This Week In Finance

"Story Stocks, Overreaction, and Market Efficiency"

Is it possible to make a few low-cost modifications to an automobile engine and get 100 miles to a gallon of gasoline? Joseph LaStella, President of B.A.T International says it's possible, and his company has the technology to do it.

"Hey," you say, "this ain't Motor Trend. What do I care about 100-mpg cars?"

Well, sit back, grab a cup of coffee, and I'll tell you why you might find this tale interesting.

According to recent stories in The Wall Street Journal and USA Today, the price of B.A.T. stock increased by 4,000 percent (!) in the first two months of 1998, rising from a few cents to a high of $3.25 per share. In recent weeks, the stock has fallen back to the 70-cent range. (Not surprisingly, daily trading volume has also varied widely from virtually nothing to as high as approximately 25 million shares.

At least two interesting Finance-related questions arise from these events. First, what does this suggest about capital market efficiency? And second, is there any possibility that Mr. LaStella's claims are true?

If your students are anything like mine, several will give that "Ah-hah!" look, and say that this case contradicts the EMH because it is unlikely that expectations about the firm's cash flows could change that much in such a short period of time.

The second question relates to the first. To wit, can savvy market participants be fooled by dramatic claims?

With respect to the first, I like to begin class discussion by emphasizing what the EMH does not say. It does not say:

1. The EMH does not say that investors don't occasionally hit home runs (er, earn excess returns); what it does say is that home runs are infrequent occurrences.

2. The EMH does not say that investors never overreact; clearly, they do. Behavioral research by Kahneman and Tversky, and empirical research by Richard Thaler (among others) provides compelling evidence that investors aren't the purely rational homo economici we sometimes assume they are. The more important questions are: Is the level of overreaction economically significant, and is it persistent? To date, the evidence is mixed.

3. Finally, the EMH doesn't say that all financial markets are totally efficient at every instant of time; rather, that, on average, market prices reflect publicly available information (i.e., are semistrong-form efficient), on average.

With respect to the second question, you can be sure I don't have the answer. I will observe, however, that low-cost engine enhancements promising 100 mpg have been claimed as far back as the 1930s. For example, Charles Nelson Pogue announced that he had invented a carburetor which would give 100 mpg (later, others claimed it would yield 200 mpg). And in the early 1940s, John Robert Fish obtained a patent for the "Fish carburetor" for which was claimed dramatic mileage improvements. Unfortunately, the Pogue carburetor seems never to have hit the mass market (some people claim that Pogue was paid a huge amount of money by a cabal of auto manufacturers and oil companies to quietly bury his invention), and the Fish carburetor, while innovative in a design sense, does not seem to yield any substantial mileage improvements.

The tale of the B.A.T. International affair suggests, at the least, that market efficiency is a matter of degree, and that one must be particularly careful when considering market values of small, obscure, firms whose shares are priced in pennies and are thinly traded, particularly those for which sellers have a "story" to tell.

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