Some interesting comments below from an article by James Duglosch who I discovered over at the MSN Strategy Lab where the Value Doc used to pick stocks. This guy used to work with Al Frank of the Prudent Speculator.
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Failures of efficient markets offer opportunities
November 17, 2004 00:01:00 (ET)
Editor's note: James Dlugosch is editor of The Rational Investor.
MINNEAPOLIS (CBS.MW) The efficient market theory, the same theory that gave rise to the trillion dollar index fund industry, is in serious trouble and that's a good thing for rational investors.
Over the years, the market has proven to be quite illogical at times with little damage to the idea that markets were highly efficient in pricing stocks. That seems to be changing with the earth shattering paper from the intellectual founder of efficient market theory, Eugene Fama.
At a conference of leading economists and business executives Mr. Fama presented his paper with the striking admission that stock prices could indeed become "somewhat irrational." Such a dramatic reversal, while admittedly subtle, could very well redefine the way investors view the markets.
In reporting the news, the Wall Street Journal quoted Fama's long-time nemesis, Richard Thaler (leading advocate of the "behaviorist" school of economics) as saying, "I guess we're all behaviorists now."
The behaviorists have long believed that markets were in there very nature inefficient because market participants were humans often acting on emotion.
The change is significant in that believers of the efficient market theory have dominated the discussion for nearly 40 years. Fama's influence over that period has been wide and deep having spawned a generation of academicians and professionals following its tenets. The entire index fund phenomenon can be attributed to the work of Fama and his followers.
Efficient market theory relies on a belief in perfect information that is immediately digested by the market thereby providing the truest measure of corporate value. Inherently no one has an advantage since in theory all investors have access to the same data at essentially the same time. Trying to beat the market becomes an exercise in futility.
Armed with the backing of the ivory tower John Bogle started his index fund juggernaut, Vanguard Funds. According to Bogle, if you can't beat the market then it only made sense to own a basket of stocks that tracked the market. Such a portfolio would be easy to manage and therefore more cost effective as compared to actively managed accounts.
The overwhelming success of Bogle and the rest of the index fund industry are well known. The combination of low pricing, academic research in favor of indexing, and a long running bull market ensured success. With the academic research crumbling amidst the end of the elixir based bull market will index funds survive?
The behaviorists theorize that a market made up of human beings is inherently inefficient. Undoubtedly some event will occur that causes markets to break down due to irrational behavior.
Opportunistic investors therefore can find opportunity in the wreckage of fearful selling or exuberant buying. The conclusion then is that stock pickers and savvy investors operating in an inefficient market should be able to outperform the indexes on consistent basis.
For much of the two-decade bull market such an approach did not have many fans. The overwhelming evidence at the time, especially towards the end of the millennium, favored the random walk down Wall Street. Even the venerable Wall Street Journal weighed in with its "throw the dart" column.
It was very difficult to be a stock picking professional in the 90's. If the barber and grandma can pick stocks effectively then maybe there is something to this efficient market theory after all. The bursting of the technology bubble would change all of that.
Finally, the behaviorists had clear evidence that the market may not have been as efficient in pricing as once thought. Mr. Thaler, who manages $2.4 billion in search of inefficient pricing, was able to demonstrate just how crazy the market was in a paper titled, "Can the Market Add and Subtract."
In that paper he noted that shares of Palm (PALM, Trade), 94 percent owned by 3Com (COMS, Trade), soared in value during the bubble thereby giving the remainder of 3Com's assets a negative value. Clearly such pricing was not rational. In the years since the bubble burst there have been numerous examples of inefficient trading.
Such may be the reason for Mr. Fama's change of heart. Stock pickers have dominated the indexes over the last few years and clearly something is amiss with the efficient market theory. To his credit, Mr. Fama does say he never believed in the purest form of his theory as evidenced by his own outperforming of the indexes with his $54 billion money management operation. Nonetheless, changes are brewing and Mr. Fama's new paper will go a long way for those defending the behavioral methodology.
As a Rational Investor, I received my training from some of the very descendents of Mr. Fama. Unable to afford The University of Chicago, I attended a public university that was filled with professors who obtained their PhD's under Mr. Fama. The finance models of Chicago permeated all of our lessons.
Fortunately, I was able to think for myself and question some of the truths that were being handed down to us. With a little help from a behavioral economist, I was exposed to a different theory that relied on finding value at the expense of irrationality. After my graduate work, those lessons were sharpened with the real world experience and tutelage of my mentor Al Frank.
Al had a remarkable skill in finding value in the market mostly due to inefficient trade. I've honed my own skill and have used that to nearly double my model portfolio since I began publishing The Rational Investor two years ago. In that time there have been many instances of irrationality that have created opportunistic trades.
At the end of 2002, the market was littered with companies that were perceived to be going bankrupt. The market priced that perception perfectly, but was ultimately wrong in assuming that these businesses were finished. Tesero Petroleum (TSO, Trade) and Metris (MXT, Trade) are two examples of businesses that not only survived but thrived. Investments in each resulted in significant profits and are still powering forward in the model portfolio.
Another great example of irrational trade is relates to SEC investigations and earnings restatements. Once again market participants of companies involved in such a quagmire assumed the worst. Prices plummeted immediately on the news of any numbers shenanigans leaving a juicy buying opportunity for Rational Investors. Elan (ELN, Trade) and Nash Finch (NAFC, Trade) are two great examples of profiting from such inefficiencies.
A third type of market trigger for Rational Investors can occur when the market perceives weakness in formerly strong industries. Prices in these situations tend to be muted, depressing valuation as compared to earnings growth.
The homebuilding sector in 2003 is a great example. Almost every participant in the sector traded for single digit multiples to earnings that were consistently growing at 20 percent to 30 percent. Buying Toll Brothers (TOL, Trade) and KB Homes (KBH, Trade) were two ways I participated in this massive undervaluation.
In current market the action in the oil sector is the clearest example of irrational behavior. Most experts agree that huge speculation, on the merits of tight supply and geopolitical instability, has driven a significant percent of the recent rise in oil prices. The absence of these buyers could trigger a dramatic fall in the price of crude.
The tightest correlation to the oil market is in the airline industry. That sector has been one of the poorest performers in 2004 due to increases in jet fuel prices. As a result of the operating difficulty, astute managements are negotiating huge concessions from labor unions. With improving oil markets, profit margins are poised to widen.
I would look closely at AMR Corporation (AMR, Trade), Delta Airlines (DAL, Trade) and Northwest Airlines (NWAC, Trade). All three of these traditional hub and spoke carriers have extracted savings on labor costs and should benefit greatly if and when oil prices fall to a more normative state. The selling in this sector has been overdone with the assumption that oil would continue its ascent. Owning airline stocks represents a fantastic way to profit from such inefficiency.
At the end of the day, I am always searching for conditions of inefficiency and I believe quite strongly that the markets are far from efficient. There is no better way to uncover value and it is the only way to ensure market beating performance. While I can't tell you what the market will do from one day to the next, I can almost assuredly tell you there will be more examples of irrationality for us to exploit down the road. |
