A Test of Market Efficiency with Mergers & Acquisitions announcements in Europe
This paper provides the structure of my thesis. The purpose of my thesis is to test the Market Efficiency with respect to merger and acquisitions (M&A) announcements using event study methodology. The Market Efficiency Hypotheses (EMH) is more and more under attack last years. This event study will test the efficiency of markets in Europe around the announcement of 100 typical M&A deals. This event study will test if it is possible for investors to outperform the market (absolute returns), with respect to the Semi-Strong form of the EMH. If the Markets exhibits the movement similar to the company, then the theory of the EMH would hold true and an investor would not be able to receive an above normal return. But if, the firm exceeds the Market for a certain period of time relative to the announcement date, then the possibility of gaining an above normal return may occur, thus possibly challenging the Efficiency Market Theory.
The reigning theory in the financial markets, often referred as ‘efficient markets', is deeply embedded in the way that markets operate (Authers, 2009). Last year's turmoil in the financial markets, which started with the problems in the U.S. housing market and was followed by the global credit crisis, has flared up the discussion between the critics about the legitimacy of this theory. In times of panics and bubbles investors don't behave rational, which is one of the cornerstones of the theory. The theory is central to business schools' curriculum and is part of the Chartered Financial Analyst qualification that acts as a gateway to the investment profession. If the theory needs to be abandoned, the effect on investing will be profound (Authers, 2009). An efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants (Fama, 1965). Fama (1965) states that the ‘instantaneous adjustment' property of an efficient market implies that successive price changes in individual securities will be independent. A market where successive price changes in individual securities are independent is, by definition, a random walk market. This implies that a series of stock price changes has no memory - the past history of the series cannot be used to predict the future in any meaningful way. To every piece of new information to markets will react in a ‘random walk' and are therefore not possible to beat. Investors are according to the Efficient Market Hypotheses (EMH) not able to earn above normal returns.
Forms of Market Efficiency
There are three forms of Market Efficiency: Weak, Semi-Strong, and Strong that explain how quickly the Market will react to new publicly announced information. According to Bodie (2005) the weak form of theory asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices or trading volume. The weak form theory states that it is impossible for an investor to achieve a positive abnormal return by using these past information. Bodie (2005) states in his book that the Semi-Strong form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price, e.g. past prices, balance sheet composition, accounting practices. This form also makes it impossible to outperform the market. This theory has been tested (Fama, Fisher, Jensen and Roll. 1969) numerous times by examining adjustments of the market to publicly available information, such as announcements. The third form, the strongest one, states that stock prices reflect all information relevant to the firm, even including information available only to company insiders (Bodie, 2005).
Mergers & Acquisitions
Mergers & acquisitions (M&A) have been the subject of considerable research in financial economics (Morellec, 2005). M&A involves the buying, selling, and combining of companies. The acquiring and target companies feel that by joining they can somehow create synergy: the value of the combined firm is greater than the two firms operating separately (Cording, 2002). When M&As are successful and they are announced to the public, it is generally a good thing for shareholders. By joining efforts the company should be able to lower the costs of the company while maintaining revenue, therefore yielding more profit (Ross, 2008). It is widely believed that the introduction of the Euro, the globalization process, technological innovation, deregulation and privatization, as well as the financial markets' boom and the surge in liquidity, have all spurred Europe companies to take part in M&As during the last decade (Campa, 2008). All these transactions are under strict regulation in Europe, requiring several approvals to be met, such as the European Commission. The major concerns of these industry regulators is to avoid the creation of monopolies.
The combination of the two
Gersdorff and Bacon (2009) tested in their paper the market efficiency of Mergers & Acquisitions announcements in the U.S. They analyzed the effect of twenty recent mergers and acquisitions announcements on stock prices in the year 2007. The authors found evidence of lingering excess returns after the merger announcement. Although, also evidence supports the semi-strong market efficiency along with a positive signal exhibited by the sample of acquiring firms during the even period (day -30 to day +30). In the study of Liang (2009), whether abnormal returns exist surrounding the announcement day, results show that there is no significant announcement effect over the event period (day -10 to day +10) for U.S. companies, but a significant effect for Chinese companies during the event period. These studies show mixed results according to the efficient markets hypotheses. This hypothesis states that investors should not be able to earn above normal returns in the Market, because all the information should be reflected in the current stock price. In my event study (day -50 to day +50) this particular hypothesis will be tested. The goal is to see if it is possible for investors to achieve a positive, abnormal return, with the announcement of a company merger or acquisition in the European Market.
The problem discussed in the introduction about the legitimacy of the Efficient Market Hypotheses concerns the whole ‘universe' of financial markets. Some of the assumptions that are fundamental for the theory, e.g. the rationality, and their corresponding implications for market efficiency, have come under attack recently (Lo, 2005). Is the market that efficient as some economist, investors and scholar's think? This event study will test the efficiency of markets in Europe in the event period around the announcement of a typical merger or acquisition (M&A). The test will be if it is possible for investors to outperform the market (absolute return), with respect to the Semi-Strong form. Therefore the research question is constituted as follows: Is het possible for an investor to outperform the market with the announcement of a merger or acquisition?
The study will include about 100 recently stock M&A announcement in Europe, and will use the event study methodology. According to the study of Gersdorff and Bacon (2009) two possible outcomes are possible. If the Markets exhibits the movement similar to the company, then the theory of an Efficient Market would hold true and an investor would not be able to receive an above normal return. But if, the firm exceeds the Market for a certain period of time relative to the announcement date, then the possibility of gaining an above normal return may occur, thus possibly challenging the Efficiency Market Theory.
Type of research
As discussed before this study will be an event study. An event study is concerned with the impact of a particular firm-specific corporate event on company security prices. Event studies measure stock performance that reflects investor opinions concerning the importance and benefit level of the event (Binder, 1998). The event study will include about 100 M&A announcements (the sample) in Europe from 2002 till 2007 of target companies (that means not the buying company but the one that will be acquired). Data will be conducted from Thompson Reuters DataStream and Bloomberg (The two world's largest financial statistical databases).
H0: The return of the stock price of the sample of firms announcing a merger or acquisition is not significantly affected by this type of information around the announcement day, as defined by the event period.
H1: The return of the stock price of the sample of firms announcing a merger or acquisition is significantly affected by this type of information around the announcement day, as defined by the event period.
Methodology / Model
The conceptual model / method of the study of Gersdorff and Bacon (2009) will be used. This is line with the event study methodology described in the literature. Part of the authors conclusion in their study is that if a larger sample is taken the signs of equilibrium in the market would probably be more obvious. Therefore in this study a larger sample of firms, longer time series and a different geographically area is taken. The next steps will be followed:
Step 1: All information about the stock price and market price within the duration of -181 days to +50 days is conducted of the 100 firms in the sample (Datastream and Bloomberg).
Step 2: The holding period return for the firms and the market will be calculated.
Step 3: Regression analyses will be performed comparing the actual daily return of each company to the market daily return covering the pre-event period (day -180 to day -50). Where the firm is the dependent variable and the market (e.g. DJ Stoxx 600) the independent variable. This regression analyses is done to calculate the intercept alpha and the beta. This is done for each single firm.
Step 4: The former step is done to calculate the normal expected returns for the event period. Now the expected return is E(R) = alpha + beta (Rm). Where Rm is the return of the market (e.g. DJ Stoxx 600).
Step 5: The Excess return (the absolute return) can now be calculated: The actual return (in the event period) - expected return (step 4).
Step 6: Average excess returns are calculated in the event period & cumulative average excess returns will be calculated.
Step 7: Graphs of the average and cumulative returns in the event period are created (for interpretation).
The question is if it is possible for investors to outperform the market? If a new M&A deal is announced (the information is made publicly), it would be expected that the actual return would be different than the expected return. With the cumulative average return related to time (event period) there could be seen if it is possible to outperform the market. In the graph (and data) can the impact be seen of the announcement on the stock price. Results of the study can lead to further review of this particular type of M&A deals and the effects of the announcement date on a target company.
In the table 1 below, an overview of the planning during the study is given. For each weak the table shows which activity is done. The project, as stated in the table, will be finished in June.
Table 1: Timeline
· Authors, J. (2009). Wanted: new model for markets. Investment theory. Financial Times, Tuesday Sep. 29,2009.
· Binder, J. (1998). The event study methodology since 1969. Review of quantitative finance and accounting, 11. 111-137.
· Bodie, Z. (2005). Investments. 6th edition. (Kane and Marcus). McGraw - Hill.
· Campa, J. (2008). The European M&A industry: trends, patterns and shortcomings. Working Paper IESE. 762.
· Cording, M. et al. (2002). A focus on resources in M&A success: a literature review and research agenda to resolve two paradoxes. Academy of management
· Fama, E. (1965). Random Walks in Stock Market Prices. Financial Analysts Journal Sep/Oct
· Gersdorff, N. and Bacon, F. (2009). US mergers and Acquisitions: A test of market efficiency. Journal of Finance and Accounting.
· Liang, H. (2009). The information implication of merger and acquisition announcements: evidence from the US and China.
· Lo, A. (2005). Reconciling Efficient Markets with behavioral finance: the adaptive markets hypothesis.
· Morellec, E. (2005). The dynamics of mergers and acquisitions. Journal of financial economics. 77., 649-672.
· Ross, S. (2008). Corporate Finance (Stephen, Randolph, Jeffery) 8th edition. US McGraw-Hill.