Question 7.SE.1: Comment on each of the following statements. (a) A stock mar...
Comment on each of the following statements.
(a) A stock market that is efficient in the strong form is one in which investors cannot make any gains from their investment.
(b) Private-equity firms are not interested in investing in business start-ups.
(c) Short-term behaviour by investors is difficult to reconcile with the notion of stock market efficiency.
(a) It is not true that the strong form of market efficiency means that investors cannot make a gain from their investment. It does mean, however, that it is not possible to make abnormal gains on a consistent basis. Under this form of efficiency, all relevant information is absorbed in share prices. Thus, even those who have ‘inside’ information concerning a business, such as unpublished reports or confidential management decisions, will be unable to make abnormal gains, on a consistent basis, from using this information.
(b) It is not true to say that private equity firms do not invest in business start-ups. They do however find them challenging for two reasons. First, they are very high-risk: investing in existing businesses with a good track record is a much safer bet. Second, start-ups and early-stage businesses often require fairly small amounts of finance. Unless a significant amount of finance is required, it is difficult to justify the high cost of investigating and monitoring the investment.
(c) This statement is true. The value of a share is represented by the future discounted cash flows that it generates. In a stock market where shares are efficiently priced, investors should therefore be concerned with the ability of a business to generate long-term cash flows rather than its ability to meet short-term profit targets. In other words, if a stock market is efficient, a critical mass of investors will not adopt a short-term view when making share investment decisions.