Featured Faculty

Shu, Tao（舒濤）

Fung King Hey Memorial Chair Professor of Finance
Chairman of the Department of Finance

Research Paper

The role of external regulators in mergers and acquisitions: Evidence from SEC comment letters

A game of disclosing ‘other events’: A message to retail investors

Winner’s curse in takeovers? Evidence from investment bank valuation disagreement

How frictions and biases impair financial markets

06 June 2024 • 8 mins read

Ideally, financial markets should function with accurate asset prices, well-informed investors, and managers maximising shareholder value, but the fact has shown otherwise. How can we enhance market efficiency?

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

Amid the grand allure of money and wealth in the finance industry, many believe that the sole function of financial markets is to seek profit. While the pursuit of profit is undeniably a driving force, it is merely a byproduct of the vital function these markets serve.

Individuals and businesses can raise capital through the stock markets. Households with extra resources can buy stock of companies that need funding, and the companies then pay back dividends to households. Financial markets connect these two parties. When the company’s value appreciates, household wealth also appreciates.

“The entire process in financial markets is about resource allocation,” says Shu Tao, the Fung King Hey Memorial Professor of Finance and Chairman of the Department of Finance at the Chinese University of Hong Kong (CUHK) Business School. “The real question is, how can we optimally allocate resources, or how can we build an efficient and optimal financial market with rational economic agents?”

An efficient financial market would require asset prices to accurately reflect underlying fundamental values. In an ideal world, investors should be able to make optimal decisions by using all information to maximise their returns relative to risk levels. Meanwhile, corporate managers could adopt optimal policies to maximise the shareholder’s value. Unfortunately, the real world is very far from ideal.

History has recorded many violations and discrepancies that resulted in stock market bubbles, market crashes, and financial crises in the past few decades. So, what caused this turmoil? In an Inaugural Lecture of Fung King Hey Memorial Professorship in Finance in March titled Frictions and Biases in the Financial Markets, Professor Shu sheds light on frictions and biases that cripple financial markets.

Information asymmetry

Transparency is necessary for an efficient market. Without proper information, investors and stakeholders would not be able to correctly price the financial assets of a company, including stock or bonds. This imbalance is called information asymmetry, and in the financial market, it could be very severe.

According to a normal distribution—a probability distribution that describes all the possible values and likelihoods of a random variable—data near the mean are more frequent in occurrence than data far from the mean. As a result, the normal distribution appears as a bell curve when graphed, which is also known as a normal curve.

However, Professor Shu’s 2019 research found that the earnings of Chinese publicly listed companies from 2005 to 2011 deviated from the normal curve. Moreover, having analysed similar data from 2013 until the end of the sample period in 2018, the result was pretty much the same, as can be seen in the picture. This means there was not much improvement in earnings management.

“If we compare this to the normal distribution, there seem to be missing pieces,” says Professor Shu. “This is what we call earnings discontinuity.”

Professor Shu explains, there are two possibilities for this. Chinese companies’ earnings may have a intrinsic characteristic that doesn’t follow a normal distribution, or some companies may manipulate their earnings reports. Although this earnings discontinuity also exists in the US and other developed markets, he observes that the magnitude in the Chinese market is significantly bigger.

“China is on the path from being a developing country to being a developed country, so we have to go through this process of improving financial market efficiency, but I think we need to speed it up,” says Professor Shu. “Therefore, I’m very glad to read a piece of news recently that says China published a set of rules to revive investors’ confidence.”

Improving transparency

In another research paper, The role of external regulators in mergers and acquisitions: Evidence from SEC comment letters, Professor Shu and his collaborators show that active government intervention can help. The researchers looked at the US Securities and Exchange Commission’s (SEC) “comment letter” process, where the regulator asks companies to clarify any potential issues within a certain period.

The study found that the comment letter process successfully reduced the information asymmetry in mergers and acquisitions (M&As) and increased market efficiency. “The goal is to make the market safer, more regulated and transparent,” he says. “This is definitely the right way to go.”

“The entire process in financial markets is about resource allocation. The real question is, how can we optimally allocate resources, or how can we build an efficient and optimal financial market with rational economic agents?”

Professor Shu Tao

Another paper titled A game of disclosing ‘other events’: A message to retail investors looks at Form 8-K, which has to be filed by companies with the SEC in case of major corporate events such as M&A, bankruptcy, departure of CEO, etc. Within this form, there is Section 8.01 (“Other News”), a voluntary disclosure of any other events the company deems important to report to security holders. While the SEC issued a very long and detailed protocol to file a Form 8-K, there is only a 64-word description for the 8.01 section.

“We suspect that this could be subject to manipulation by firm managers, and we found some evidence that this seems to be the case,” says Professor Shu. “At least, some firms seem to manipulate the tone or sentiment of these voluntary disclosures.”

The study found that companies engage more in “other news” manipulation when they need to temporarily push up or push down stock prices in the short term, i.e., pushing up stock prices before the executives sell their shares or, when the companies want to use the stocks as payment for acquisitions. Individual investors are more vulnerable to this manoeuvre. “This is not very surprising because individual investors are known to be less sophisticated than institutional investors.”

An example of behavioural bias in the financial markets: The winner’s curse

Classical economic and financial theories are based on the assumption of rationality, where the human mind operates like a supercomputer that processes all known information to make optimal decisions. However, these theories cannot completely explain many phenomena in financial markets.

For example, researchers have shown that US public companies lost a total of US$240 billion in their acquisitions from 1998 to 2001. Winners of takeover bids tend to perform worse than the losing bidders by 24 per cent over three years after the merger. In a paper titled Winner’s curse in takeovers? Evidence from investment bank valuation disagreement, Professor Shu and his collaborators look deeper into this phenomenon and a potential explanation based on “the winner’s curse”.

“It has been widely known that bidders perform poorly in M&A,” says Professor Shu. “The winner’s curse may contribute to poor bidder performance in M&A, although there’s a debate if this is true or not.”

A winner’s curse was first discovered by three petroleum engineers in 1971 after realising oil companies suffered unexpectedly low returns on their investments. Oil companies normally bid for the drilling rights on the oil fields merely by their own estimation without knowing exactly the value of the field. Oftentimes, after winning the bid, the company found out the actual value was much lower than the price they paid.

The engineers then published an economics paper and claimed that the mismatch was a result of cognitive bias. The competitive bidding environment makes bidders with no sufficient knowledge sway each other. The value of oil in the ground should have a similar value for all bidders, yet the bidders must fight to outbid their competitors.

“Someone wins in bidding because they pay too much, and they will not win if they pay a reasonable price,” says Professor Shu.

But what about in the case of a single bidder in M&A? Professor Shu gives an example to explain that the winner’s curse could still occur because only the target firm normally knows the actual value of itself. In this example, if the target firm accepts the bid, the takeover will happen. Professor Shu shows that, even if we assume the acquirer can create synergy or a new value that is equal to 50 per cent of the target firm’s value, the bidder will suffer a loss if its bid is accepted.

“With the same logic, the bidder only wins if they offer too much,” says Professor Shu. “The bidder should consider this conditional probability and lower their bids, while pondering the likelihood of winning or losing.”

What and how to disclose when facing banking crisis

The winner’s curse is cognitive bias fueled by uncertainty of the target firm’s value. The higher the uncertainty, the more likely the winner’s curse take place. To prove this premise, Professor Shu and the co-authors apply a unique approach by looking at the takeover deals involving multiple investment banks. Each of these banks gave their advice on the valuation of the target company, and the researchers looked at the disagreements in the valuation between various investment banks to measure the uncertainty of the target value.

The analyses found that when there is a high level of disagreement, bidders tend to pay too much on average. Additionally, these bidders often have worse performance and create less new value. In short, those who win the bid are the ones that offer the highest price but not the ones that can create the highest value. The researchers also found the winner’s curse is more pronounced among overconfident CEOs. “It seems that a winner’s curse is an important manifestation of CEOs’ overconfidence,” Professor Shu adds.