What Does the Efficient Market Hypothesis Mean for Value Investors?
The efficient market hypothesis suggests that stock prices always make sense. Can value investors still find bargains in the market?
Everyone seems to have an explanation for daily fluctuations in the stock market. (Unsurprisingly, no one's making obvious money hand over fist by exploiting these fluctuations.) One of the most popular explanations of stock prices is the efficient-market hypothesis.
What is the Efficient Market Hypothesis?
The efficient market hypothesis is a theory of stock prices which suggests that the market as a whole tends to find the best price for stocks all the time. At any point in time, the price of any stock reflects all of the information available about that stock (and the underlying business). There are no undervalued or overvalued stocks because the current price is always fair (or at least reasonably close to fair).
On its surface, this makes some intuitive sense. The market is a weighing machine. At any point in time, the price of a stock represents an agreement between buyers and sellers. The most recent successful trade represents a price where someone willing to sell a stock found someone willing to buy that stock.
For a huge stock such as Ford, Coca-Cola, or Google, millions of shares trade hands every day. Thousands (hundreds of thousands?) of buyers and sellers make trades every day. For everyone who's bullish about the stock and wants to buy, there's someone else bearish who wants to sell. You can see those trades take place and the price fluctuate, but does the price really reflect all of the knowledge about the stock?
The theory is interesting, but it doesn't always work in practice.
Assumptions of the Efficient Market Hypothesis
One of the biggest problems of the efficient market hypothesis is that it assumes that the most recent transaction of the stock reflects the information available about the company. For the hypothesis to work, a buyer and a seller must actually complete a transaction. If one person believes that Coca-Cola is about to quadruple in price and wants to buy a billion shares for $0.01 apiece, what are the chances of finding enough sellers to fill that trade at that price?
Is an offer to buy at $0.01 a legitimate piece of information about a stock? Maybe it's not a realistic view or a realistic offer price, but it's a piece of information about that stock. One person believes something outrageous. If that person found sellers, would those transactions depress the value of the stock? Would other people jump on that trend? (What if people had automatic trading rules to sell their shares if KO went below a price threshold? What if several thousand of those rules all flooded the market with offers to sell at a low price? What does that represent about the company?)
Contrarily, what if I believe that my shares of KO are worth $100 apiece and have a standing offer to sell them at that price? That doesn't reflect majority opinion about the market, yet the efficient market hypothesis will agree with my analysis if I successfully complete one trade at that price.
Those are surface criticisms, however. A bigger problem of the EMH is that it fails to account for how easy it is to buy or sell shares. If there simply aren't enough buyers or sellers, how can you assume that the current price represents an equilibrium which, on average, gives a representation of investor sentiment? If only 100 or 1000 shares of Jewett-Cameron trade hands every day, is the sample size enough to represent consensus? Even if how markets and investors value a stock agree in this case, will a transaction actually take place?
The Efficient Market Criticism of Value Investing
Proponents of the efficient market hypothesis have similar criticisms of value investing. The most direct argument is that the market pricing model offers few chances to find inefficiencies. In other words, you're not going to see a stock underpriced long enough to jump on a good value investing opportunity because the market will quickly correct itself. Similarly, you won't find overpriced stocks, because they'll be sold at a profit.
Those arguments don't hold up well. The former is circular ("efficiency means that there are no inefficiencies") and the latter requires strict short-term thinking ("I've made a profit on this stock, therefore there's no reason to keep it").
If you're thinking "That's not the biggest problem with that argument," you're right! Perhaps it's not obviously rational to hold on to a stock that's made a sufficient profit, but to make that assertion, you have to understand ideas such as rational and sufficient profit. Can any single analysis of the price of a stock account for investors as diverse as the pension fund of an American state, a day trader, an elderly retiree, and a 22 year old who's directed all of the contributions of her 401(k) into a S&P 500 index fund? Can the irrationalities of one position counter fully the irrationalities of other positions?
If I'm holding KO because I bought it at $6 per share (adjusted) and want to sell it at $60 per share, what does that say about the underlying value of the stock? If 90% of investors believe a best-case financial forecast scenario and it just doesn't come true, what then?
One of the worst assumptions of the efficient market hypothesis is how it overvalues market price in general. What does market price mean? The market price of a stock is that price, at a fixed point in time, where a buyer and seller agree. That's it. What does that tell you?
Intrinsic Value Versus Efficient Markets
Global financial insecurity may mean that fewer people buy sugary drinks (or automobiles or gasoline or yachts) than if the global economy were flying high, but can you really condense that belief into a single price all day, every day? Can that price really be correct? After all, not everyone with a stake in the price of a stock makes an visible economic decision about that stock every day. Some people buy and hold for years, quite happily.
Meanwhile, the intrinsic value of a stock—the underlying business, its assets, its debt, its ability to make revenue on invested capital—continues despite investor sentiment. Of course, investor sentiment may affect the business's ability to take on short or long term debt, to approve plans which require shareholder votes, and to make other management decisions—but these are discrete events, not continual votes in a second-by-second popularity contest.
Over Time, the Stock Market Is Efficient
Does that mean the stock market is inherently chaotic and inefficient? No. Over time, successful businesses thrive and unsuccessful or unscrupulous business go out of business. A well-managed business may have lean years and great years, but it'll continue making money for its investors. Similarly, a failing business may descend into penny stock status before going bankrupt. Stocks without successful businesses don't last.
There will be inefficiencies in the market. There's incomplete information about stocks. There are fears. There are structural reasons why large players in the market (pension funds, hedge funds, institutional investors regulated by the SEC) can only take limited positions for limited times. More than that, there's asymmetry all over. I may believe that Berkshire-Hathaway is the best investment position I could take but I might not be able to afford $200k per share right now—or no one might be willing to sell at that price.
How Do Value Investors Find Market Inefficiencies?
If the market is relentlessly and maddeningly and unpredictably inefficient, can you still make money investing? Step one is to identify inefficiencies. The second step is determining your taste for profit. Are you a buy and hold investor? Are you willing to be more active and trade a few times a year, when you've made your target amount of profit? There's no secret formula to pick profitable stocks, but if you stick with intrinsic value, pay attention to earnings, and look at how well companies turn investor money into accountable revenue, you may be surprised at how many opportunities the so-called efficient market leaves available.
After all, if the market were truly efficient, no one would ever beat the market's returns—and it's possible to do so.