Many investors who believe in fundamental analysis and stock picking are usually strong opponents of Efficient Market Hypothesis (EMH), a fancy theory published by a group of economists at the University of Chicago during the 1960s. In simple terms, the theory postulates that any new information about a company is fully and immediately reflected in the price of its stock. So, the theory suggests that it is not possible to beat the market returns by selectively and actively buying stocks based on fundamental analysis. Instead of pointing to Warren Buffett’s consistent track record and dismissing EMH as entirely flawed, I am more sanguine about it. Most of the time, the marketplace incorporates any new information (e.g., product failure, profit warning etc.) pretty quickly by adjusting the stock price. On a case-by-case basis we can evaluate whether the level of correction is appropriate or excessive.
That brings us to the key question: if markets are generally efficient most of the time then what “edge” do we have as investors that will enable us to beat the market returns over the long term? To answer that question, let’s look at the key assumption of EMH — investors and markets are rational and objective and act swiftly to eliminate any discrepancy between stock price and the value of the business. However, in real life, there are many more factors that come into play which introduce frictions and restrictions. These factors lead to security prices that are not true indicators of the value of the business. Our edge is our ability to exploit some of these frictions in the marketplace and, therefore, deliver superior investment returns. Let me outline a few such frictions that gives us an edge over large asset managers and Wall Street institutions:
Too focused on short-term: Most research analysts on Wall Street issue 12-month price targets for the stocks they recommend. They are evaluated on how accurate they are in predicting stock price over the next 12-month period. It doesn’t matter how good/bad they are at estimating the long-term business prospects. Of course, in many cases, the stock price tracks the change in business prospect of a firm, but not always. In those cases, where there is a divergence between the business’ long-term prospects and the price, we can exploit those opportunities to build our long-term portfolio of investments. I am not talking about 12-month or 24-month periods here; we are investing for the next 5, 10, or 20 years. So, we don’t have the pressure of being right about stock price over the next 12 months. We have seen in so many cases that when a business starts to invest for the future and its profitability takes a hit in the short-term, Wall Street analysts rush to the exit as they are unlikely to see the returns of those investments in the next 12-months. We actively look for those opportunities to buy our favorite company stocks at a cheap price. The market is quick to incorporate short-term news and quarterly results etc. But, it is not so efficient when it comes to incorporating the long-term business prospects of the firms.
Small cap limitation: Investing a small amount in a small cap company is typically not worth the time of a fund manager who is managing billions of dollars. For a large $2 billion mutual fund or hedge fund, investing just $5 or $10 millon in a small cap company doesn’t scale well. That works to our advantage. Because of these restrictions (issues of scale of investment and lack of public awareness, etc.), small cap stocks provide a good hunting ground for us. Small investors are well positioned to take advantage of the inefficiencies in the small cap world. In 1999 at Berkshire Hathaway’s annual meeting, Warren Buffett said: “If I had $10,000 to invest, I would probably focus on smaller companies – because there would be a greater chance that something was overlooked in that arena.” He went on to say, “I could name half a dozen people that I think could compound $1 million at 50 percent per year. But they couldn’t compound $100 million of $1 billion at anything remotely like that rate.” To be clear, we don’t expect to compound anywhere near the rate of 50 percent per year! But, investing in small caps is an edge individual investors have over larger money managers. Small cap stocks can be risky. So, it is important to make sure that small caps are a reasonable allocation of our well-diversified portfolio.
Overreaction: Too often we see that if a company doesn’t meet its quarterly result expectations then the stock price drops a disproportionately large percentage point the next day. Part of the reason for this is probably because our brain is prone to recency bias – putting too much weight on recent events. In addition to recency bias, the obsessive short-term focus of Wall Street and the financial media make stock price overshoot the rational level of correction. As long as the long-term investment thesis is intact, we can try to take advantage of those situations if it happens to one of the companies we own or have been watching.
Machine-driven mass selling/buying: In recent years there has been a significant rise in high-frequency trading (HFT) and in the popularity of ETFs. As market sentiment changes about different sectors of the economy, money flows in and out of these ETFs impacting the stock price of all companies, including great companies in those sectors, in those investment vehicles. So, the baby gets thrown out with the bathwater. We love buying in those waves of indiscriminate selling in the marketplace. (Consider the mass selling of energy related stocks during the Gulf of Mexico oil leak as a case in point or during the COVID crash of 2020 March.)
It is not an easy task to identify and take advantage of these inefficiencies. That’s where bottom-up analysis of companies and calculating a range of intrinsic values come in as a handy reference point. Armed with a reasonable estimate of what the business is worth we can buy those stocks on the cheap when such an opportunity presents itself.