Tests of capital market efficiencyBonus share issues
Capitalisation or bonus share issues involve little more than a bookkeeping entry that
gives existing equity shareholders an increase in their holding of shares without
increasing each individual’s slice of the ownership of the business. For example, an
investor owning 100 ordinary shares in a business which has a total of 1 million shares
issued owns one ten-thousandth of the equity value of that business. If the business
makes a bonus issue of one for two, our shareholder now has 150 shares but, as the
total number of shares at issue will now be 1,500,000, this still represents one ten-thou-
sandth of the equity. As the total value of the equity has not changed as a result of the
bonus issue, logically share prices should adjust so that three shares after the issue are
worth as much as two were before. Naïve investors might feel that this was a real gain
and see the post-issue price of two-thirds of the pre-issue one as a genuine bargain.
This would cause them to come into the market as buyers, forcing the price up.
Research conducted on the LSE and on Wall Street by Firth (1977a) and by Fama,
Fisher, Jensen and Roll (1969) respectively found no such naïvety, and found that secur-
ity prices reacted in the logical way.
Change in accounting procedures
Another example where the superficial interpretation of events could be the wrong
one is where profits appear to improve as a result of a change in accounting proced-
ures. Sunder (1973) looked at a number of US businesses that had changed their
method of inventories valuation so that they appeared to show higher profits than if
the old method had been adhered to. This would appear to be the perfect trap in which
to catch the naïve investor, in that the economic consequences of the change would be
adverse since the businesses’ tax charges (which are based on accounting profits)
would increase. Rationally, the change in accounting policy should cause a drop in
equity share prices for those businesses because the change would adversely affect
their cash flows (increased tax payments). Sunder found that reason appeared to have
prevailed in that, for these businesses, the change had an adverse effect on share
prices. Sunder also took a group of businesses that had altered their inventories valu-
ation method in exactly the opposite way and found this had, as reason would
demand, caused the opposite effect on share prices.
Using UK data, Morris (1975) found that share prices had adjusted to take account
of a reduction of earnings figures to adjust for inflation, even before the adjustment
had been published.
Speed of reaction
Efficiency can only be said to be present where new information immediately, or at
least rapidly, affects security prices. Dann, Mayers and Raab (1977) conducted some
research on the effect of trades of large blocks of shares of a particular business on the
US market. These trades were much larger in terms of the number of shares involved
than the typical stock market transaction. Among other things the researchers noted
that the turbulencecaused by such trades, the period during which the market assessed
the effect of the trade, lasted about fifteen minutes at most. This is to say that an unex-
pected event, albeit an event occurring in the heart of the capital market (Wall Street
in this particular case), had been assessed and was reflected in the new price within a
quarter of an hour. Large block trades are felt to have possible informational content
in that a purchase or a sale of a large quantity of the security might imply that the
investor initiating the trade has some new information that has precipitated the action.