Rolls-Royce: Profits up, Share price down?

An efficient capital market is expected to display the following forms of efficiency; operational, allocational and, most importantly for this discussion, pricing efficiency.  Pricing efficiency means that share prices fully and fairly reflect all information whether past or future.  This idea was further developed by Fama (1970) who pioneered the concept of the Efficient Market Hypothesis (EMH).  EMH is a concept concerned with establishing share prices in a capital market and states that share prices reflect all relevant available information.  As a result it is expected that in an efficient capital market undervaluation and or overvaluation does not occur as current and past information is immediately reflected in the share price.  However this ideology is flawed as it relies on perfect market conditions.  This ‘perfect’ market quite simply cannot and will never exist.

The recent story of Rolls-Royce does little to support the theory of an efficient capital market.  On Thursday morning Rolls-Royce announced record profits of £1.16bn, an increase of 21% on the previous year.  This has been driven by increased demand for their civil aircraft engines; the order book upon announcement had reached £62bn as orders rose 5% from the previous year.  These are impressive figures for the company and it would be expected in an efficient market that the information would be reflected positively almost instantly in the share price.  This presumption seems logical and is what I would expect to happen.  However by mid-morning the shares had fallen over 3.5% in value; at 10.23am the share price was down by 32p to 753p.  This has left many scratching their heads.  How can an extremely positive announcement of record profits result in a fall in the share price?

So, why has this happened?  The graph shows that since the start of February Rolls-Royce shares have gone up by 49.5p, a notable short term increase in share value of 6.73%.  I believe it could be that these increases were the result of anticipatory trading activity from investors with insider knowledge.  Insiders and close followers of the company will have been well aware of the positive performance that had been achieved during 2011.  As a result they will have been trading up the price of the shares prior to Thursday’s announcement.  However when the news officially hit the market they will have been inclined to sell as the information was public knowledge and according to the EMH should have been immediately reflected in the share price.  I feel these investors selling their shares will have been a major factor in the share price falling immediately following the news announcement.

Is the Rolls-Royce case a supporter for the Random Walk theory? Random Walk (Kendall, 1953) theory suggests that the relationship between share prices across time periods is completely random.  This is because news, which affects share prices, is by definition rando making it impossible to predict future changes in share price.  Rolls-Royce share price has reacted in the opposite way to which theory and logic would suggest so maybe its share price is just following a random walk.  It is my opinion that generally, in periods of no relevant news, companies share prices do reflect a random walk or at least one which follows the general pattern of the entire market.  However I would expect when there is relevant news the market would react rationally in line with EMH theory.  To put this into context Diageo announced, also on Thursday morning, that its profits were up 15% to £1.86bn.  As a result shares rose steadily on the day by 13.81p, the kind of reaction expected on the back of a positive news announcement.  The puzzling thing about Rolls-Royce is that the opposite of what basic logic suggests should happen has happened.

Has the bombardment of positive news stories relating to Rolls-Royce played a part in this reaction?  Over the last year it seems there has been a constant stream of positive news stories relating to Rolls-Royce.  In the new year they announced that Rolls-Royce car sales were at a record high in the company’s 107 year history.  Also there have been many announcements in recent weeks detailing the company’s upcoming expansion plans in Asia.  Share prices over the last year have risen dramatically by 115p (17.49%) which could suggest that a lot of good news is already reflected in the Rolls-Royce share price.  It would be fair to expect that this uninterrupted increase cannot continue and at some point the share price will reach its optimum level.  I feel that perhaps Thursday’s announcement was one good news story too far and some investor’s immediate reaction was to get out while the going really was at its very best.  The remaining shareholders will be asking themselves; is now the time to sell up?