Over the past couple of years, events like the Internet and more recently, the Enron and Global Crossing debacles, have spurred people to reconsider the Efficient Markets Hypothesis, “EMH.”
For those unfamiliar with EMH, here’s a brief textbook definition: prices of securities fully reflect available information. Investors should expect to obtain an equilibrium rate of return. “Semistrong-form” EMH asserts that stock prices already reflect all publicly available information. “Strong-form” EMH asserts that stock prices reflect all relevant information including insider information. “Weak-form” EMH asserts that past prices are of no use in predicting future prices. The leading argument in favor of market efficiency are studies showing that, on average, actively managed investment funds under perform market indexes, suggesting that as a whole, investment professionals don’t obtain greater than equilibrium rates of return.
During my Christmas break, the question was even taken up by a professor in an online philosophy study group, who very precisely asked: “Does the current price *always* reflect the best evaluation possible given the available data, or does the price sometimes (for more than an hour) get out of line with that data?”
This is an incredibly important question. Its answer has profound implications for one’s investment choices. If markets are perfectly efficient, then one should have no interest in securities analyst or actively managing one’s portfolio — those would be useless tasks. Even with “semi-strong” market efficiency, in which all public information is reflected in security prices, the same conclusion would be reached.
Over the past years working as an equities analyst and portfolio manager, I’ve had to deal with this question every day. So I can offer my observations on the subject.
I think securities markets reflect the opinions, contexts, and knowledge of its participants, roughly weighted by their level of participation. Different participants dealing in a given stock have different approaches to investing, different information they focus on, different motivations, financial resources, risk tolerance, and different levels of knowledge. A given security price at a point in time reflects these inputs.
As an equity analyst, it’s my job to try to find situations where the views and actions of market participants for a security or market fail to reflect some significant facts of reality.
One analyst like myself cannot ever know a greater total number of facts about a company than the sum of market participants. But an analyst can make good use of his time by trying to find a few facts about a company that he believes are very significant but are under-appreciated by participants, and thus not given enough weight in its stock price.
For example, a year ago, a large number of telecommunications firms had high debt balances and interest burdens relative to their revenues. Those who were writing reports and those who appeared to dominate the trading of these stocks tended to either ignore this fact altogether, or dismiss it as insignificant, given their expectations of high future growth.
Analysts appeared to count on the availability of new equity or debt financing to support these companies.
But my analysis suggested only incredibly unlikely sales growth rates would save these companies, and I doubted that new investors could be found to provide money at interest rates acceptable to already cash-poor firms. So my firm went short these firms, and the trades generally worked, because in time, the companies’ business slowed, and an increasing number of market participants became aware of and increasingly concerned about the issues I noted, eventually made obvious to all by bankruptcy announcements.
There are times when this approach works terribly.
From about 1998 through mid 2000, equity market participants paid almost zero attention to balance sheet issues. For example, if someone has key information about a company, but the company decides to not fully disclose its problems for some time, then their trade could fail before it becomes an important issue. Many people lost money shorting Enron, Global Crossing, and Tyco in past years, despite having a superior understanding of their businesses. Or sometimes, a company is just stronger than people ever imagined — AOL had accounting issues many years ago, but the company’s sales ultimately skyrocketed and overwhelmed doubters’ concerns.
Some dispute the EMH by noting that market prices rarely conform to their calculation of “intrinsic value.”
Stock prices mostly reflect participants’ expectations about the future, and not just the data of the present. One can try to predict events that will lead to estimates of future cash flows from a company, but these events are subject to the choices and actions taken by multitudes of individuals. The advocate of intrinsic value says — I built a model for this company predicting the next thousand years of cash flow of this company, and predicted the exact investment return that millions of people will require from this company’s stock, which tells me that the stock is actually worth $57.23, not the $52.50 that the last buyer yesterday prescribed to it. Anyone who trades the stock at a price other than $57.23 is irrational, (until I next update my model).
Using “intrinsic value” this way is wrong because a company is not a chemical reaction — the combination of a certain amount of water and sodium always yields the same product, but the combination of human inputs does not always lead to the same results, due to human free will. Yet valuation estimates such as those used to arrive at “intrinsic value”, when used rationally, can be a useful tool. Sometimes a stock or a group of stocks will, for a time, be priced in a way that is different from what one could reasonably expect to ever get back from it. There were many examples among internet stocks where companies were priced as if they were expected to gain something like 300% of the world’s market share in their industries. In such a case, the odds are strongly against such a company succeeding enough to justify its stock price.
Consider the example of a biotech company XYZ. Let’s simplify and say that there are two key issues for this company: it’s researching a potential multi-billion dollar drug, and has great scientists; also the company has racked up large debts, is running out of cash, is behind schedule, and has no current source of revenues. The company may be worthless, or be worth billions. Let’s say that you know absolutely that the company’s scientists will never figure out this drug, and so it would have ongoing negative cash flows, an no investment worth. So you short the stock, and wait for it to declare bankruptcy. But you didn’t know that a larger drug company has scientists who think that their research plus XYZ’s patents will lead to the discovery, so they acquire the company XYZ at twice the current stock price.
Was the market efficient? Should the market have predicted the acquisition or should it have predicted bankruptcy, or was it right for the stock to vary between both poles, depending on the levels of optimists in the market? The problem was that the XYZ was objectively a worthless company to all but one market participant. And what if the acquirer’s scientists hadn’t noticed XYZ’s patents?
It’s a simple example, but this principle affects all companies and securities to varying degrees. For Nabisco, the question isn’t the dramatic one of whether it successfully develops a drug, but hundreds of millions of successes or failures selling cookies at the store.
So what’s my conclusion about the EMH? I think it is possible to make extra money betting against market prices. But it’s extremely difficult to do so consistently, and it’s never a sure or easy thing to do — even insiders lose money. And even if you can exploit what you think are inefficient market prices, you’ll never convince a finance professor who’s a true-believer in EMH that you did so without taking on extra risk. Most people will do themselves a favor if they act as if semi-strong EMH holds in the long run, that the current price is the best price, and invest in index funds. But a few people, having unusual knowledge and skill, and willing to bet on their brains against the rest of the world, should go for it. Let’s hope that the NYU finance MBAs are unusually rich in such abilities. After all, as Warren Buffet said, “I’d be a bum in the street with a tin cup if the markets were efficient.”
