| ||||
Aggregating data
The extent to which managers should rely on market prices depends upon the range and accuracy of that information. Because market prices represent the aggregation of many information sources, it is often difficult to determine exactly which pieces of information any single price reflects. Posed in terms of the dilemma faced by the managers in the pulp and paper concern, will spot and futures from pulp and paper markets reflect publicly-announced capital expenditure plans by their competitors? Will those prices also reflect the private expenditure plans of all competitors, whether announced or not?
 | |
| Ultimately, managers must make their own judgments about how much weight to give to the market. These will be based upon an understanding of what information market prices are likely to incorporate and how such information can be best extracted. | |
 |
|
| —Lisa Meulbroek |
In general, market prices incorporate most public information and some private information. Private information comes from trading by informed market participants. These might include the managers themselves, who are permitted to trade (subject to insider trading restrictions) in both the US and the UK if they report such actions to regulators.
Studies suggest that the amount of information in prices can be significant. More than that, even the most casual market observers will report that stock prices can move dramatically before news of mergers and other events becomes public. These sizeable pre-announcement movements further support the notion that prices incorporate private information.
Market reactions
Since market prices tend to reflect most public information, as well as some private information, the market reaction to a managerial decision has the potential to offer managers an informed assessment of that decision.
Consider, for example, Quaker Oats' 1994 acquisition of Snapple Beverages. Quaker Oats, maker of Gatorade sports drink, announced its purchase of Snapple Beverages, a maker of fruit juices and iced teas, for $1.7 billion. After the announcement, Quaker Oats' stock price fell by 9.9 per cent, a drop amounting to more than $1 billion in Quaker's market value. The price did not rebound in subsequent trading.
Quaker explained to analysts that it hoped to gain distribution and other synergies from buying Snapple. Quaker Oats distributed Gatorade through traditional supermarkets; Snapple distributed mostly through other stores. Quaker's managers expected each brand to bolster the other's weaker distribution channel.
Quaker's attempts to explain these expected synergies did not change the market's response. Ultimately, Quaker's managers concluded that the market response was incorrect and stemmed from a misunderstanding of the distribution synergies to be gained. They moved ahead with the merger. Unfortunately, the expected synergies never materialized. Quaker later sold Snapple to Triarc Companies for $300 million, much less than its $1.7 billion purchase price.
This example underscores both the potential value of the market's response to managers' decisions and the complexities managers face in interpreting that reaction. Managers who believe, after careful re-examination, that a fall in the stock price is unwarranted might choose to disclose information they believe has been overlooked by investors.
Of course, concerns over proprietary information may sometimes limit such disclosures, making the loss in shareholder value a [presumably temporary] cost of maintaining secrecy. If prices fail to rebound even after additional information is released, as in the Quaker example, managers may want to reconsider their own assessment.
Ultimately, managers must make their own judgments about how much weight to give to the market. These will be based upon an understanding of what information market prices are likely to incorporate and how such information can be best extracted. Ironically, one indication of the formidable nature of this task comes from the performance of financial asset managers. That these professional money managers as a group so seldom outperform the market suggests the difficulty in determining whether market prices already reflect the information upon which their investment decisions are based.
In the end, however, the value of market information does not rest upon its ability to incorporate private information. Indeed, even if market prices reflected only publicly available information, managers would still have much to gain by using those prices. That is, as collectors and aggregators of information, market prices are a low-cost way for managers to estimate important variables, especially in areas unrelated to their managerial expertise.
So, a manager needing an estimate of future inflation can extract that information from market prices of inflation-indexed treasury securities and conventional treasury bonds, rather than devote time to developing macroeconomic forecasting skills. Even the US Federal Reserve relies on such market "forecasts" when it uses the volatility implied by government bond option prices as an indicator of the degree of uncertainty about future interest rates.
· · · ·