Does the Efficient Market Hypothesis make sense?

Sep 8, 2014

Beijing, China

Dear Diary,

At 7am on Saturday morning we were still in our hotel room at the China World Hotel, looking down on 8 lanes of traffic...chock a block...and come to a dead stop.

"The last century was America's century," says our Chinese colleague. "This is China's century."

"You know why America was such a success," he continued. "Because it was a fairly free market and such a large market within the US itself. Companies could scale up in the highly competitive internal US market. That would make them larger and more advanced than their foreign competitors, so they could enter foreign markets and easily beat the locals.

"Now, US internal markets are getting gummed up by taxes, debt and regulation. Outside of Silicon Valley, most of the companies are old. There are few new businesses and not much new technology. I think you wrote something about the declining number of start-ups in America. It's a big deal that few people recognize. I think you said it was a result of crony capitalism. The feds subsidize and protect the big boys...and bail them out when they get into trouble. That's why GM and Fannie Mae are still in business. But the little guys can't even get credit.

"China, meanwhile, is full of new companies. Everything is new. And the internal market is fairly free compared to America. about scale...these companies can grow huge before they have to compete on the world markets.

"Take Alibaba, for example. It's a huge company already. It recently introduced a new kind of bank account, where you earn interest a much higher rate than banks in the US. Within a week, it was the 3rd biggest, in terms of deposits, in the world.

"Alibaba is going public soon. It will be the largest IPO ever."

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More evidence of the liberty with which Chinese firms operate comes from a dear reader:
    Bill, I probably shouldn't bother you, but this one (about China) is right on and close to my heart. My wife has been a naturalized U.S. citizen for 3 years, an LPR for 3 years before that/. For the year before that (2007), we were waiting for the I-190 immigration processing. We were married in 2007 in Nanchang, Jiangxi province, her family home town. She had been running a business in Guangzhou. At startup, she went to ONE place for a license. She started to tell the guy she planned to deal in Suzhou silk embroideries, calligraphies, and paintings. He cut her off with, "You want to buy and sell things. Okay." She paid nominal taxes. In the U.S. there is Schedule C, state B&O tax, county property tax, city license and taxes, and aaaarrrgggghhh We own a small "fangzi" in Nanchang and visit China every few years (her daughter is our partner and manages the property). For some time I have felt that China is MUCH more truly "free market" than we are. How tragic!
But let us leave China...[we took the plane back Saturday afternoon]...and return to the subject of these last few diary entries: how to invest intelligently in a world where real knowledge is scarce. (This is the third in our series...we have one or two more coming.)

We grew up with the Efficient Market Hypothesis. The idea was popularized by Burton Malkiel and others in the '70s and '80s...that market prices reflect the sum of real knowledge about a company. Early on, it was clear that, as an investment theory, EMH didn't help very much. Stock prices are 'perfect?' So what? Some stocks still go up more than others; you still want to find them.

And sometimes the whole stock market still seems out of sync with reality. According to EMH extreme swings in stock prices shouldn't happen. Stocks are priced as a rational calculation, the present value of an anticipated stream of earnings, discounted by the interest rate. If the interest rate is 10% -- from a 'risk free' government bond - you'll want to apply the same measure when figuring the value of a stream of income from the stock market too. It wouldn't make sense to accept less...and you couldn't expect more. (We're simplifying...but this is how we understand it.) So if you expect $10 of income next year, when Treasuries yield 10%, it will be worth $9 today. And the following year's income will be worth $8, and so forth. As the interest rate goes down, naturally, the present value of the income stream goes up.

Academics attacked EMH from several directions. Some, such as a well known investor from Omaha, pointed out they were able to get consistent above-market gains, which EMH theory said was impossible. How did they do it?

We recently put the question to Porter Stansberry. His reply:

    I've nearly doubled the S&P 500 in stocks over the past 10 years, beating the market in both bull and bear markets... despite the significant handicap of having to do something on a monthly basis. How could I do that if the market was efficient...?

    And I'm far from the only investor who has proven able to beat the market consistently, over long periods of time.

    These investors aren't lucky monkeys. They all tend to follow the same types of strategies -- strategies that exploit proven anomalies in the market.

    The efficient market hypothesis, on the other hand, is the creation of academics who have never been tasked with making a living by their investments. This is second-hand knowledge of the worst kind. The EMH logic you're aping is precisely the kind of 'phony' knowledge you've written books about.

    But let just give you a few simple examples that make a mockery of the EMH.

    Right now two of the smartest investors in America -- Carl Icahn and Bill Ackerman can't agree on whether or not Herbalife is a fraud. Herbalife, as you probably know has been a public company with audited financial statements for the past 20 years. One extremely knowledgeable investor says it's a ponzi scheme. The other says it's a great business. How could all of the available information about this business be accurately priced into the stock market?

    The answer, of course, is that it can't be. Nor could it ever be.

    Bill, as you know better than anyone else that I know, human beings aren't driven by logic or facts. They're driven by the delusions of their hearts. These delusions are reflected in the price of stocks. That creates frequent opportunities to buy stocks at prices that are attractive.

    Off the top of my head, I can list at least a dozen "delusions" that are almost always available in the stock market...for the sake brevity here are four that I've used in my career to trounce the market over the past ten years...

    1. The most important quality of any insurance company is the ability to profitably underwrite across the insurance cycle. But, there is zero correlation between insurance company stock prices and underwrting track record. Instead, Wall Street values all insurance stocks based on return on equity alone -- even though all professional investors "know" that insurance company earnings are merely estimates that future losses will actually determine. Betting on the insurance companies with good underwriting culture is nearly a free bet that shouldn't exist in an efficient market. This opportunity has existed for as long as there is good data on underwriting and shows no signs of disappearing do to investor "knowledge."

    2. Certain homebuilders -- NVR for example -- have an enormous advantage by not owning any land. Rather than tying capital up in landholding, they merely option the land they need, at the time they need it. These facts were clear for all investors to "know" and have been for at least the last 25 years. At yet... the human bias to desire land is so strong that not only do these firms rarely trade at a premium to other large homebuilders, they frequently will trade at a discount. Meanwhile, the performance of the 'land-less' homebuilders dwarfs all of the "landed" homebuilders, both on annual measures (like returns on assets and equity) and in terms of stock performance over the long term. No one on Wall Street has ever mentioned this advantage, and, in fact, Wall Street and most professional investors continue to publish research professing a desire to own the land banks inside most homebuilders.

    3. Investors favor buying puts rather than calls. Investors irrationally fear losses far more than they desire gains, leading to a permanent imbalance in the demand for put options as opposed to call options. This imbalance makes it easy for investors to invest in put options (buy selling them) and immediately gain an advantage over other investors who are unwilling or unable to sell puts. We've used this advantage produce market beating average returns in stocks while taking much less risk in my Stansberry Alpha product.

    4. Credit investors are far better informed and far more rational than equity investors. Frequently credit investors will price a firm's debt at a price that indicates bankruptcy is an inevitability. In nearly every case, these firms do in fact go bankrupt. Meanwhile, equity investors will value the attached common stock as being worth hundreds of millions of dollars, when in fact, there is no possibility of even making the bond investors whole. Shorting these stocks is sometimes even possible after bankruptcy has been announced and after the company has publicly advised its shareholders that no recovery is possible.

    5. Okay.. one more... frequently there are opportunities to profit from publicly announced mergers, acquisitions, spin offs, and special dividends. Warren Buffett claims that will relatively small amounts of capital, investors can routinely earn 50% annually exploiting these anomalies. I can recall buying shares of Anheuser Busch in the fall of 2008 for less than $56 per share within weeks of a fully funded, all-cash offer of $70 per share. While this is, admittedly, a dramatic example, you couldn't argue that all of the information about this deal wasn't "known" to the market participants.

    6. Just one more... The entire stock market continues to be priced according to "earnings" -- which are derived from FASB accounting. These accounting methods were developed by the PA Railroad more than 100 years ago. They are nearly useless for evaluating companies that have low capital investment requirements. This continuing anomaly is largely responsible for Buffett's success... and mine. It's easy to build a model that will always outperform the S&P over any reasonable period of time (5 years) by simply focusing on companies with good margins and low capital costs. These firms will produce higher cash returns for investors per dollar of sales. Again, this information is available to all investors... And yet most investors continue to believe what they "known" about earnings -- much of which isn't so.
Not only are individual stocks and groups of stocks often mispriced. Sometimes, the whole stock market wanders far from the path beaten for it by EMH. The discounted stream of income from the stocks themselves tends to vary far less than actual stock prices. As everyone already knows, the market goes up...and then it goes down. It doesn't seem to be doing the math EMH supporters think it should.

Robert Shiller, among others, looked back at what investors actually did, as opposed to what EMH said they should have done. This "behavioral finance" approach demonstrated a wide gulf between EMH theory and real world investor activity: "As tests were developed, they tended to confirm the overall hypothesis that stock market volatility was far greater than the Efficient Market Hypothesis could explain."

Again, as any old-timer could tell you, investors are moved by greed and fear...often becoming too bullish...and sometimes too bearish.

This, of course, was obvious. Shiller went on to explain what Buffett, Stansberry et al were really doing. The 'smart money' takes advantage of the irrational behavior of other investors, he said. When investors misprice a stock, which he referred to as an "innovation," a smart investor with a sharp pencil and a clear mind buys the stock. Inevitably, the stock returns to a more reasonable price and the smart investor makes more than the great mass of emotional, greedy, fearful investors.

Readers will recognize our own Simplified Trading Strategy STS as a way to "time" the market at these extremes of greed and fear. According to the EMH theorists - as well as many Graham and Dodd value investors - timing the market is impossible. But just as a single stock is sometimes extremely over, or under, valued, so is the entire stock market. Our system is just a blunt, and rather stupid, way to take advantage of the same anomaly. Shiller described the difference between the 'smart money' and the rest of investors in a way that makes most investor seem innumerate. Rather than do the numbers, they read the paper...react to the news and opinions...and are greatly influenced by recent history. They are 'feedback investors,' he says.

As stocks move higher and higher, in a bull market, more and more people come into the market hoping for quick and easy profit. These unsophisticated investors are particularly 'feedback' sensitive. They have not done the math. They don't know the real value of the shares they buy. They bid them up. Then, seeing the stock market rise, they become convinced that it is going higher still. The smart money sees this as irrational behavior...

"Find the trend whose underlying premise is false," says George Soros. "And bet against it."

As we have seen in our discussion of the asymmetry of knowledge, it is easier to know what is false than what is true. The STS gives us a way to profit from it.

More tomorrow...including how much you could have made with STS, had you lived as long as Irving our series continues.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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