Can We Really Trust Efficient Market Theorists

Is it possible to “beat the market” on a consistent basis?

I for one, honestly believe that it is not just possible but very much doable, by just about anyone who is willing to learn.

However, the first condition to beat the market is to get out of this popularized and highly endorsed, yet a completely insane idea that market is efficient.

You need to break from the mass market delusion supported by both financial analysts and market gurus that stocks are informationally efficient and hence everyone has pretty much the same chance of beating the market–zero.

What Is An Efficient Market Anyway?

There is no better way to understand this crazy idea than by a real life example. Suppose you are walking down the streets and suddenly you see a $100 bill lying on the road. What do you think? Do you think that it’s your lucky day for you have just got $100 richer. Or do you think that it is highly improbable for that amount of bill to lie on the road and not be taken by someone else, concluding the bill must be fake.  If you fall in the later group, congratulations! You belong to the elite group of those who believe in efficient market hypothesis.

And sad for you, because just as you won’t pick the $100 bill lying on the road, you would also discard an undervalued stock when you see it believing that if it were really undervalued, people would have already picked it.

But believe it or not, in reality market is far from efficient.

Benjamin Graham, the father of value investing and one of the most respected security analyst of all time, have gone so far to say that the market is a paranoid, manic-depressive and emotionally unstable entity that quite frequently presents you with insane opportunities to both buy and sell (Read the famous allegory of Mr. Market).

How can a paranoid, manic-depressive and emotionally unstable entity be efficient at the same time?

Therefore, It’s just a matter of proving Ben Graham correct to disprove the theorists who endorse and promote efficient market.

What’s better way to prove Graham right than to present you with the results of his ardent disciples who always capitalized on the market pricing securities below their intrinsic value and were successful in beating the market year in and year out, for most part of their investing career.

They could, as some may say, be the exception to the rule, but if you consider the high concentration of all those who beat the market on consistent basis belonging to the Ben Graham’s Value Investing Camp, you realize it is not just a co-incidence or pure luck.

Following are just some of the more successful investors (belonging to Ben Graham’s camp) who had beaten the market on a consistent basis :

  • Walter J. Schloss  (compounded annual return of 21.3% between 1956–1984)
  • Tom Knapp (compounded annual return of 20.0% between 1968–1983)
  • Warren Buffett (compounded annual return of 29.4%  between 1957–1969)
  • William J Ruane  (compouned annual return of 18.2% between 1970-1984)
  • Charlie Munger (compouned annual return of 19.8% between 1962–1975)
  • Rick Guerin (compouned annual return of 32.9% between 1965–1983)
  • Stan Perlmeter (compouned annual return of 23% between 1965–1983)

(Source : SuperInvestors Of Graham And Doddsville By Warren Buffett)

Why Stocks Become Undervalued?

In an efficient market, it really doesn’t matter which stock you buy or when you buy it, because the market always prices it correctly. In other words, there is no opportunity for an investor to buy undervalued securities.

To illustrate this point, suppose a stock is trading at $100 and it announces a good news that could double its value in next one year. Effcient Market theorists will say, the stock price will automatically and immediately adjust itself to the value at which it will give you market returns. That is, if market returns were 10% the stock price will become $181.82 to give you that exact return by the end of the year. Therefore it is impossible to capitalize on any information.

Except, for this to happen, there should be a universal access to an agreed upon, high-speed pricing mechanism among all investors making buying or selling decisions without factoring in their own unique desires and emotions.

But we all know, most investors are far from rational when it comes to investing. Here are just some of the reasons why you can still find undervalued stocks to generate superior to market returns :

  1. Panic Selling: Fear of loss is a much greater driving force than greed, and hence investors often start dumping their stocks at the first sign of trouble thereby plummeting its price.
  2. Herd Mentality : It is quite common to see investors rushing to buy or sell stocks based on inadequate information or even temporary events just because someone else is buying, thereby leading to a snowballing sort of effect.
  3. Difference in valuation method : There are as many valuation techniques as there are types of investors. Therefore, the stock price doesn’t reflect the actual value of the stock in the short term.
  4. Unnoticed Or Overlooked stocks. Some stocks do not garner investors’ attention as others do. It is not technically feasible for financial news sites to cover every singe stock under heaven with equal frequency. Hence, there is a fair chance that some of them might escape the eyes of analysts and hence may be undervalued. This is especially true of non-glamorous, small cap or foreign companies.
  5. Market Crashes Or Bubbles : The over all economy or market crash may drag the price of even the best of the companies down to the extent where it might become significantly undervalued.
  6. Short term Problems : A company might be facing short term problems like a bad quarter or a bad deal. This may result in the market valuing it much less than it’s intrinsic value. This is often followed by a correction when the company overcomes these problems.
  7. Sector wise trend : Good trends in one sector may cause investors to shift their money from other sector, thereby driving the prices of companies in the later down.

In conclusion

The stock market is much more emotion driven than it is information driven.

This presents to those who think independently and rationally some very sound opportunities to invest in undervalued securities. The market as Graham has pointed out is a voting machine in the short term and a weighing machine in the long term. This means stocks price is driven in the short term by the stock’s popularity. Whereas in long term it is driven by it’s fundamentals i.e. how it performs as a business. Those who realize this simple truth and act accordingly are often the ones who post superior returns than the market.