No such thing as an 'efficient market'
Thursday 20 January 1994
The academics who believe in the so-called efficient market theory argue that, nowadays, analysts receive all the information necessary to value a company and ensure its shares are correctly priced. They go on to say that investors who regularly beat the market are lucky and are the kind of statistical exception that proves the rule.
I prefer Elmer Letterman's view that 'luck is what happens when preparation meets opportunity' and Gary Player's remark that 'the harder I work the luckier I get'.
I believe that the efficient market theory is absolute nonsense. The most amusing and complete refutation of it was argued by Warren Buffett in 1984 in Appendix 1 of the classic investment book The Intelligent Investor.
Mr Buffett asks you to imagine that 225 million Americans engage in a coin-flipping competition of 20 flips starting at a dollar and doubling up each time. This would result in 215 people winning every flip and, as a result, making over dollars 1m each.
DEFYING THE THEORY
Mr Buffett anticipates that the 215 winners would become a bit cocky and soon begin telling everyone the secrets of efficient and successful coin-flipping. They would say to the sceptical academics: 'If it can't be done, why are there 215 of us?'
The academics might reply that the same competition with 225 million orang-utans would have produced 215 victorious orang-utans.
Mr Buffett then goes on to point out that if 40 of the 215 victors had come from a particular zoo, you would begin to wonder if you were on to something. You might question the zoo-keeper and ask if he had been feeding the 40 orang-utans something special, or exercising them in a special way, or what books they read.
At this point, Mr Buffett draws attention to the remarkable investment records year by year (flip by flip) of the main value investors (the 40 winning orang-utans) who followed the teachings of Graham and Dodd. The nine investors in question, including Mr Buffett himself, were all close and early disciples of Ben Graham and subsequently became managers of very substantial funds. Their detailed track records make it clear that they consistently beat the market by a wide margin and over a very long period. Mr Buffett's key point is that they all had the same intellectual origin. They all followed the teachings of Graham and Dodd and were among the very few big fund managers who did so. They all had a similar approach, method and discipline and that, not luck, helped them all to achieve such exceptional results.
VALUE FOR MONEY
A successful investor needs a discipline - a method to focus on and temper, refine and improve by constant practice. All systems of investment really come down to one basic idea - trying to seek out shares that offer value for money. This means buying a share at a discount to its real value. The share price is there for all to see, but establishing the real value and making sure that the share is a bargain is where the difficulty arises.
Graham and Dodd had several different approaches, but are best known for buying assets at a discount. Mr Buffett expanded this concept with a wider interpretation of asset values by including competitive advantage in the form of business franchises and brand names.
Another simple method is to buy growth stocks with low PEGs (price-earnings growth factors) - prospective price-earnings ratios that are low in relation to their estimated future earnings growth rates. This is equivalent to buying growth at a discount.
A further well-known approach is to buy high-yielding shares - which I like to think of as yield at a discount. This is a simple and reliable method that beats the market regularly by a sufficient margin to refute, on its own, the efficient market theory.
Next week, I will write about how and why the high yield approach works so well.
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