Why the Efficient Market Hypothesis Breaks Down, and Where Smart Investors Still Win

Investors are constantly reminded that the markets are efficient and there is no use trying to beat the market as it cannot be done on a consistent basis. In fact, we are told that over 70% of the mutual funds fail to beat the market, presenting this as evidence to somehow imply, in some convoluted logic, that we are better off handing over our money to the same mutual funds and invest passively, rather than take control of our own portfolio. I find this argument even more vacuous, considering that the best investors and stock pickers, who also happen to manage significant sums of money, do not usually run mutual funds.

The proponents of the Efficient Market Hypothesis, Eugene Fama and Kenneth French, were at one time so perplexed by things that did not fit their Efficient Market Hypothesis that they explained these away as anomalies. Interestingly, these anomalies, like the value premium, continue to exist, indicating that these are essential characteristics of the capital markets. An alert investor should seek to profit from these “anomalies,” not write them off because they do not fit their worldview.

But Is the Market Truly Efficient?

The Efficient Market Hypothesis states that the securities prices reflect all publicly available information. Trading based on insider knowledge is illegal, and even if it were possible, not enough investors would be privy to such non-public information to make any significant impact on the overall returns of any stock. If the Efficient Market Hypothesis were true, wouldn’t it imply that no investor has any particular advantage over any other when it comes to investing in stocks? If security prices immediately adjust to reflect any new public information, then perhaps the only predictor of stock performance is the amount of risk an investor is willing to take.

Indeed, most financial products available to investors today tacitly assume the sanctity of the Efficient Market Hypothesis. Passive investing, diversification, and overall market index as a benchmark for performance are all a result of a blind faith in the EMH. Or to put it another way, if what you know about the past of the company doesn’t matter (since the stock price already reflects it), and there is no way of reliably knowing the future of the company, you might as well invest in a basket of stocks to cancel out individual stock risk and let your portfolio ride on the market risk alone.

No wonder index funds and passive investing are such easy sells. The financial industry has all the incentive to continue to promote the EMH and use it as an excuse for their own incompetence.

Even History Doesn’t Support the Efficient Market Hypothesis

Many studies on the historical performance of stocks classified by asset classes have shown that over reasonably long periods of time, small-cap stocks tend to outperform large-cap stocks, and value stocks outperform growth stocks. Traditionally, this has been brushed aside by asserting that small-cap stocks and value stocks are riskier than the market, so it is not surprising that the returns are higher. However, a study by Ibbotson Associates (now part of Morningstar) goes even further and shows that small-cap value stocks outperform all other asset classes on a risk-adjusted basis.

Professor Greenwald, in his seminal book Value Investing: From Graham to Buffett and Beyond (Wiley Finance, affiliate link), shows that if investors had blindly bought a portfolio of the lowest Price to Book ratio stocks, they would have done better than the market. Even a slight introduction of a value bias improves portfolio performance.

So if the Markets are Efficient, How Can This Be?

Markets are efficient in aggregate, and they are also reasonably efficient for well-understood companies with highly liquid stock. For a large company that has a good number of Wall Street analysts following it, it is understandable that almost everything that is known is reflected in the stock price. Liquidity in the stock ensures that complex computer-generated trades continuously work to exploit any inefficiency that may occur from time to time and quickly erase it.

However, there are quite a few situations where the markets are not as efficient, and one can find stocks that are truly undervalued if one is alert. Here are a few cases where this is true:

• Small-cap stocks that are not well followed: Large institutions such as mutual funds and pension funds tend to avoid these stocks. Typically, these funds avoid buying meaningful stakes in any company as that comes with additional filing requirements and the responsibilities of being a large shareholder. A smaller stake may not make sense for a large fund as any performance advantage of these stocks will just be a blip on their overall portfolio. They are also not covered adequately by Wall Street, as some of these companies are too small to be an investment banking prospect.
• Industry, sector, or stock-specific bull or bear market: In the short term, the market overdoes its exuberance or pessimism for certain sectors or even individual companies. Eventually, the market does settle at the correct valuation, but the discrepancy may persist for a long time. For example, the real estate bubble lasted much longer than expected. Even after it was plainly clear to most market observers that a bubble exists, most institutions could not simply unwind their positions quickly as that would cause an immediate market collapse. A retail investor can move much more quickly than an institution in these situations and take advantage of the gap between price and value.
• Certain cyclical industries go through a boom-to-bust cycle regularly: Metals, commodities, shipping, etc., are a few examples. If an investor can determine that the demand for the product is not eroding, but rather the sector is doing badly due to excess capacity and oversupply issues, then it is just a matter of waiting until the capacity/supply imbalances are corrected for the stocks to recover. If you do your research right, these can be potentially phenomenal stocks to buy and wait for the cycle to repeat.
• Unwanted stocks, special situation stocks: A stock is sold off by funds when they no longer fit the charter of the fund. This is generally done regardless of the investment merit of the stock. When this happens, a small window of undervaluation is created that can reward investors handsomely. The following are some of the few common situations where this happens:
  • A stock leaves a popular index, causing all the funds that invest in this index to sell the stock.
  • A large company spins off a small division, and the funds holding the parent company are not interested in the smaller spun-off company.
  • Mergers and acquisitions involving part or all of the acquired company where the market is not clear about the fundamentals of the business being acquired.
• Aggressively marketed stocks: If there is one example of a situation where sellers are privy to more information about the company than the buyers are, it is the IPO market. This is one case where insider selling is legal, and it is not a surprise that the buyers in the IPO markets generally lose. 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).

Market inefficiencies create undervaluation that an investor can buy into. In some other cases, it can also create overvaluation that an investor can sell into or avoid. It is beneficial for a self-managed investor to be alert for these situations, as the difference in performance between a value-biased portfolio and a market-neutral portfolio can be very significant over the life of the portfolio. Make sure you look for investments outside of the typical Wall Street research and research the company deeply to understand its business and prospects. If the stock has been left for dead, but the business is humming along, it can be a terrific investment. These are the hidden corners of the market where the best stock picks lie, and if you do not look for them yourself, you will never find them.

And this is why Warren Buffett and other investors believe that small investors have a great advantage over Wall Street. We are largely unconcerned with such things as stock liquidity, float, market caps, etc., which often stymie the large institutions. We can focus solely on the business fundamentals for our investment decisions.

Note: A version of this article appeared at Business Insider on Jan 7, 2012.

Photo by Jakub Żerdzicki on Unsplash