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.