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Ever heard of the Efficient Markets Hypothesis (EMH) and wondered what it’s all about?
You certainly aren’t alone. However, the real questions you should be asking yourself are, “How important is it that I understand the Efficient Markets Hypothesis, and how much does it threaten deep value investing strategies?”
In order to answer these questions, we first need to understand what the Efficient Markets Hypothesis is, what it hypothesizes, and how this hypothesis contradicts the core philosophy of deep value investing.
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What Is the Efficient Markets Hypothesis?
“There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.
“Because of the collective resources of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.”
As you probably told yourself immediately, such beliefs are considered heresy amongst the deep value investing community. The glaring issue is that the two schools of thought (the Efficient Markets Hypothesis and deep value investing) are mutually exclusive — that is, they cannot exist together in harmony.
Marks has more:
“Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and protect from instances when they are wrong.
“Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are ‘fair’ relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a ‘free lunch.’ That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.”
So, the Efficient Markets Hypothesis basically tells us that any and all of our attempts to beat the market are futile. Because the market decides the prices of all traded assets and everyone within the market has the same quantity and quality of information available to them, it is impossible to outsmart the market — there is no way for anyone, regardless of their level of investing/financial knowledge, to perform better than the market, on average.
As we said before, this sentiment is a direct counter to the beliefs held by those operating as deep value investors, such as value investing guru Seth Klarman. In fact, the conditions upon which deep value investors often commit their entire fortunes necessitates the existence of mispriced securities within the financial markets. Undervalued securities are the sustenance that deep value investors require for survival.
There Can Only Be One Winner
While there may be some intuitive sense to this hypothesis, the black and white nature of the argument between the Efficient Markets Hypothesis and deep value investing is such that there can only be one true winner. In truth, there is arguably no area in economics and finance in which there is more at stake. On one hand, we have the unstoppable force of the Efficient Markets Hypothesis, backed by the minds of some of the greatest economists to ever walk the planet. On the other hand, we have the immovable object that is deep value investing, buttressed by some of the most successful investors of the past century. With entire livelihoods to lose, neither side has taken this confrontation lightly.
Now, back in reality, Marks gives his own two cents on the hypothesis:
“Now my take. When I speak of this theory, I also use the word efficient, but I mean it in the sense of ‘speedy, quick to incorporate information,’ not ‘right.’”
Without transforming his book into a full-blown English lesson, Marks makes a very simple, yet fascinating point — just because markets react to news instantly does not mean that their reaction is correct, or even logical.
While it is true that even the smallest piece of news can cause both instant and volatile movements in the stock price of a company, it is also true that it is more often emotion rather than rationality that drives traders’ or investors’ decisions.
“I agree that because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. I do not, however, believe the consensus view is necessarily correct. In January 2000, Yahoo sold at $237. In April 2001 it was at $11. Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions. But that doesn’t mean many investors were able to detect and act on the market’s error.”
The point here is that the argument that a share price can be worth $X one day, and significantly less on the next day/week/month/year, just cannot be so. Over short periods of time, it should not — and cannot — be the case that the “correct” value of an asset be able to fluctuate significantly. Such a statement would be synonymous with the following example:
Imagine a car is selling second-hand at a price of $10,000. The price is reasonable when compared with other models of similar age and mileage. However, unbeknownst to prospective buyers, the car is faulty and would require $5,000 in repairs to bring it back to the standard of other similar models (its net value is $5,000). The car is ultimately bought from the dealer at $5,000. The next day, the buyer discovers the fault and is forced either to spend $5,000 on repairs or sell it at the new market price of $5,000.
The Efficient Markets Hypothesis would argue that this car was correctly priced at the time of purchase at $10,000, due to the fact that this was the agreed upon market price — formed by the sacred supply and demand function. However, the Efficient Markets Hypothesis would also argue that the new market price of $5,000, formed just a day later, is also the correct price. In this case, quite clearly, the $10,000 price was never “correct.”
Now, reverse this example — imagine the car being sold by the dealer is in perfect working order, but also happens to have $5,000 lying in the glove box (money which the dealer is not aware of). By buying the car for $10,000, the buyer is getting half of his investment back immediately. They are essentially paying just $5,000 for a car that is worth $10,000. In this case, the real value of the car was $15,000, but the buyer got it for $10,000. Within the financial markets, this is the type of deal that value investors aspire to find, and it is the existence of such value investments that proves the Efficient Markets Hypothesis wrong.
Where It All Goes Wrong
Marks uses a case study on the price of Yahoo as an example of Efficient Markets Hypothesis investing failing. However, there are countless others that you could refer to — how about Black Monday, or just the fact that your favorite large-cap company’s share price changed hundreds of times yesterday, for seemingly no reason at all?!?
None of us is perfect, and none of us make the correct decision all of the time. If this is true at an individual level, it is also true at a group level. Therefore, markets are certain to make mistakes — meaning that value is certain to exist within publicly traded securities markets!
If you’re still a little skeptical about whether there is room for Efficient Markets Hypothesis investing in financial theory, just consider this next paragraph from Marks:
“There are many investors hard at work.
- They are intelligent, diligent, objective, motivated and well-equipped.
- They all have access to the available information, and their access is roughly equal.
- They’re all open to buying, selling or shorting (i.e., betting against) every asset.
“For those reasons, theory says that all the available information will be smoothly and efficiently synthesized into prices and acted on whenever price/value discrepancies arise, so as to drive out those discrepancies.”
When put in this context alone, without outside thoughts or influences, it all seems to make sense. If there are many investors out there, all rational, ambitious, capable, intelligent, market-aware, information-saturated, and all equally willing to go long/short on any security, then how could we not get financial market prices right all of the time? Right?
For all of our brilliance, Marks tells us how we do indeed manage to get it wrong, consistently:
“But it’s impossible to argue that market prices are always right. In fact, if you look at the four assumptions just listed, one stands out as particularly tenuous: objectivity. Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.
“Likewise, what about the fourth assumption? Whereas investors are supposed to be open to any asset — and to both owning it and being short — the truth is very different. Most professionals are assigned to particular market niches, as in ‘I work in the equity department’ or ‘I’m a bond manager.’ And the percentage of investors who ever sell short is truly tiny. Who, then, makes and implements the decisions that would drive out relative mispricings between asset classes?
What this means is that it is absolutely possible to find kinks in the armour of the “efficient” market, as Marks similarly concluded:
“A market characterized by mistakes and mispricings can be beaten by people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.”
What Marks is telling us here is that the human condition actually precludes us from acting in a way that supports the Efficient Markets Hypothesis. Our lack of rationality — a key assumption of the Efficient Markets Hypothesis (and economics more broadly) — and the rules-based approaches that investment firms take actually rule us out from making multi-trillion-dollar markets anything close to efficient. What this means is that it is absolutely possible to find kinks in the armor of the “efficient” market.
The Efficient Markets Hypothesis: To Trust or Not to Trust?
Marks signs off on the argument over the Efficient Markets Hypothesis with a somewhat tame conclusion:
“In the great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree. I wholeheartedly appreciate the opportunities that inefficiency can provide, but I also respect the concept of market efficiency, and I believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.”
While not the rousing call to arms that value investors might have hoped for, Marks does a good job of bringing us back to reality. While he verifies his belief that markets do not always reflect efficient prices, he also warns that we cannot use this to assume that all security prices are mispriced. While the opportunities are out there, we must be mindful that not all securities — particularly the high-profile, S&P 500 companies — are necessarily mispriced. Bear this message in mind as you pursue further security acquisitions!
What began as a discussion on the debate between academics and practitioners was followed by conclusive evidence that markets can never be completely efficient. While aspects of a market may display characteristics and some securities may indeed be at time correctly priced, the financial markets are too vast — and the human population too irrational — to be able to consistently price every security efficiently. There is simply too much that has to go perfectly in order for this to happen — and humans are notoriously imperfect.
What then can we learn from this lesson?
For one, value investing, when done right, works. One need look no further than Tweedy, Browne’s What Has Worked in Investing to see why counterintuitive investing strategies such as the purchasing of low-priced stocks in relation to book value (the lowest p/b stocks outperform the highest on a compound annual return basis of more than 8%), low-priced stocks in relation to earnings (approx. 7% excess annual return), and high dividend yield stocks (approx. 6% excess annual return) produce outsized returns.
This is why the world has begun to wake up to the prospects of deep value investing — these strategies simply work!
Whether you have a master’s degree in finance from Harvard Business School or are a public servant keeping our streets clean, there is a place for you in the value investing community.
Evan Bleker runs Net Net Hunter and Broken Leg Investing out of Seoul. Following in the footsteps of Ben Graham and early Warren Buffett, Evan’s earned a very solid market beating return since 2010. His primary strategy are Graham’s classic net net stocks but he also picks up outstanding low price to net tangible assets stocks he calls Ultra stocks.
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