (The Telegraph, 2015).  Balfour Beatty also announced that due to the financial difficulties they were facing they would not be paying shareholders an annual dividend (BBC News, 2015).  We can see from Graph 1 below that Balfour Beatty’s share price dropped significantly on the day of the announcement.   This I believe demonstrates a semi strong form of efficiency, as the share price reflects all publicly held information and not just historical price movements (Fama, 1970).  The fall in share price could reflect shareholders discontent at the news that dividends will be axed! (wouldn’t you be annoyed if you were a shareholder in Balfour Beatty?!)

Graph 1: Share price of Balfour Beatty from 25^th March until the 30^th March

Source: London Stock Exchange

The chief executive of Balfour Beatty, Leo Quinn announced the company were facing a variety of legal challenges in a number of construction projects and stated they were facing ‘major short term problems (BBC News, 2015).  This announcement was publicly available to the market and may have encouraged investors to sell their shares in the company as the short term future of Balfour Beatty doesn’t look positive, suggesting they will not be reinstating a dividend policy anytime soon!

A contrasting story to Balfour Beatty is that of moneysupermarket.com, who on the 31^st of July 2013 announced half year profits were up 70% from £11.6m to £19.8m (BBC News, 2013).  In the six months previous to the announcement EBITDA had risen 29% to £39.9m and revenue grew 10% to £112.3m (BBC News, 2013).  You would have thought if you were a shareholder in moneysupermarket.com you would be delighted (or laughing all the way to the bank as they say).. well your wrong! Despite the announcement of an increase in profit share price fell 15%!

Graph 2: Share price of moneysupermarket.com on 31^st July 2013

Source: London Stock Exchange

In an efficient market you would assume that the market would react positively to news of improved performance, thus impacting the share price of moneysupermarket.com, which we can see in the graph above didn’t happen.  This in my opinion shows a lack of efficiency in a market place, as this reflects share price of historical information and not positive publicly held information.

Does this mean that share prices are entirely random? Well that was what Kendall (1953) proposed in a theory of random walks, highlighting that share prices change in a random manner arguing there was no link between share prices.   However Kendall (1953) did acknowledge that share prices were random because they only changed when new information entered a market place, which in itself can be entirely random.  The fall in share price of Balfour Beatty would support this theory, as shareholders did respond to information that entered into the market place at a random time, however it doesn’t explain the fall in moneysupermarket.com’s shares.  Could it be because Balfour Beatty’s announcement was concerned with dividend payments and moneysupermarkets was only an increase in profit?

Even though Kendall (1953) proposes that the stock market is entirely random, how do investors make so much money from it? Is it simply luck? Or maybe insider information that isn’t publicly available.   If the latter were true it would suggest that different people are investing in different markets in theory, an investor with insider information would be investing in a market which by Fama’s (1970) definition is a strong market.  

In my overall opinion I don’t believe you can predict the stock market (no matter how much I wish I could), because I think share prices are subjective to any news which is released publicly.  I don’t think anyone can predict the future and no one can tell what is going to happen tomorrow, therefore how could someone predict what news will be announced and the effect this will have on share prices.   It should also be noted that as demonstrated by the dip in moneysupermarket.coms share prices that not all information is relevant to shareholders, it seems information which will directly affect investors such as dividend policy causes more of a market reaction than other pieces of news.

I think it is vital that stock markets are efficient, if they were not then it would be hard for directors and managers to know what strategies and steps to take to create shareholder wealth wouldn’t it? I can’t imagine the look on moneysupermarket.com manager’s faces when share prices dipped as they announced an increase in profit!  Managers will rely on an efficient market in order to ensure they make wealth creating financial decisions (Arnold, 2013).

References:

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

BBC News. (2013, July 31). Moneysupermarket.com share price drops despite 70% profit rise - BBC News. Retrieved from http://www.bbc.co.uk/news/uk-wales-north-east-wales-23517365

BBC News. (2015, March 25). Balfour Beatty reports £59m loss and axes dividend - BBC News. Retrieved from http://www.bbc.co.uk/news/business-32046614

Financial times. (2013, July 31). Moneysupermarket hit by change to Google algorithm. Retrieved from http://www.ft.com/cms/s/0/aedcccfc-f9c7-11e2-98e0-00144feabdc0.html#axzz3Vy4TuXbb

London Stock Exchange. (2013, July 30). MONY MONEYSUPERMARKET.COM GROUP PLC ORD 0.02P. Retrieved from www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary-chart.html?fourWayKey=GB00B1ZBKY84GBGBXSTMM

London Stock Exchange. (2015, March 25). BBY BALFOUR BEATTY PLC ORD 50P. Retrieved from www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary-chart.html?fourWayKey=GB0000961622GBGBXSTMM

The Telegraph. (2015, March 25). Balfour Beatty scraps its dividend for a year after falling into the red - Telegraph. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/constructionandproperty/11493591/Balfour-Beatty-scraps-its-dividend-for-a-year-after-falling-into-the-red.html

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson

Mergers and Acquisitions

Some of my previous blogs have looked at the effect of dividend policy and capital structure on shareholder wealth creation, this blog will focus on mergers and acquisitions.  Can they really create shareholder wealth or is it just a rather enlarged CEO ego that drives M&A activity?

Sabadell, the fifth largest bank in Spain made a takeover bid for TSB for £1.7bn (BBC News, 2015).  Sabadell highlighted a number of reasons for their takeover bid; firstly they want to increase their international presence as a result of a business drying up thanks to the recession, secondly they believe that they can increase business lending and reduce household mortgage costs by taking over TSB (The Telegraph, 2015) Oh and lasty.. Lloyds were ordered by European regulators to sell the bank as a condition of its government bailout during the financial crisis (BBC News, 2015) so they don’t have a massive choice in the matter as they only have until the end of 2015 to sell the rest of their TSB stake and other offers aren’t exactly flooding in!

This can be classed as a horizontal merger as both firms are in the same industry, banking (Watson and Head, 2013). In this case the TSB- Sabadell seems to be a friendly takeover; Sabadell offered 340p a share which TSB stated they are willing to recommend (BBC News, 2015), however the offer of cash didn’t seem to install much faith in Sabadell’s current shareholders.   Shares in Sabadell were suspended after they suffered a 9% fall due to the takeover announcement (The Telegraph, 2015) I would assume because investors may have predicted Sabadell would need a hefty rights issue to fund the cash takeover!

Coffey et al (2002) argue that related acquisitions are more likely to succeed as they have the advantage of transferring product knowledge as well as increased economies of scale.   Some savings could be achieved as a result of the takeover as TSB currently rents its IT systems from Lloyds at a cost of £100m a year, which will double in 2017, if the bank can move into a new infrastructure with Sabadell they can expect a payment of up to £450m from Lloyds! (The telegraph, 2015)

One of the reasons some mergers fail can be due to the people and organisation fit between the two companies (Coffey et al, 2002).  Whilst Sabadell said they were unlikely to make changes to TSB because ‘We are very respectful about the way British banks do banking’ (Hawkes, 2015) who’s to say they Spanish culture and the British culture will merge?  TSB’s boss Paul Pester said the only job losses would be in the investor relations department as they would no longer be needed once the bank ceases to have a separate stock market listing (Hawkes, 2015).  Will this mean employees will feel secure knowing that only one department will lose their jobs? Or will it result in reduced employee motivation and fear of more job cuts?

Ottone and Murgia (2000) conducted a study in the banking industry and concluded that there is a positive increase in shareholder wealth at the time of the deals announcement; with regards to commercial banks they argued that there is a significant market reaction for a period of around 11 days.

We can see from the chart below as they day of the announcement (12th March) saw a dramatic increase in TSB’s share price, almost two weeks later and the share price has remained high and constant, showing investors approval of the takeover bid and the potential for increased shareholder wealth.   This is consistent with Jensen and Rubecks (1983) findings that the shareholders in the target company are likely to achieve a positive gains, whilst the bidding companies shares will decrease after the announcement, which we can see has occurred (Chart below).   Sabadell’s shares dropped significantly upon the announcement and as previously mentioned had to be suspended, however they are showing signs of improvements, possibly because of the positive reaction of TSB to the takeover? 

TSB's share price at the deal announcement. Source (London Stock Exchange) 

http://m.londonstockexchange.com/exchange/mobile/stocks/chart.html?tidm=TSB

Sabadell's share price at the deal announcement. Source (London Stock Exchange) 

http://m.londonstockexchange.com/exchange/mobile/stocks/chart.html?tidm=0H00

In conclusion, I would agree that mergers create shareholder wealth, but like the findings of Jensen and Rubeck (1983) it seems that a takeover only benefits one party, in this case TSB.  Whilst M&A’s are largely criticised for being unsuccessful in creating shareholder wealth in the long run it does appear they are successful in the short term particularly at the time of the merger announcement.  However this merger will be subject to regulation due to concerns over Sabadell’s capital strength within the European banking market (Euronews, 2015).   It will be interesting to see how the Spanish and British cultures will merge in this takeover, whether any synergies will occur and whether it will be beneficial for shareholders of both Sabadell and TSB in the long run.

References:

BBC News. (2015, March 12). TSB confirms £1.7bn takeover move by Spain's Sabadell - BBC News. Retrieved from http://www.bbc.co.uk/news/business-31848517

Coffey, J., Holbeche, L., & Garrow, V. (2002). Reaping the benefits of mergers and acquisitions: In search of the golden fleece. Oxford: Butterworth-Heinemann.

Cybo-Ottone, A., & Murgia, M. (2000). Mergers and shareholder wealth in European banking. Journal of Banking & Finance, 24(6), 831-859. doi:10.1016/S0378-4266(99)00109-0

Euro News. (2015, March 14). Sabadell bid for TSB could be blocked by UK regulator. Retrieved from http://www.euronews.com/business-newswires/2979216-sabadell-bid-for-tsb-could-be-blocked-by-uk-regulator-analysts/

Hawkes, A. (2015, March 21). TSB's new owner Banco Sabadell pledges to support small firms. Retrieved from http://www.thisismoney.co.uk/money/news/article-3005749/TSB-s-new-owner-Banco-Sabadell-pledges-support-small-firms.html

The Telegraph. (2015, March 12). TSB shares jump as Spain's Sabadell considers takeover offer - Telegraph. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/11466405/TSB-shares-jump-as-Spains-Sabadell-considers-offer.html

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.

Whats the true cost of capital? The case of Afren

In my first blog I discussed shareholder wealth maximisation, I will now look into how a company’s capital structure can affect shareholder wealth, to what extent can a mixture of equity and debt increase shareholder wealth, or in some cases.. destroy it?

It’s obvious when running a business that reducing your costs would improve your profit, seems only logical that the cost of finance should be considered in those costs doesn’t it? This is where the debate of capital structure arises, can a company actually minimise its cost of capital by taking on a mixture of debt and equity.  The WACC acts as a ‘hurdle rate’ or the discount rate which companies can use in investment appraisal decisions (Watson and Head, 2013), therefore it influences a company’s investment options thus having a knock on effect on company profit.

African oil producer, Afren is currently reviewing its capital structure (Mann, 2015) in order to improve shareholder wealth; this is due to Afren’s share price plummeting over the past year (shown below).  A 59% decrease in net profit was reported in  the second quarter of 2014, falling from $309m to $127m (Afren, 2014) as a result of lower oil production in its primary Nigerian fields coupled with falling oil prices (Telegraph, 2014).

Afren admitted in February of defaulting on interest payments of $15m and as a result of a funding crisis want to review their capital structure to allow for a cash injection of $132m (Morris, 2015). Afren management suggested an equity funding that could double its current market capitalisation, diluting its current shares by 50% (Mann, 2015), clearly shareholders weren’t happy at that idea and share prices tanked even more (surprise, surprise!)  Afren finally decided to load up on debt, agreeing $300m and in loans before June as well as equity, issuing $321m high yield bonds (Morris, 2015).

(Source:London Stock Exchange)

We can see from shareholder’s reaction to Afren’s new capital structure proposal that both debt and equity have their gains and losses.  Equity in itself can be very costly; issuing shares on the stock exchange can result in high transaction costs and can be viewed as more risky by shareholders as there is no guarantee of dividends being paid.  The London Stock Exchange (2015) released a statement commenting on Afren’s new capital structure stating ‘existing shareholders would be unlikely to see any return on their current investments’.  If Afren can’t improve their financial situation and end up going into liquidation it should be noted that investors are ranked lowest on the creditor hierarchy (Watson and Head, 2013) therefore this increased risk results in a higher cost of equity capital.

However, Ebok, the creditor who is lending Afren $300m will require a significantly lower rate of return than shareholders due to the interest repayments they have arranged (Arnold, 2013).  As debt has a much lower transactional cost and tax benefits it is a cheaper source of finance than equity ( Watson and Head, 2013).

Seems pretty obvious company’s should just finance themselves through debt and forget all about equity right? Well, wrong, despite it seeming slightly simple and obvious, a lot of companies continue to raise capital through issuing shares.  US oil producers are issuing new shares at the fastest pace in over a decade (Bloomberg, 2015) in order to raise cash to reduce debt.  RSP Permian Inc, aims to raise $232m by selling additional shares, with Encana Corp, Noble Energy Inc and Carrizo Oil and Gas all issuing shares in a bid to reduce debt (Bloomberg, 2015).

Whilst some may argue it seems obvious that companies should just load up on debt, debt is not without its risks also.  It may reduce the WACC because it’s a cheaper source of finance, however the cost of equity increases due to shareholders demanding a higher return for the increased level of risks they are taking (Watson and Head, 2013).  Whilst taking on debt increases gearing, it can be argued that a company’s level of gearing can only go so far before it causes financial distress.  The financial risks a company take are intensified by a higher level of debt due to the risk of liquidation increasing, therefore WACC increases hence reducing shareholder wealth (Arnold, 2013).

I think the US oil producers mentioned above were justified in trying to reduce their level of debt, as the level of risks in the oil market have increased significantly due to the uncertainty surrounding oil prices.   ‘Equity does not have to be paid back and requires no disbursements of revenue and net profit’ a comment made by Troy Eckard who owns Eckard Global LLC when asked why large oil companies choose equity over debt. (Bloomberg, 2015).  

Miller and Modigliani (1958) argued that a company’s capital structure had no influence on the WACC or the value of a firm, concluding that an optimal capital structure doesn’t exist.  They highlighted that as the cost of debt is lower and normally a larger proportion of capital structure, therfore it offsets any increase in the cost of equity that rises with gearing.   However the theory makes a number of assumptions that seem unrealistic and cannot be applied in today’s market, such as perfect market efficiency, no costs of financial distress and no tax.

After making modifications to their theory in order to take into consideration tax (1963) and financial distress (1971) they changed their theory to suggest it may be possible to achieve an optimal capital structure.

I believe an optimal capital structure does exist, however it may be difficult to find it and I don’t believe that ‘one size fits all’ in this case.  Each firm’s capital structure will be significantly different.  The oil companies I have mentioned earlier are extensively impacted by economic influences, such as oil prices, drilling expenses and even conflict with Islamic State Militants! Therefore I would agree with these oil companies decision to increase equity rather than debt.

References:

Afren Plc. (2014). Afren Plc 2014 Half- Yearly Results. Retrieved from Afren Plc website: http://www.afren.com/investor_relations/financial_calendar/
Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

Bloomberg. (2015, March 20). Shale Producers Have Found Another Lifeline: Shareholders. Retrieved from http://www.bloomberg.com/news/articles/2015-03-20/shale-producers-have-found-another-lifeline-shareholders

London Stock Exchange. (2015). AFR AFREN PLC ORD 1P. Retrieved from www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB00B0672758GBGBXSSMM&lang=en

Mann, H. (2015, January 27). Afren plummets 50% after reviewing capital structure. Retrieved from http://www.iii.co.uk/articles/219772/afren-plummets-50-after-reviewing-capital-structure

Morris, J. (2015, March 13). Afren share price falls as much as 30 per cent after refinancing agreement | City A.M. Retrieved from http://www.cityam.com/211545/afren-share-price-falls-much-16-cent-despite-refinancing-agreement

The Telegraph. (2014, August 24). Profits half at scandal-hit oil company Afren. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11062902/Profits-half-at-scandal-hit-oil-company-Afren.html

The Telegraph. (2015, March 13). Afren shares plummet as it unveils $300m rescue plan - Telegraph. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11469139/Afren-urges-shareholders-to-support-300m-rescue-plan.htm
Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.

Is it better to have one bird in the hand than two in the bush? The effect of dividend policy on Lloyd's share value

In earlier years of corporate finance dividend policy referred to whether a firm should retain its earnings or pay its shareholders a cash dividend, addressing the frequency of payments and if the company decides to pay, then how much.   However in today’s society dividend policy has gone beyond this scope to include such issues as whether to distribute cash via share repurchase, or through specially designated rather than regular dividends and how to maintain and improve the value of its shares and stocks in the market.  (Hussainey, 2011).

Miller and Modigliani (1961) proposed that dividend policy is irrelevant to shareholders and that share price was determined by future earning potential not the dividends paid arguing that share value is determined by investment policy and not the amount of earnings distributed.   However they did make a few assumptions which cannot be applied in the modern day stock market; they assume that there exist a perfect capital market that is no transaction costs or tax, free and costless access to information about the market, that investors are rational and that they value securities based on the value of discounted future cash flow to investors and that there is certainty about the investment policy of the firm.  

Is a bird in the hand really worth more than two in the bush? Bird in the hand theory takes a more traditional view of dividend policy; theorists such as Gordon and Shapiro (1956) and Linter (1961) argue that in a world of uncertainty investors would tend to prefer dividends to retained earnings.  They highlight that management continue to pay dividends in order to send a signal about the firm’s future prospects, what kind of signal does it send when you stop paying them altogether like Lloyds did in 2008?!

Agency cost is the cost of the conflict of interest that exists between management and shareholder (Ross et al., 2008) this arises when manages act in their own self-interest rather than on behalf of the shareholders who own the firm.  This is contrary to the assumptions of Miller and Modigliani (1961) who assumed that managers are perfect agents for shareholders and that no conflict ever exists between them.  Managers conduct certain activities that can be costly to shareholders, in the case of Lloyds it was an unnecessarily high compensation package awarded to António Horta-Osório, the boss of Lloyds to the tune of £11.5million in pay and share bonuses. (The Guardian, 2015)

Lloyds announced in February that they will be preparing to pay a dividend for the first time since its taxpayer-funded bail out in 2008, a victory for its 3million shareholders! (BBC News, 2015) Lloyds share price has risen significantly as a result of the banks successful turnaround, with the share price the chief executive will receive being valued at 78p in comparison to the 35p they were worth in 2008.

 

After discussing dividend policy theories, it’s vital to look at how seven years without dividends has affected Lloyds share price and try and answer the million dollar question.. who was right? Miller and Modigliani or the traditional theorists?

Source Yahoo Finance 

Looking at the share price in the chart above you can see that after Lloyds announced they would not be paying out dividends share price plummeted!! Whilst some of the dip can be attributed to the economic recession it seems obvious that Lloyds investors are consistent with the traditional view of dividend policy, they would rather have a bird in their hand than two in the bush!  However, if you look at dividends from Miller and Modigliani’s point of view you could argue that Lloyds invested their earnings and had no retained earnings left to pay dividends,  but since they’ve recorded a loss between 2010 and 2013.. it doesn’t seem likely!

Miller and Modigliani also suggest that the clientele effect exists, referring to the tendency for investors to hold stocks which are in line with their dividend payment preferences.  Lloyds share price could have decreased due to its clientele being investors you preferred dividend pay outs ,  however share price has remained steady year on year since 2008 with no mention of dividends, could this mean that Lloyds may have attracted a new type of clientele? They may have obtained investors who prefer for funds to be reinvested, so now they have decided to pay out dividends it will be interesting to see if this changes the clientele of their investors and if share value increases.

We can see from the chart below that since rumours first circulated that Lloyds would be paying out dividends their share price has increased.   This could be due to the announcement of their 2014 profits and investment plans, which may have instilled faith in investors at the potential future earnings of Lloyds or it could be as a result of attracting a new clientele of investors who wish to receive dividend pay outs. 

Source Yahoo Finance 

Overall, I would argue that in the case of Lloyds their dividend policy has significantly affected their share price, therefore Miller and Modigliani’s theory seems less relevant whilst a traditional theory could be deemed more applicable.  It will be interesting to see if Lloyd’s new dividend policy will increase their share value in the future and if the investors who preferred retained earnings will sell their shares!

References 

BBC News. (2015, February 27). BBC News - Lloyds Banking Group to resume dividend payments. Retrieved from http://www.bbc.co.uk/news/business-31655343

Gordon, M. J., & Shapiro, E. (1956). Capital Equipment Analysis: The Required Rate of Profit. Management Science, 3, 102-110. doi:10.1287/mnsc.3.1.102

Hussainey, K., Mgbame, C. O., & Chijoke-Mgbame, A. M. (2011). Dividend policy and share price volatility: UK evidence. The Journal of Risk Finance, 12(1), 57-68. doi:10.1108/15265941111100076

Lintner, J. (1962). Dividends, earnings, leverage, stock prices and supply of capital to corporations. Journal of Economics, 64, 243-269.

Miller, M. H., & Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares. Journal of Business, 34, 411-433. doi:10.1086/294442

Ross, S. A., & Ross, S. A. (2008). Modern financial management. Boston: McGraw-Hill/Irwin.

The Guardian. (2015, February 27). Lloyds pays boss £11.5m and resumes dividend after seven years | Business | The Guardian. Retrieved from http://www.theguardian.com/business/2015/feb/27/lloyds-pays-antonio-horta-osorio-11m-resumes-dividend-after-six-years

Yahoo finance. (2015, March 6). LLOYDS BANKING GRP Share Price Chart | LLOY.L - Yahoo! UK & Ireland Finance. Retrieved from https://uk.finance.yahoo.com/echarts?s=LLOY.L#symbol=LLOY.L;range=1d