Can the market add and subtract? Mispricing in tech stock carve-outs Owen A. Lamont Richard H.

Thaler Summary Implications of the efficient market hypothesis (EMH): The first is that it is not easy to earn excess returns. The second is that prices are correct in the sense that prices reflect fundamental value. This latter implication is, in many ways, more important than the first. Do asset markets offer rational signals to the economy about where to invest real resources? If some firms have stock prices that are far from intrinsic value, then those firms will attract too much or too little capital. While important, this aspect of the efficient market hypothesis is difficult to test because intrinsic values are unobservable. Law of one price: The law of one price is an economic law stated as: "In an efficient market all identical goods must have only one price." The law of one price relates to the outcome of free trade and globalization. It is the theory that some day all areas of the world will make the same amount of money as every other part of the world for equal work/product quality. Where the law does not apply: The law also need not apply if buyers have less than perfect information about where to find the lowest price. In this case, sellers face a tradeoff between the frequency and the profitability of their sales. That is, firms may be indifferent between posting a high price (thus selling infrequently, because most consumers will search for a lower one) and a low price (at which they will sell more often, but earn less profit per sale). The Balassa-Samuelson effect argues that the law of one price is not applicable to all goods internationally, because some goods are not tradable. It argues that the consumption may be cheaper in some countries than others, because non-tradables (especially land and labor) are cheaper in less developed countries. This can make a typical consumption basket cheaper in a less developed country, even if some goods in that basket have their prices equalized by international trade. The driver of the law of one price in financial markets is arbitrage, defined as the simultaneous buying and selling of the same security for two different prices. The profits from such arbitrage trades give arbitrageurs the incentive to eliminate any violations of the law of one price. Arbitrage is the basis of much of modern financial theory, including the Modigliani-Miller capital structure propositions, the Black-Scholes option pricing formula, and the arbitrage pricing theory and related multi-factor asset pricing models. Do arbitrage trades actually enforce the law of one price? This empirical question is easier to answer than the more general question of whether prices reflect fundamental value.

Joint-hypothesis: Tests of this more general implication of market efficiency force the investigator take a stance on defining fundamental value. Fama (1991) describes this difficulty as the .jointhypothesis problem market efficiency per se is not testable. An efficient market will always fully reflect available information, but in order to determine how the market should fully reflect this information, we need to determine investors risk preferences. Therefore, any test of the EMH is a test of both market efficiency and investors risk preferences. For this reason, the EMH, by itself, is not a well-defined and empirically refutable hypothesis. Many investors seek to exploit temporary market inefficiencies by buying a security they believe is under-priced and shorting a similar security they believe is overpriced. This is designed to limit fundamental risk, or the chance that bad news will hurt the investment. Since many types of news will affect all companies in the industry, shorting a competitor can cushion the risk. However, no two securities are a perfect match. For example, the trader who buys Citibank and shorts Bank of America runs the risk that a piece of negative news will hit Citigroup exclusively. Focus of this study is equity carve-outs in technology stocks in which the parent company has stated its intention to spin-off its remaining shares. Lamont and Thaler examine several cases of mispriced stocks and document the precise market friction that allows prices to be wrong, concluding that two things are necessary for mispricing: trading costs and irrational investors. Description of the Shorting Process Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. That may sound confusing, but it's actually a simple concept. (To learn more, read Benefit from Borrowed Securities.) When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money. Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more However, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being called away. It doesn't happen often, but is possible if many investors are short selling a particular security. Because you don't own the stock you're short selling (you borrowed and then sold it), you must pay the lender of the stock

any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price. Shorting Costs and Overpricing Short sale constraints -- including various costs and risks of shorting, as well as legal and institutional restrictions -- can allow stocks to be overpriced. If these impediments prevent investors from shorting certain stocks, then these stocks can be overpriced and thus have low future returns until the overpricing is corrected. By identifying stocks with particularly high short sale constraints, one identifies stocks with particularly low future returns. Consider a stock whose fundamental value is $100 (that is, $100 would be the share price in a frictionless world). If it costs $1 to short the stock, then arbitrageurs cannot prevent the stock from rising to $101. If the $1 is a holding cost that must be paid every day that the short position is held, then selling the stock short becomes a gamble that the stock will fall by at least $1 a day. In such a market, a stock could be very overpriced, yet if there is no way for arbitrageurs to earn excess returns, the market is still in some sense efficient. If frictions are large, "efficient" prices may be far from frictionless prices. Short Sale Constraints To be able to sell a stock short, one must borrow it, and because borrowing shares is not done in a centralized market, finding shares sometimes can be difficult or impossible. In order to borrow shares, an investor needs to find an owner willing to lend them. These lenders receive a fee in the form of interest payments generated by the short-sale proceeds, minus any interest rebate that the lenders return to the borrowers. This rebate acts as a price that equilibrates supply and demand in the securities lending market. In extreme cases, the rebate can be negative, meaning investors who sell short have to make a daily payment to the lender for the right to borrow the stock (instead of receiving a daily payment from the lender as interest payments on the short sale proceeds). This rebate only partially equilibrates supply and demand, because the securities lending market is not a centralized market with a market-clearing price. Once a short seller has initiated a position by borrowing stock, the borrowed stock may be recalled at any time by the lender. If the short seller is unable to find another lender, he is forced to close his position. This possibility leads to recall risk, one of many risks that short sellers face. Generally, it is easy and cheap to borrow most large cap stocks, but it can be difficult to borrow stocks that are small, have low institutional ownership, or are in high demand for borrowing. In addition to the problems in the stock lending market, there are a variety of other short sale constraints. U.S. equity markets are not set up to make shorting easy. Regulations and procedures administered by the SEC, the Federal Reserve, the various stock exchanges, underwriters, and individual brokerage firms can mechanically impede short selling. Legal and institutional constraints inhibit or prevent investors from selling

short (most mutual funds are long only). We have many institutions set up to encourage individuals to buy stocks, but few institutions set up to encourage them to short. In addition to regulations, short sellers also face hostility from society at large. Policymakers and the general public seem to have an instinctive reaction that short selling is morally wrong. Short sellers face periodic waves of harassment from governments and society, usually in times of crisis or following major price declines, as short sellers are blamed. The Overpricing Hypothesis Short sale constraints can prevent negative information or opinions from being expressed in stock prices, as in Miller (1977). Although constraints are necessary in order for mispricing to occur, they are not sufficient. Constraints can explain why a rational investor fails to short the overpriced security, but not why anyone buys the overpriced security. To explain that, one needs investors who are willing to buy overpriced stocks. Thus two things, trading costs and some investors with downward sloping demand curves, are necessary for substantial mispricing. This willingness to hold overpriced stocks can be interpreted either as reflecting irrational optimism by some investors, or rational speculative behavior reflecting differences of opinion. In the rational model of Harrison and Kreps (1978), differences of opinion, together with short sale constraints, create a "speculative premium" in which stock prices are higher than even the most optimistic investor's assessment of their value.Short sale constraints generate a pattern of overpriced stock leading to subsequent low returns. Not One Price but Two: In a partial public offering, an equity carve-out is defined as an IPO for shares (typically a minority stake) in a subsidiary company. A spin-off occurs when the parent firm gives remaining shares in the subsidiary to the parent's shareholders. Palm and 3Com: The most prominent example of mispricing in this study is the case of Palm and 3Com. Palm, which makes hand-held computers, was owned by 3Com, a profitable company selling computer network systems and services. On March 2, 2000, 3Com sold 5 percent of its stake in Palm to the public through an IPO for Palm. Pending IRS approval, 3Com planned to spin off its remaining shares of Palm to 3Com's shareholders before the end of the year. 3Com shareholders would receive about 1.5 shares of Palm for every share of 3Com that they owned, thus the price of 3Com should have been 1.5 times that of Palm. Investors could therefore buy shares of Palm directly or by buying shares embedded within shares of 3Com. Given 3Com's other profitable business assets, it was expected that 3Com's price would also be well above 1.5 times that of Palm. The day before the Palm IPO, the price of 3Com closed at $104.13 per share. After the first day of trading, Palm closed at $95.06 per share, implying that the price of 3Com should have jumped to at least $145. Instead, 3Com fell to $81.81. The day after the IPO,

the mispricing of Palm was noted by the Wall Street Journal and the New York Times. The nature of the mispricing was easy to see, yet it persisted for months. In cases of equity carve-outs, a negative "stub value" indicates an extreme case of mispricing. The stub value represents the implied stand-alone value of the parent company's assets without the subsidiary, a projection of what the company will be worth after it distributes these shares. In the case of Palm and 3Com, after the first day of trading, the stub value of 3Com, representing all non-Palm assets and businesses, was estimated to be negative $63, a total of negative $22 billion. Since stock prices can never fall below zero, a negative stub value is highly unusual. To study this and other cases of mispricing, Lamont and Thaler built a sample of all equity carve-outs from April 1985 to May 2000 using a list from Securities Data Corporation. They combined this list with information on intended spinoffs from the Securities and Exchange Commission's Edgar database. The final sample contained 18 issues from April 1996 to August 2000. This example is puzzling because there is a clear exit strategy. This spin-off was expected to take place in less than a year, and a favorable IRS ruling was highly likely. Thus, in order to profit from the mispricing, an arbitrageur would need only to buy one share of 3Com, short 1.5 shares of Palm, and wait six months or so. In essence, the arbitrageur would be buying a security worth at worst worth zero for -$63, and would not need to wait very long to realize the profits. If one had been able to costlessly short Palm and buy 3Com, one could have made very substantial returns. This mispricing was possible because shorting Palm during this period was either difficult and expensive, or (for many investors) just impossible. Conclusion: To determine ways that an investor could profit from the mispricing, Lamont and Thaler tested an investment strategy of buying the parent and shorting the subsidiary, which on paper yielded high returns with low risk for these six cases. In order to short a stock, an investor bets that a stock will go down in value and looks for an institution or individual willing to lend shares of this stock. The investor then borrows the shares, sells them to another individual, and later buys the shares back at a hopefully lower price to cover the short. Buying the shares back at this lower price yields a profit for the initial investor. While these negative stub situations present attractive arbitrage opportunities, the high returns are difficult to realize due to problems with shorting the subsidiary. The major obstacles to arbitrage in these cases were short sale constraints, which make shorting very costly or impossible. In some cases, institutions or individuals may be unwilling to lend their shares to short sellers, the cost of borrowing the share may be too high, or the demand for shares may exceed what the market can supply, creating a price which is too high. Authors have also studied the options market for more evidence on how high shorting costs eliminate exploitable arbitrage opportunities. Options can make shorting easier,

both because options can be a cheaper way of obtaining a short position and because options allow short-sale constrained investors to trade with other investors who have better access to shorting. The options prices confirm that shorting Palm was either incredibly expensive or that there was a large excess demand for borrowing Palm shares that could not be met by the market. One possible explanation is that the type of investor buying the overpriced stock is ignorant about the options market and unaware of the cheaper alternative. In looking at who buys the expensive shares and how long they hold them. Authors did not generalize that these overpriced stocks reflect problems with all stock prices; their evidence casts doubt on the claim that market prices reflect fundamental values because these cases should have been easy for the market to get right. Their analysis offers evidence that arbitrage doesn't always enforce rational pricing. If irrational investors are willing to buy Palm at an unrealistically high price, and rational but risk averse investors are unwilling or unable to sell enough shares short, then two inconsistent prices can co-exist.