In The Risk Return Fallacy, we showed that a portfolio filled with undervalued stocks will generate higher returns with lower risk than a portfolio filled with overvalued stocks, provided the stock prices revert to their underlying values over time. A value-based investment strategy, in other words, removes the link between risk and return.
But, does the market really offer stocks at prices substantially below their underlying value?
Market efficiency is a funny thing. Anyone that has participated in the public equity markets for more than a few minutes knows with certainty that the market is far from efficient. The academics and intellectual elite look at the market from thirty thousand feet and claim that it is.
We suspect the differences lie in a person’s point of view and in their definition of what market efficiency really means. The academics look at aggregates and speak in broad sweeping terms. The practitioners are in the details of the moment. The academics accuse the practitioners of being too deep in the weeds to really understand the broader markets. The practitioners accuse the academics of having their heads in the clouds.
We don’t need to tell you where we stand on this topic. The market may very well be efficient from thirty thousand feet, especially if the definition of efficient is very carefully crafted.
What the market looks like from thirty thousand feet and how it compares with the intellectual elite’s definition of efficient is of no interest to us. We simply don’t care.
Our primary interest is whether the market price of a specific security on a specific day deviates materially from its underlying value. Looking at the facts and circumstances of the publicly-traded equity markets, there is no doubt that specific stocks are occasionally mispriced in the market.
In making our case, we will draw on both the mechanics of the markets and the price action of specific securities.
With respect to market mechanics, some people looking at the market from thirty thousand feet incorrectly assume that market prices somehow reflect all available information about that particular security. The imbedded assumption in that view - although never stated explicitly - is the market somehow canvasses all the potential buyers and sellers of that security and magically incorporates all the known information about that security into a price and presents that price to the market. That’s a complete joke. Nothing could be further from the truth.
A market price, it is important to note, is the most recent transaction between one seller and one buyer. If the buyer gives up $50 for a share of stock and the seller takes the $50 and gives up the security, the market price for that security is $50. The closing price for a security at the end of the day reflects the last transaction that happened to occur on that day.
The people and institutions that actually hold the stock and the people and institutions that know something about the stock and elect not to hold it may have very different views about the underlying value of the stock than the two individuals involved in the most recent transaction. The most recent transaction in no way incorporates any of those other views.
The market price, then, is not some sort of consensus of market participants nor is it even a majority opinion. It merely reflects the most recent transaction.
Any claim of market efficiency at the individual security level must somehow assume that each of the market participants involved in the most recent trade not only had all the available information about that particular security at that particular time, but also acted in a way that was consistent with all that information. We have seen and interacted with thousands of market participants; believe us when we say many of them transact day in and day out with very little information about the security or the underlying business it represents.
If each of the participants of the most recent transaction did have all the available information about the security and acted in a way that was consistent with that information, there would be no basis for a trade. The very basis of the transaction requires that the two participants have different views about what the security is worth. The buyer believes the security is worth more than the transaction price and the seller believes it is worth less. That is what creates the transaction.
The mechanics of how the market works blows holes in the Efficient Market Hypothesis. The conditions precedent for a mispriced security do not require that the whole market gets the price wrong; it just means that one schmuck is willing to sell a security at below its underlying value. All other participants could be perfectly rational. There are lots of schmucks out there.
With respect to the price action of individual stocks, we likewise see plenty of evidence of inefficiencies.
The price of Amazon stock, for instance, has compounded at just over 30% annually for the last 25 years. If the market were perfectly efficient at pricing securities according to underlying value, it would have placed a value on the stock 25 years ago that reflected its cash generating potential from then to eternity. The price of Amazon stock would have been much higher back then to reflect that potential and compounded based on some time-value-of-money formula, which would have substantially less than 30%.
That of course never happens. There were lots of uncertainties associated with Amazon’s business 25 years ago. The market is no better seeing through those uncertainties than individual participants in the market. The market cannot magically predict the future.
Amazon stock didn’t reflect what turned out to be its magnificent earnings and cash generating potential because its magnificent earnings and cash generating potential were far from certain 25 years ago. The market doesn’t have some magic window on the future. No one claims the market is that efficient.
But wait. If underlying value reflects the future cash-generating potential of a company discounted to the present at some appropriate discount rate, what we are implying when we say the market cannot magically predict the future is that market prices cannot reflect true underlying value. It just isn’t possible. Short of some magic crystal ball, which doesn’t exist, there is no way the market can be perfectly efficient.
