Can

the Market Add and Subtract? Mispricing in Tech Stock Carve-outs

Integrative Analysis #2
Group 3

Introduction:
The essential question, which is to be answered, is: Do the asset markets offer rational signals as to where to invest real resources? The presented article and the related article all take different aspects to whether or not the efficient market theorem is achievable. Essential to the efficient market theorem is the idea of the law of one price. The law of one price stipulates that it must not be conceivable that an asset is sold at two different prices simultaneously. This law is essentially driven by arbitrage. Given that arbitrage is the exploitation of such discrepancies on the market it would automatically eliminate any violations of this law. Hence arbitrage works as a key driver to enforcing the law of one price. In regards to the market and the perception of efficiency there are some fundamental aspects, which complicate the existence of the law of one price. Essentially they relate to the fact that it is extremely difficult to identify and determine the fundamental value of the problem- this is also referred to as the problem of the joint hypothesis. Furthermore, one will find that identifying and evaluating fundamental risk is also extremely difficult. An additional aspect, which exists in the intermediate run, is the noise- trade risk, stemming from the fact that investor sentiments may shift, given that an investor may fund and short fundamentally mispriced assets, enforcing the mispricing. Even in the event that these risks will be eliminated in the long run, the trader faces transaction costs, which in terms creates difficulty in the enforcement of the law

of one price. In the face of transaction costs the arbitrageurs are forced to price an asset at a different price than its fundamental value. The paper investigated looks at the definite violation of the law of one price, which is the situation of carve-outs followed by a spin-off. Notice that to be certain that it necessarily is a violation of the law, the carve-out must be negative. Carve-outs are defined as an IPO for shares in a subsidiary company. The subsidiary company raises money by selling shares to the public and then typically giving some or all the proceeds to its parent. While a spin-off is defined as when the parent firm gives remaining shares in the subsidiary to the parents shareholders this means that no money fundamentally changes hands between the firms. To understand these actions it is central to understand what the reasons are to impose this situation. The reasons relate to the fact that the parents wish to raise capital for themselves or for their subsidiary to use. Additionally, the firm may want to disperse its shareholders such that it gains a form of corporate control and furthermore it will manage to diversify its risks. Moreover, carve-outs may serve as a mean to avoid flooding of the market; therefore they wish to sell in small pieces initially. Finally, it may in fact serve as a mean for adjusting the price. Particularly it may serve as a mean of raising the price of the parent if they are underpriced while the subsidiary may be overpriced. The remainder of the text will focus on the sample and the analysis conducted by Lamont and Thaler. From then on, we will on describing why and how the stocks become negative stubs. This will lead us to our discussion of the paper Is this in

fact a effective way of portraying the violation of the law of one price as well as the discussion regarding sample size and sample evaluation.

Summary:
Following the introduction, section 2 of the research paper focuses on the sample of carve-outs followed by spin-offs, which have resulted in negative stubs. Generally, a carve-out is an IPO for shares in a subsidiary company to raise money by selling shares to the public and then typically giving some or all proceeds to its parent. This action, as was discovered by many psychologists like Allen and McConnell and others, helps the parent company raise capital for itself. The parent company might want to establish a dispersed base of shareholders in the subsidiary for strategic reasons or, for example, raising the parent stock is particularly attractive if the parent stock is underpriced or if the subsidiary is overpriced. During this process a spinoff occurs when the parent rm gives the remaining shares in the subsidiary to the parents shareholders. Next, in our case, one could define stub as a stock representing the remaining equity in a corporation left over after a spin-off. Out of 155 cases of carve-outs from 1985 till 2000, only 18 tech stocks were considered from 1996 till 2000, as they had sufficient information to be investigated. The study concentrates more on six cases out of the 18, as these cases showed negative stubs, meaning, subtracting the product of the spin-off distribution ratio and the subsidiary price from the price of the parent would result in a negative value. Hence, a clear violation of the law of one price. The next section deals with the risk and return on stubs. Since negative stubs are

a clear evidence of mispricing, the ideal strategy would be to buy the parent (as it is undervalued) and to short the subsidiary (as it is overvalued). This would be an easy, low-risk high-return investment, opportunity for arbitragers thus sending the stock prices to their fundamental values and eliminating the mispricing. However, according to the authors paper work and calculations, this type of investment is not likely to happen and is in fact less conveyable than portrayed. Before continuing with the constraints of such investment strategy, the authors first point out some risks that are specific to stubs. The first is cancelling the spin-off, which could happen for legal or managerial reasons and has actually been recorded in one of the positive stubs cases. The other risk is changing the distribution ratio, which could result in several complications. After explaining the process of shorting, section 4 elaborates why the strategy of buying parent and shorting subsidiary does not work. The main reasons for the failure of this strategy are the market and firm-specific risks, and the short- sale constraints. In general, fundamental, noise-trader, liquidity and idiosyncratic (firm-specific) risks, and the huge costs and difficulties of shorting, limit the arbitragers from implementing the strategy and force the existence of mispricing. Later on, the authors confirm the constraints of the shorting by checking and analyzing the options prices of the negative stubs, which by their turn also showed clear evidence of mispricing. Finally, the authors talk about two important factors that cause mispricing in the first place. The first factor is the investor characteristics. In our case, investors were too optimistic and overconfident, and did not show rational behavior. Another general characteristic would be that according to different beliefs,

investors come with acts that they would justify as rational. The second factor is the IPO day returns. Records have shown that parent companies gain excess returns of about to 2 percent on the announcement of carve-outs. This could be the result of optimistic investors drive up the price of the parent on the announcement days and later get rid of the parent in order to obtain the subsidiary on the IPO day.

Evaluation:
As we have seen after the introduction, the research paper continues with introducing the sample that was investigated, then the risk and return on stubs, later the short-sale constraints and finally what causes the mispricing, before ending with the conclusion. Structural-wise, in section 4, where the authors talk about the short-sale constraints, they start by describing the shorting process. We think that this should have been illustrated a bit earlier, especially that shorting was mentioned in section 3 on the risk and return on stubs. Talking about the sample, the authors searched for carve-outs from year 1985 till 2000 and have found 155 cases but were only able to consider 18 cases due to the lack of information about the others. These 18 cases were from the period of 1996 to 2000 and only 6 had clear negative stubs. It is clear that sample was very small and also just 33% of the 18 cases showed negative stubs. The persistence of the mispricing could have existed for other reasons than just the constraints of the short-sale. A larger sample would have definitely given a clearer view. One should not also forget that the period of these 18 cases was

during the dot-com bubble, where the Tech stocks prices were rising much higher than their fundamental value, hence another form of mispricing to be added to the parent and subsidiary stocks. In other words, we could say that this investigation of mispricing in carve-outs was done on Tech stocks that were, in the first place, mispriced. In section 3, Risk and Return on Stubs, the authors state in the first paragraph that the ideal strategy to profit from negative stubs is to buy the parent and short the subsidiary. However, they add that on paper such strategy will not work although they are aware of individual investors who did make money on these situations. One could comment by saying that the reason Behavioral Finance came to life is that investors and markets behave opposite to what theories on papers stated. So, we believe that it would have been more beneficent to investigate how some investors made money out of it and not why the majority did not make money out of it. In addition, this would contribute to reducing mispricing. Moreover, since the headline of the paper states Mispricing in Tech Stock Carve- outs, the majority of the paper was trying to show evidence that the researched cases were clear negative stubs and that arbitrage was not able correct the mispricing, but it did not focus much on the reasons of the mispricing. We believe that giving the causes of mispricing more attention could lead to the reduction of mispricing and thus a more rational market. In general, the risks, short-sale constraints and the reasons of mispricing did not include all six cases. For example: the risks on stubs were just hypothetical and were not present in any of the six cases and the strong evidence of short-sale

constraints in options was found in only two cases out of the three that had options traded. This brings us to the point that investigating a larger sample could have resulted in better conclusions.

Conclusion:
In conclusion there are clearly some cases of mispricing, as the 3Com Palm. This evidence becomes even more strong and unquestioned when you evaluate the use that the author made of the instruments (negative stubs) to measure this issue, being cautious to consider as undoubted mispricing just the ones that had relevant negative stubs for a relative long period of time. Even being so strict, trying to avoid skeptical people arguments, six cases were identified. After identifying six clear cases that violates the law of one price, one could ask why this mispricing was not quickly corrected. The explanation found by the author is that this correction took some time to happen because it didnt present arbitrage opportunities, mainly because of the transaction costs involved in shorting the subsidiary companies. Even finding clear cases of violation of the law of one price, the author sustain a skeptical opinion about the existence of recurring violation, as the finding of six cases is almost insignificant comparing to the size of U.S. equity market, and all of them were examples of just one group, Internet Stocks. In this point the author seems to be really realistic with his findings, not trying to see the evidence as something unquestionable and generalized, also the paper leaves the validation of the law of one price weaker but still as a question: is the market efficient enough to guarantee that generally all prices are right?