Why Value Investing Works – The Myth of Efficient Markets

Why Value Investing Works – The Myth of Efficient Markets

Eugene Fama is generally credited with creating the academic model of Efficient Markets in his Phd. thesis at University of Chicago. At its very basic, the weak form of Efficient Market Hypothesis states that the securities prices reflect ALL publicly available information. The semi-strong form of EMH further states that any new public information is immediately reflected in the price of the security. The strong form, which has been widely discredited, claims that even non public information – such as insider knowledge is already reflected in the prices.

This hypothesis is used to propagate the belief that it is not possible for any one investor to consistently beat the market returns on a risk-adjusted basis for a reasonably long period of time. Sure, you can always beat the market, but you can only do so by taking on more risk.

Ergo, the proliferation of lazy and ultimately mediocre investments such as index funds and various assorted ETFs.

Some Form of Efficiency Does Exist

This is not to say that markets are completely random. Prices do react to news and when viewed in aggregate, the markets do appear to be efficient to a large degree. For example, the SP500 index does reflect the general business environment in US when viewed over a range of time. Some of the larger companies with a very liquid stock also have a mostly efficient market in their secondary shares. So, for example, when you are considering an investment in a Microsoft or Exxon, you can be reasonably sure that the returns you will get will be in proportion to the risk you are taking on that investment.

In this day and age where institutions and hedge funds use super computers and complex algorithms to arbitrage on any mispricing or information advantage, it would appear that the opportunities to find undervalued stocks have largely disappeared. It is not so.

But There are Pockets of Inefficiencies

There are and will always be some pockets of inefficiencies. They arise due to many reasons, listed below are some common ones

  • Small company stocks that are largely underfollowed – generally large funds and institutions do not buy these stocks since any level of investment will just be a blip on their portfolio returns. They are also not covered adequately by the Wall Street as some of these companies are too small to be a investment banking prospect.
  • Industry or sector specific bull or bear market – In short term, the markets are known to overdo their exuberance or pessimism for certain sectors or even individual companies. This is more likely to happen in cyclical industries but really can happen anywhere (you probably do remember the real estate bubble!). For example, currently the bulk shipping sector has been decimated due to over-capacity problems and the book values of the ships (assets) are grossly inflated on the balance sheets compared to what they will actually fetch in the market. However, there are shipping companies that are financially strong enough to survive the down cycle without having to scrap any of their ships and their stocks have been dragged down along with the rest of the industry. These stocks might be excellent investments today if the investor is willing to wait for 2-3 years for their investment to work out.
  • Unwanted stocks – When a stock leaves a popular index (such as SP500), they will be mercilessly sold off by the funds who are chartered to own only the stocks that are part of that index. Most of the time, this selling has nothing to do with the investment merit of that particular stock. If the markets are efficient, there should be an army of buyers waiting to buy these stock and the price needle should not move much. This army of buyers is often much smaller than the index funds selling the stock  and a window of opportunity is created.
  • Aggressively marketed stocks – IPOs are not only bad investments, they are almost always overpriced. Selling the IPO stocks short as they are being hyped up is a fool proof investment strategy – the trick of course is to be able to find some shares to short. Perhaps if a sector is witnessing a lot of IPO activity, an investor might take it as a sign of an overheated market and sell any holdings in that sector (or avoid it like a plague).
  • Special situation stocks – Spin-offs may also become one of those unwanted stocks. Funds that own the parent company may sell off any shares they get in the company that has been spun off as the spun off company maybe either too small or may not in some other manner fit the investment charter of the fund. A small window of undervaluation may become available. Mergers and acquisitions can create more opportunities if an investor determines that the market has not properly understood or valued the potential of the merged company.

There are of course other pockets of inefficiency – for example, if the company stock has been beaten down due to incompetent management, an activist value investor might buy enough stock in the company to be able to get on the board and cause the management to change. This may not be something a retail investor might be able to do, but he or she can surely take note if a known activist investor suddenly starts accumulating shares in one of these companies and might consider piggybacking.

It is interesting to note that some of these inefficiencies are created by the same funds that symbolize the Efficient Market model. There is a reason Warren Buffett and other investors believe that the small investors have a great advantage over the Wall Street. Unfortunately, most small investors do not have time of inclination to research and monitor their own investments and are happy to accept mediocre returns by investing in a index or other mutual funds.

About the Author: Shailesh Kumar, MBA, writes about value investing and provides undervalued stock analysis for self directed investors.

23 Responses to Why Value Investing Works – The Myth of Efficient Markets

  1. Made me smile this morning!

    EMH is over glorified, misunderstood, and for all practical purposes, a great way to have an excuse for lazy. I like to shop the <$5 stocks for a good bargain, and there are plenty!

    I think the reason why I prefer value over growth is that as long as I get a great value in a stock, I get growth at a reasonable price. None of my value stocks are growing EPS at 15% per year, but most of them are growing, and their share prices are growing, too.

    High-five for sticking it to the man. The real money is in the stocks no one wants to love, so don't giveaway the secret. :P

  2. I think your analysis is spot on. EMH is applicable to most investors because beating it requires education and effort. If someone can barely be bothered to put money in their 401k, it’s unlikely that they will invest the effort required to develop an educated investment strategy. Index funds are for those people (including me) who can’t/won’t/don’t research those stocks which defy the EMH.

    • You are right, but it almost pains me to see people agonizing for days on a new microwave purchase, and will choose a model that fits just right for them, and think nothing of plunking down thousands on an index fund just because everyone says it is the smart thing to do without researching alternatives that might be better.Guess which purchase impacts their future wealth and lifestyle more!

  3. @Evan, Thanks for hosting my post!Let me answer your question. You are right. The reason you are smarter than the market is that you did your research and looked beyond the temporary problems that company might be having. The problem with the market today is that it seldom looks beyond a quarter.In many cases the stock may truly be undiscovered and as more investors stumble on to the stock and discover its story it will appreciate to reflect its true value.@JT, looks like we think alike!

    • I just saw this comment, whoops!

      Looks like we do think a lot alike. My portfolio is mostly small cap value stocks that I pick individually. Looking at your SeekingAlpha profile, it looks like you favor larger stocks than I do, though. Either way, value is value. If I can buy $1 for $.50, I’m all about it. ;)

      • @JT, Thanks for checking me out! I do own quite a number of small caps but I do try to keep the market cap above 30 million. Too small a stock and the risk goes up. They might be one customer payment delay or one lawsuit away from going bankrupt, you never know.

  4. I like to think I am a value investor, but then every couple months I have a wave of thought that puts into question my beliefs and it always comes down to:

    Is Value Investing only buying a company today in the hopes that the entire market will realize that you are smarter than them and buy it at a higher price later?

    • Yes.

      Most people don’t do the digging. Sure, there are countless analysts for every blue chip, but how many are there for firms with market caps of less than $100 million. Usually no more than one or two, and considering that the firms that employ the analysts have hundreds of billions of dollars, making 200% on a $100 million company simply isn’t worth their time.

      Look at VCs. They don’t touch an idea unless it can be worth $50M+. Sure, they could angel a firm and earn $1 million on a $8,000 investment, a hell of a return, but its still nothing more than a rounding error to the firm. Why spend time speaking to an entrepreneur that can make you $1M when there’s others that can make you $50M.

  5. agreed – there are some many small cap players that operate in limited geographies (i.e. handful of states or just even one) that don’t get the exposure. if the business model is sound (not necessarily the next best idea), the stock is likely to appreciate as the business expands (natural progression). i have made a good deal of money investing in undervalued small cap comps that are exactly in this boat.

  6. Since May our portfolio is looking pretty awful. Hoping it is just the summer duldrums. That being said, we do stick to dividend aristocrats and index investing – but that is primarily due to my not finding the time to research a little more than I do.

    • I am loving my undervalued dividend aristocrat portfolio! But it takes me like 1.5 – 2 hours of research and/spreadsheeting

    • Not that I follow the media industry but a quick look at News Corp it doesn’t seem like they were really hurt by the scandal. YTD the stock is still up 9%!

      • I think the scandal is still unfolding. But, I think the stock is down 10% over the last 3 months, about 10% worse than the S&P 500. That’s a lot more instability than it usually exhibits.

  7. (At the risk of sounding pedantic)…Actually, it’s not a myth. There is some agreement that there is a semi strong form of the emh. And those examples of when the efficient market doesn’t work are called anomolies. No theory is “perfect” as there are always exceptions. Over time, you can’t lose more than the market(s) by going with a sensible and diversified asset allocation! Very good article.

  8. I am surprised you haven’t been shot down yet for criticizing the EMH theory. I won’t defend it since I love picking small cap energy stocks for my DIY portfolio while I keep my RRSP portfolio indexed. Let’s call it balancing risk!

    • I can’t believe I didn’t get more people attacking this guest poster (even though he makes a damn good argument)!

  9. I’ve written and have been meaning to publish an article about efficient markets, but haven’t gotten around to it.Specifically, the argument in that not-yet-published article is that even if markets were highly efficient (which to an extent, they are), it’s a complex and messy mix of short term and long term goals. If all the available data is taken into account in a stock price, it’s taking into account probabilities on meeting quarterly earnings targets, probabilities of being an astounding 10 year investment, and everything in between.Investors that focus on only a subset of that information/noise (such as those seeking solid long term returns), you’re target is different from that of the aggregate market even if you’re working with the same information, or less information, than the aggregate market.

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