Value investing is a bit like a Toyota car – it just works.
Proponents of the efficient market hypothesis (EMH) will tell you it is impossible to beat the market or predict stock prices. The idea behind EMH is that a stock price incorporates and reflects all the information that is available and as a result, the price that you see is always the fair value price.
There are a few different forms of this hypothesis – the weak, semi-strong and strong forms – but they all refer to the amount of information reflected in a stock price. For example the strong form suggests that stock prices even incorporate insider information, while the weak form states that stock prices only reflect all past publically available information.
Why an insider buying stock is not such a great signal?
The efficient markets theory would stress that stock pickers and market timers are bound to fail because additional research would not yield any information that isn’t already baked into a share price. The biggest cheerleaders of this theory often throw out the idea that if you had 100 monkeys throwing darts at a list of stock tickers, you might observe that 9 or 10 of them beat the market but ascribing any skill to their efforts would not make a lot of sense.
Their point is that investors are like those monkeys. The ones that make the headlines are just the lucky ones who got where they are through no skill of their own.
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Value investing works
Efficient Markets Theory comes under its fair share of criticism. Warren Buffett’s rebuttal of efficient markets involved the presentation of nine different managers who beat the market over long periods of time. Now while efficient markets would have predicted that there would be investors capable of beating the market due to chance, the key to Buffett’s case is that these nine managers all shared two qualities, they all used a value investing strategy and had a personal connection to Buffett.
That is interesting. While it is possible that these nine managers simply were the lucky ones – it’s hard to discount that they all share the same philosophy, namely value investing principles based off the teachings of Benjamin Graham and David Dodd. If 10 out of 100 monkeys outperform the market, that’s one thing, but what if all of them were educated at the same school?
In fact value investing is one of the most successful ways to invest in equities and the developer of Efficient Markets Theory, Eugene Fama, himself pointed out in a 1992 paper that value stocks outperform growth stocks over time – a finding that would fly in the face of efficient markets. He called this the value premium, basically the excess return gained from implementing a value based approach. His analysis spanned the years between 1926 and 1963 and researchers have replicated these results for other time frames and in different markets. In fact, research shows that value outperformed growth in 12 out of 13 international markets between 1975 and 1995.
If markets are truly efficient, then it would be a fool’s errand to try and beat it. Whether it is the weak to semi-strong and strong forms of efficient markets, the mispricing of assets that value investors thrive on would not occur.
Here are a few reasons markets may not be efficient
Human behavior is complicated and fallible
Behavioral economists have known for a long time that people are not completely rational beings and that behavior plays out in the financial markets, where we see evidence of herding behavior, speculation and mania.
Trends are real
There are curious trends that researchers have identified in markets, trends that play out over and over again.
For instance, there’s the January effect, a seasonal increase in stock prices that takes place in January. Usually this increase is attributed to a flurry of buying following the selloff that occurs in December as investors get rid of losers in order to optimize their taxes come April.
Then there’s the size effect. This phenomenon tells us that companies with smaller market caps tend to outperform those with larger market caps – even if you control for risk. Fama again pops his head here, as his research showed that small-cap stocks returned 4.5% in excess return over larger-cap stocks.
Research also confirms the existence of the momentum effect. Companies that performed the best in the past (between 6 to 12 months ago) tend to perform better in the future than firms that performed worse over the same period. The reason for this effect is debated, but likely has to do with investor psychology – people want a piece of what’s hot.
All of these examples suggest that markets are in fact, inefficient. Efficient market theory points to the idea that prices of securities in financial markets would be random, and the existence of the market anomalies pointed out above show us that they are anything but.
The bottom line
The reality is that efficient markets theory is a tool, one that can help investors think about markets in more optimal ways and is not and should not be the gospel.
For the most part, information about stocks does flow fairly “efficiently” across the markets but there will always be pockets where inefficiencies take hold. If markets were 100% efficient then stock prices would immediately adjust to new information and then stay there. Stock price charts would just look like flat lines with immediate jumps to lower or higher prices. Currently that is not what price charts look like. Instead we see investors underreact and overreact to information. We see corrections and wild speculation in equal measure.
It is perhaps fair to say that markets are inefficient in the short-term and efficient over the long-term.
The beauty is that if you understand this tendency of financial markets then you can take advantage by employing a value-investing framework. Where fear and confidence drive other investors, the value investor, by using the concepts of intrinsic value and margin of safety, can safeguard his or her principal and focus on positive long-term rewards.
Smith, Noah. “The Fundamental Reason Buffett Beats the Market.” Bloomberg.com. Bloomberg, 24 Aug. 2016. Web. https://www.bloomberg.com/view/articles/2016-08-24/the-fundamental-reason-buffett-beats-the-market
Fama, Eugene and French, Kenneth. ”Value versus Growth: The International Evidence.” https://faculty.fuqua.duke.edu/~charvey/Teaching/IntesaBci_2001/FF_Value_versus.pdf
Wharton, UPenn. “Financial Market Anomalies.” http://finance.wharton.upenn.edu/~keim/research/NewPalgraveAnomalies(May302006).pdf
Malkiel, Burton. “The Efficient Market Hypothesis and Its Critics.” http://www.sfu.ca/~kkasa/malkiel.pdf.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.