Stock Valuation & Learning

Question 1

Berk and Green 2004

Answer 1

• Title: Mutual Fund Flows and Performance in Rational Markets
• rational model of active portfolio management
• reproduces many regularities widely regarded as anomalous.
• Fund flows rationally respond to past performance in the model even though performance is not persistent and investments with active managers do not outperform passive benchmarks on average.
• The lack of persistence in returns does not imply that differential ability across managers is nonexistent or unrewarded or that gathering information about performance is socially wasteful.
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Question 2

Pastor and Veronesi 2005

Answer 2

• The develop a model of optimal initial public offering timing in which IPO waves are preceded by high market returns, followed by low market returns, and accompanied by increases in aggregate profitability. In addition, IPO waves should be preceded by an increased disparity between new firms and old firms in terms of their valuations and return volatilities. IPO volume should be related to changes in stock prices, but less so to their levels.
• Implication: the high IPO valuations observed in the late 1990s are not necessarily irrational. IPO valuations in this model tend to be relative high, partly because IPO timing is endogenous and partly due to prior uncertainty about the average future profitability of IPOs. According to its proxies, prior uncertainty was unusually high in the late 1990s. this high prior uncertainty may have attracted many firms to go public and it might also have contributed to the high valuations of many IPOs at that time.

Question 3

Pastor and Veronesi 2006

Answer 3

They argue that the Nasdaq valuations in the late 1990s were not necessarily irrational ex ante because uncertainty about average profitability, which increases the fundamental value of a firm, was usually high in the late 1990s. Stocks with the highest M/B ratios in the late 1990s also had highly volatile returns, consistent with the premise that these stocks had the most uncertain future growth rates. They argue that the level and volatility of stock prices are linked through uncertainty.