# Are markets efficient?



## Marc

Free Markets: Information, Prices, Risk and Return

EMH = Efficient markets hypothesis

See [broken link removed] for more 


Active*investors in contrast to passive investors believe that they can beat the market. To beat the market without accepting more risk is possible only if you posses information that is not known to the market. It must be information that only you or a small group of investors are aware of. As a result, all active investors or traders should ask themselves these questions before trading:


Why wouldn’t this information already be embedded in the price?
Is this inside information or is it information that is well known to all investors?
Is there a convincing reason to assume that the current price is unfair?
The vast majority of investors trade on publicly known information (earnings forecast, revenues forecast, expected resignation of a CEO, past price trends etc.) that is already incorporated in the prices of publicly traded securities. *Therefore, there is no convincing reason to assume that current prices are not fair.

If you are buying stocks of a certain company to speculate on any information how can you be sure that the guy selling the stock to you does not have better information? If he is selling why are you buying? If the guy selling the stocks is an experienced investor or a mutual fund manager, are you really sure that you posses more valuable information than these highly educated people?


In conversation with Eugene F Fama, economist at the university of Chicago and father of the efficient markets hypothesis.

Others: The concept of what is fair pricing of stocks and securities and the interpretation of what the efficient markets means for fair prices is quite an interesting discussion…

Eugene F Fama: Prices at any point in time fully reflect all of the information that is available at that time-which means whatever can be predicted about the future based on available information.

Others: This information flow is a very, very, very complex network of human behavior, data invention, mistakes….


 Efficient market theory does not say that markets are perfect… every price could be wrong, …but those errors are random.

The reason prices are fair is because they are not predictable…in other words if there was an easy way to game on all that, they wouldn’t be fair…


Q. In the last 12-months we have seen very volatile period in the markets-it is not the first time, we have had a lot of people out there saying and this proves that the Efficient Market Hypothesis (EMH) is dead-what do you say to those people?

A. Well, there is a more general challenge today to market per se; I mean this kind of economic event brings out the woodwork of the people who never thought markets were not worth anything anyway. I don’t mean just academics but people who in general are very suspicious of market allocations of resources-tend to jump in when things like this happen

…But as far as I am concerned the increase in volatility was to be expected given the degree of increase in economic uncertainties-looks like things are looking a little better now-but a very few months ago people were talking about something akin to the Great Depression-which was a period of incredible economic uncertainty and very depressed economic activity which indeed merited a very large decline in prices from 1929 to 1932-much larger than what we have seen this time…now if there is a little rebound in prices then I think that is a judgment by investors who after all determine prices- that things may be not as bad as they first looked…

…But the market can only know what’s knowable-it can’t resolve uncertainties that are unresolvable-so when there is a large amount of economic uncertainty out there…there is going to be a large amount of volatility in prices and that’s what we have been through-as far as I am concerned that is exactly what you would expect an efficient market to look like-the fact that prices went down says two things-expected profitability went way down and in addition people probably became more risk averse-so the premiums they probably required to hold stocks went up-in this period of time-but that is very consistent with an efficient market.

Q. So very simply the fact that market at any time does not anticipate what is going to happen next-does not mean that it is inefficient!

A. No, of course not then there would be no uncertainty about the future.

Q. Ok, so the implications are, still notwithstanding what has happened in the last year that for the average investor, in order to achieve or go for a higher expected return, the more sensible thing to do is to have a diversified portfolio -but to increase or reduce the risk according to the level of appetite.



A. That’s exactly right. I don’t know of any empirical evidence that goes against that-in fact if you look at the people-the behavioural finance people for example- go on and on about inefficient markets-and at the end they will say-but of course it is so difficult to say where the inefficiencies are-you are better off buying passive products and just do a risk-return trade off-and at that point I sit up and say-if markets were really as inefficient as we were talking about-I think you would be better identifying these inefficiencies in some practical way that investors could use-but they generally punt on that one at the end.

Q. So you do not discount the possibility that there are investors out there who do achieve better returns than the market?

A. What does the evidence say? ‘Insiders’ do better in their own stocks-as far as they trade in their own company stocks they do better, but they do better only by a bit as it turns out. So the market is not efficient as far as the insiders of a company are concerned-at least the top insiders.

…So it (the market) is not efficient at every level but for practical investment purposes, of almost everybody I can think of, including myself, it (the market) is EFFICIENT.

Q. What’s the most potent challenge that you have ever had from another academic to the EMH?

A. Well there is evidence that there is somewhat more momentum in stock returns that can’t easily be explained by a risk theory-that gives me a little trouble…then there is another one that says that the market returns following earnings announcements tend to persist a little more than you would expect if the markets were completely efficient-but neither of these present a lot of opportunity on which a lot of money can be made-because it involves so much trading and trading costs…but as far as I know those two are the biggest contradictions or potentially biggest contradictions of market efficiency…

…So you have to realize that market efficiency is a model-which means it is a simplification of the world,-which does a good job on almost everything-but there are some things on which it doesn’t do a good job-so insider trading would be one, there is momentum phenomenon is another one, and maybe this post earnings is another one…

…But they are few and far between, these things, and for practical investment purposes, the market is efficient for pretty much everybody.

Q. So if I can sum up in layman’s terms-what you are saying is that EMH is not a perfect explanation of everything that happens in the markets-but it is the best working proposition for use by investors in a practical sense-that most investors should presume that the only way in which they can reliably effect the expected return from their portfolios is by verifying the level of risk they are prepared to take.


A. Absolutely true.

Q. And nothing that has happened in the last 12 months that has altered that in any way?

A. No, I don’t see any informed opinion to the contrary on that. There are some people claiming that markets are not efficient-but they are not claiming there are easy profit opportunities out there, which seems like a conflict to me – it is either one or the other.


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## Chris

First off I will say that I do not buy into the general idea of EMH protrayed by Fama, in that markets always fully reflect all available data, but I am also no expert on the matter. I do believe that a market price is the subjective interpretation of buyers and sellers based on all available information, but that does not mean that that subjective opinion, of even millions of buyers and sellers, is correct or rational. 

EMH implies that all market participants arrive at a rational expectation of future returns based on all available information, which would suggest an almost uniform expectation by all market participants. But the exchange of goods, or trade, implies a non-uniform expectation between buyer and seller who have opposing expectations; and even among buyers there are differeing expectations of future returns. 

It is this area of rationality and subjectivity that I believe EMH largely discounts and fails to address. During bubbles, like our recent housing one, thousands of people bought property, where EMH would suggest they did so based on all information available. The problem here is not that all information was reflected in the price, but that buyers were behaving in an irational way, be it due to myopia, greed or avarice. By and large buyers made the wrong decisions based on all information available, i.e. the subjective opionion of the average market participant was based on irational ideas of future expectations. Bubbles are the obvious example here, but the same can be applied to individual securities.

To me EMH also means that there is no point in fundamental analysis, as all past information is already reflected in the price and has no impact on future price movements. I think this is summed up in the part of the interview you post, where he is asked about some people doing better than average. He only points to insiders and not those outsiders that have proven that they can consistently outperfrom markets. While Buffett is the most well known investor that has consistently outperformed the market there are many other value investors that have achieved this; my father has done so in 26 of the last 30 years and I have been able to achieve it in 9 of the last 10 years since I started actively investing. But in the interview this is not even mentioned or acknowledged.


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## Marc

Chris,

The EMH does not say that people will not beat the market. It says that those people who do beat the market are no more than you would expect by pure random chance. Furthermore, those that do so are taking more risk not excercising more skill.  In other words once we correctly adjust for risk, those that beat the market are probably just lucky.

You are correct in the observation that the EMH states that there is no point in fundamental analysis. So, what it is really saying is that you are either an investor or a speculator and investor or a trader. You either believe you can beat the market or you don't. There is no point in pretending that it is any different.

French Philosopher Louis Bachelier writing in 1900 in "The Theory of speculation" stated that the expected return from speculation before costs is zero. The amount by which you win your bet is equal to the amount by which I lose mine. After costs therefore speculation is a negative sum game. 

Therefore most people (since on average we are all average) would be better off investing rather than speculating.


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## ringledman

Buffett has a 60 year record of beating the market because he is a rational guy in a largely irrational world of investors. 

Hence he buys cheap when other are selling and vice versa. He believes in the principles of fundamentals and valuations which the EMH academic theorists away from the real world of investing ignore or more likely are not mentally wired to understand.

It takes a certain person to act rationally when all other are not. Behavioural theory plays a lot bigger part in the markets than the EMH theory, particularly in bear markets.

I like to take the view of real investment managers such as Grantham and Montier at GMO who look into the theory of bubbles, irrational behaviour and fundamental analysis in forming the view on markets. 

It is as much about avoiding buying into bubbles too late than trying to forecast the future. The EMH forms this crazy idea that it is acceptable to buy into any market at any price, irrespective of fundamentals.

We remain in a secular bear market in the Western markets. Index investing on the basis of the EMH will most likely lose many investors money, inflation adjusted over the next so many years. 

The EMH seems to ignore valuation and the long term secular cycle of P/Es from bull market top to bear market low.

I'll stick to a value approach of unloved sectors on low P/Es, high yields, cash rich, mega caps until the secular bear ends in 5-10 years. Then it will be a time to buy cheap indexes and ride the slightly more efficient secular bull.


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## Marc

Here is an interesting thought on market efficiency and value investing. 

Gene Fama both conducted the original research on market efficiency in the 1960s and published in 1992 the most widely cited article in the journal of finance on the value premium in stock markets and sits on the board of a major us fund manager which specializes in value investing.

I'd say he understands better than most how equilibrium pricing works and how stocks sorted by a high book to market ratio have a higher expected retun than growth stocks.The two are not mutually exclusive.


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## Firefly

ringledman said:


> I'll stick to a value approach of *unloved sectors on low P/Es, high yields, cash rich, mega caps* until the secular bear ends in 5-10 years. Then it will be a time to buy cheap indexes and ride the slightly more efficient secular bull.



Hi Ringledman,

Would you care to provide examples of these sectors?

Thanks,
Firefly.


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## Chris

Marc said:


> The EMH does not say that people will not beat the market. It says that those people who do beat the market are no more than you would expect by pure random chance. Furthermore, those that do so are taking more risk not excercising more skill.  In other words once we correctly adjust for risk, those that beat the market are probably just lucky.


And this is where I very much disagree with EMH and the throwing darts comparison. Luck itself would indicate a random gamble, but this would suggest that consistently beating an index would be near impossible. There are too many successful value investors to at the very least point to a problem in this statement.



Marc said:


> You are correct in the observation that the EMH states that there is no point in fundamental analysis. So, what it is really saying is that you are either an investor or a speculator and investor or a trader. You either believe you can beat the market or you don't. There is no point in pretending that it is any different.


Or you can believe that the market is more irrational than it is believed to be and that there are very regular opportunities to buy securities that pay off in an above average way. I would even claim that fundamental analysis can immensely reduce the risk of investing, as analysis of a couple of years worth of financial statements can indicate serious problems within a company and avoid a loss.



Marc said:


> I'd say he understands better than most how equilibrium pricing works and how stocks sorted by a high book to market ratio have a higher expected retun than growth stocks.The two are not mutually exclusive.



Is this not a contradiction? If he accepts that the book to market ratio can point to a higher return then he has to perform fundamental analysis of past data, which according to EMH should be futile. Am I misunderstanding something here?


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## ringledman

Firefly said:


> Hi Ringledman,
> 
> Would you care to provide examples of these sectors?
> 
> Thanks,
> Firefly.


 
I like Pharmaceutical in particular. Also supermarkets, telecoms, utilities, oil & gas. Basically the defensives.

I am not keen on the cyclicals, some have had a good run up since March 2009 but I think risky - banks (impossible to value), consumer retailers, holiday companies, auto, airlines, etc.


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## Firefly

ringledman said:


> I like Pharmaceutical in particular. Also supermarkets, telecoms, utilities, oil & gas. Basically the defensives.
> 
> I am not keen on the cyclicals, some have had a good run up since March 2009 but I think risky - banks (impossible to value), consumer retailers, holiday companies, auto, airlines, etc.



Thankyou sir.


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## Marc

Chris 

Some really good questions. 

The first one on luck and successful value investors sort of answers itself. 

Prior to 1991 we only had the capital asset pricing model to explain investment returns in a portfolio. The fama and French research looked at the problems with the CAPM and showed that value stocks do have a higher expected return than growth stocks and their explanation being that these stocks were more risky. In other words distressed companies have a higher cost of capital than growth companies and therefore investors in these companies have a higher expected return as compensation for the additional risk.

So when we point to somoeone who has beaten the Market they probably took more risk than the market and loaded up with value companies or small companies or both.This explains the performance of fund mangers like peter lynch and anthony bolton at fidelity.

Once we properly account for risk using a multi factor analysis then the fund manager's alpha almost invariably goes to zero.

Anyone else was probably just lucky.


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## Marc

Your second point is interesting also

Do you believe in making an analysis of the accounts of a company that you will uncover some new information that everyone else has missed?

The EMH says that the current price of a stock already incorporates all this information. So further analysis is pointless. 

In this sense the current price is an unbiased predictor it might not be perfectly right but it is just as likely to be correct as it is incorrect. 

This is like the favourite in a horse race it isn't sure to win but equally likely to win as lose and we know that the favourite in a horse race is a reasonable predictor of the outcome of the race. Despite the fact that my Mother selects horses to back based on their names!!


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## Marc

The last point is not a question of fundamental analysis but a simple ratio between price and book value. 

Unhealthy companies trade at a higher than average book to market ratio.

This is a fundamental risk factor in investing and simply reflects a rational decision on the part of investors who require a higher expected return as compensation for bearing the additional risks of a less healthy company. 

Think wal mart healthy company compared to k mart unhealthy company. Investors in aggregate need to be indifferent between both stocks so the price of k mart is going to fall the point at which an investor has the same expected risk/return trade off between both companies. 

There is nothing inconsistent here with Market efficiency.


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## ringledman

_*In other words distressed companies have a higher cost of capital than growth companies and therefore investors in these companies have a higher expected return as compensation for the additional risk.*_

Marc, where do you get this view that value stocks are always in distress, hence their low valuation and high potential return?

My view of value and many others are companies that are often in excellent health but unloved by the markets. 

Currently defensive value stocks over cyclical growth stocks. Value has been unloved for a few years, hence is cheaper on a P/E, P/B and yield yet in the main their fundamentals in terms of cash on balance, debt, ROCE is better than that of the cyclical growth stocks. 

Your investment theory and that of the academics doesn't seem to take this into account. It's flaw is justifying value as distress, hence must be more risky and therefore must be the reason why value outbeats growth. 

Rather the real reason is - certain sectors are unloved, prices stagnate whilst earnings grow, valuations become cheap, people realise once more that the market is cheap or a new generation of unburnt investors enters the fray, people buy back in, prices rise as sentiment improves and the story becomes positive once more.

Markets are driven by long business cycles and sentiment.


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## Jim2007

Marc said:


> Do you believe in making an analysis of the accounts of a company that you will uncover some new information that everyone else has missed?
> 
> The EMH says that the current price of a stock already incorporates all this information. So further analysis is pointless.
> 
> In this sense the current price is an unbiased predictor it might not be perfectly right but it is just as likely to be correct as it is incorrect.



All this theory is based on the assumption that people act rationally and there in lies the problem, they don't!  Take for example analysts recommendations, the analyst makes an assessment of a company and recommends it to his clients, but when the company fails to meet his recommendations, what happens?  Investors punish the company and not the analyst, by following the new recommendation of a sell because the company failed to meeting the analysts expectations!

I would argue that the wide use of models that assume people act rationally is what gives value investors the opportunity to achieve above average results.  It's not about discovering some new information about a company, it's about how the existing data is evaluated that is important.  Good companies do get punished for all kinds of reasons and it's up to the value investor to decide if he things those reason are valid or not.  Very often the market is correct, but at the same time it is wrong just often enough to offer the value investor the opportunities he requires.

Jim.


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## Prehistory

*great...*

that's great, thank very much


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## Marc

So here we have laid out the two sides of the investment world. 

Those who think that there are mispriced securities that are unloved by the markets. That by studying the accounts these mispriced securities can be uncovered and an opportunity to make profits for no additional risk. 

The other side says no these are priced economic risk factors and that risk and return are related and that current prices fairly reflect all these views and opinions. If it were possible to identify misplaced stocks to beat the Market without taking more risk then that should show up in studies of the performance of real investors.

The problem is that it doesnt. Real investors almost always only beat the Market when they take more risk than the Market and this additional risk regularly means that their performance is more volatile. 

Also past winners are not a good predictor of future winners.

The explanation being that if luck plays a part, sure enough this luck is sure to run out.


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## Chris

Hey Marc, this is turinging out to be a great discussion, thanks for getting it started.



Marc said:


> Chris
> So when we point to somoeone who has beaten the Market they probably took more risk than the market and loaded up with value companies or small companies or both.This explains the performance of fund mangers like peter lynch and anthony bolton at fidelity.
> 
> Once we properly account for risk using a multi factor analysis then the fund manager's alpha almost invariably goes to zero.


I think this is the fundamental part of EMH that I disagree with. I do not believe that investing in value stocks necessarily means taking on more risk. In many cases I believe that a value investment approach reduces risk substantially.



Marc said:


> Do you believe in making an analysis of the accounts of a company that you will uncover some new information that everyone else has missed?


No, I don't believe that I can uncover something that hasn't been uncovered. What I believe is that a stock can be undervalued because a large enough proportion of the market come to a subjective opinion that is extremely different to that of a value investor. Just because all information is factored into the price of an equity doesn't mean that the subjective evaluation of the majority is correct.



Marc said:


> The problem is that it doesnt. Real investors almost always only beat the Market when they take more risk than the Market and this additional risk regularly means that their performance is more volatile.
> 
> Also past winners are not a good predictor of future winners.


As already mentioned this is the part of EMH that disagree with. I do not believe that a value stock is necessarily higher risk at all.


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## ringledman

A classic example of how the EMH is a load of rubbish lies in closed ended funds (or investment trusts).

As these trade often at huge discounts or premiums to their advertised daily net asset value there is a clear difference between the net worth of the fund in question (NAV - Net asset value) and it's perceived value set by the emotions of the market participants (share price).

For the EMH to work in the real world, the share price would always converage towards the NAV as market participants continually price in the overvaluation or undervaluation of the share price to the NAV on a daily basis. There would be no difference between the NAV calculated by the fund managers on a daily basis and the public investors at large. In an efficient world we would all be pricing in the same NAV and share price daily. The two would track closely together. 

This rarely happens! Especially in markets such as the last few years.

In reality when people get scared as in late 2008 the discount (NAV-share price) grew massively to be up to 50% in many cases. 

Granted the NAV fell for many funds during the crisis as the underlying value of the companies was not what it was before the crisis (ie future earnings would not return to bubble territory, dividends cancelled and not coming back) etc. However, of interest is that the fall in true worth (NAV) was often far less than the fall that the market had priced in (share price).

Classic inefficiencies in the market. A lot of the closed ended discounts have since narrowed as fear has fallen and greed has returned. In the recent bull market the pace of discount narrowing has often been far faster than the pace at which the NAV rose at! 

So clearly in bear markets people sell much quicker than stocks/funds fall in true value and likewise during bull markets people push share prices up quicker than the true value of the stock/fund in question actually rises in terms of net asset value. 

Classic inefficiencies.

Closed ended funds are an excellent choice for the value investors out there who believe in market inefficiencies.


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## Marc

Markets Don't Have to Be Right to Be Efficient

The EMH has been contested since its debut 40 years ago. Usually, critics say it's a fanciful idea that looks good on paper but in the end is irrelevant because it doesn't explain some quirky (and usually recent) behaviour of prices.

The very fact that the hypothesis still comes under assault is stronger testimony to its deep relevance. People don't argue about irrelevant ideas and the EMH still dominates the research agenda. It has stood through endless testing and debate with almost no modification because simply repeating its core ideas dispatches most objections. These core ideas are useful to consider while investing, and are all too often misunderstood.

In a nutshell, the EMH purports that markets are full of people trying to maximize profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a stock is the consensus of their opinions about the stock's value. This is based on all their information about the stock, everything they know that has happened in the past and everything they predict will happen in the future. The end result is that the price of the stock is usually a good estimate of its intrinsic value.

Critics often challenge the notion that investors on the whole are informed enough to price stocks correctly by consensus. Most investors can't possibly know that much about any given stock. But market efficiency doesn't require that most investors have information. It only requires that "many intelligent participants" have information. In fact, no single investor has that much information. Even the smartest, most savvy guy has only a tiny fraction of all the information out there. Information isn't a big secret squirreled away somewhere; it is widely distributed in little pieces. The market functions as a mechanism that gathers the information, evaluates it, and builds it into prices.

This is what it means to say prices are a consensus view of a stock's value. At some level every investor includes (or doesn't include) a security in his or her portfolio until the stock's value to the investor is about equal to its market price. Since the price is the same for everyone, so is the value. Now granted, if everybody investing is wrong, prices might conceivably be poor estimates of value. For this to happen on any scale, the ignorant investors would have to be overly optimistic or overly pessimistic as a group. Otherwise, the optimists will cancel out the pessimists and the price struck will be rational. Since stocks are more likely to trade when the person selling is pessimistic and the person buying is optimistic, prices on average are more likely to represent rational consensus.

Admittedly, sometimes it can be hard to view prices as rational. We see stocks with no assets other than a website and with little or no profit suddenly become bigger than General Motors only to melt down a year later. How can such prices be good estimates of value? They seem so illogical, possibly the consensus view of ignorant day traders.

Let's suppose for the sake of argument that investors behave like lemmings and that the market systematically misprices stocks. Such a market would surely be child's play for a smart investor with real analytical skills. The reason such successes are hard to identify is that there's more than just one or two smart investors out there. There are thousands of savvy analysts looking for over- or under-valued securities. The opportunities to generate excess profit are diminished when these investors trade away disparities between a stock's price and its intrinsic value.

The EMH does not claim markets are always perfectly rational or that the information reflected in prices is always correct. The consensus view of investors can temporarily result in prices well above or well below a stock's intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants does not consistently profit over other participants.

After taking risk into account, do more managers than you'd see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding "no." Mike Jensen in the Sixties and Mark Carhart in the Nineties both conduct exhaustive studies of professional investors. They each conclude that in general a manager's fee, and not his skill, plays the biggest role in performance. Since mutual funds report performance after deducting fees, the bigger the fee, the worse the performance. Aside from that, expert investors with nearly unlimited resources working around the clock can't seem to outpredict the market.

This means investors are better off avoiding active managers—especially pricey active managers. History shows that in the long run a thoughtfully designed, diversified strategy of "passive" funds typically beats all but a few active managers. It's not easy to structure and maintain such a strategy. It requires some initial research and discipline to stay the course. But it's much easier than predicting which active managers will randomly beat this approach.


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## Marc

Chris

Your comments point to Ben Graham's margin of safety concept. 

Basically if you buy a stock that is cheap you build in a margin of safety and so the investment is less risky. 

The problem with this logic is that it doesn't discuss why the stocks got to the price they are now. 

One camp says that these stocks are unloved, ignored by the Market and are trading at a discount to their true value. Seek out these stocks that are mis priced and you can make money. 

This suggests that there is money on the table. The Market has screwed up and left the prospect of a higher expected return for no more risk. 

The informed investor doesnt buy this argument. There is no free lunch in economics.

If the price of a stock is down then it is some manifestation of risk that is being priced by the market and typically associated with distress (but not always).

So we say compared to growth stocks these unloved stocks or value stocks must carry more risk otherwise why would an investor expect a higher return? Risk and return are related. Value stocks on average do better therefore on average they must be more risky.


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## Chris

Marc said:


> The end result is that the price of the stock is usually a good estimate of its intrinsic value.


Not a good estimate or even a right estimate, but just an estimate. As I said before this is where I believe EMH takes a leap of faith.



Marc said:


> Critics often challenge the notion that investors on the whole are informed enough to price stocks correctly by consensus. Most investors can't possibly know that much about any given stock. But market efficiency doesn't require that most investors have information. It only requires that "many intelligent participants" have information. In fact, no single investor has that much information. Even the smartest, most savvy guy has only a tiny fraction of all the information out there. Information isn't a big secret squirreled away somewhere; it is widely distributed in little pieces. The market functions as a mechanism that gathers the information, evaluates it, and builds it into prices.


I would certainly agree with this, but I think this highlights precisely why a majority of market participants can end up being incredibly wrong. During the dot com boom everyone had the same information available, but suddenly the majority of investors ignored earnings and started looking at fancy things like potential clicks per second. I don't disagree that the market shows the current sentiment of all participants in a more or less instant manner, that is precisely what a market is. But I just do not believe that people are rational and therefore markets efficient.



Marc said:


> This is what it means to say prices are a consensus view of a stock's value. At some level every investor includes (or doesn't include) a security in his or her portfolio until the stock's value to the investor is about equal to its market price. Since the price is the same for everyone, so is the value. Now granted, if everybody investing is wrong, prices might conceivably be poor estimates of value. For this to happen on any scale, the ignorant investors would have to be overly optimistic or overly pessimistic as a group. Otherwise, the optimists will cancel out the pessimists and the price struck will be rational. Since stocks are more likely to trade when the person selling is pessimistic and the person buying is optimistic, prices on average are more likely to represent rational consensus.


This is the crux, EMH believes that buyers and sellers are much more rational than they actually are. Large scale irrationalities like the dot com and housing boom are common enough, and so are individual undervalued securities.



Marc said:


> Admittedly, sometimes it can be hard to view prices as rational. We see stocks with no assets other than a website and with little or no profit suddenly become bigger than General Motors only to melt down a year later. How can such prices be good estimates of value? They seem so illogical, possibly the consensus view of ignorant day traders.
> 
> Let's suppose for the sake of argument that investors behave like lemmings and that the market systematically misprices stocks. Such a market would surely be child's play for a smart investor with real analytical skills. The reason such successes are hard to identify is that there's more than just one or two smart investors out there. There are thousands of savvy analysts looking for over- or under-valued securities. The opportunities to generate excess profit are diminished when these investors trade away disparities between a stock's price and its intrinsic value.


I think that value investing is often over simplified when it comes to the work involved. I also think that just looking at institutional investors is a poor yardstick, even if it is the only practical one really. My personal portfolio has at times been very un-diverse and an institutional investor would probably never be able to sell such a portfolio as a fund. But taking the value investment approach to choose stocks has given me an above average return in 9 out of 10 years. Now of course this is a pretty short time period, and that theoretically could reverse. But applying the same rules my dad has "beat the market" in 26 or 27 out of 30 years.
Without a doubt, there are thousands of institutional investors out there, but I do not believe that value investing makes up a large portion of them. Generally I find they are way to over analytical and fancy in their ideas and often stray way too far from the basics.



Marc said:


> The EMH does not claim markets are always perfectly rational or that the information reflected in prices is always correct. The consensus view of investors can temporarily result in prices well above or well below a stock's intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants does not consistently profit over other participants.


I think EMH and its most public proponents are extremely vague and even dismissive when it comes to rationality. While the information reflected in the prices certainly is correct, to a large extent, the prices are quite often not a correct reflection of that information. But this is something that EMH seems to largely dismiss as a rare occasion.



Marc said:


> After taking risk into account, do more managers than you'd see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding "no." Mike Jensen in the Sixties and Mark Carhart in the Nineties both conduct exhaustive studies of professional investors. They each conclude that in general a manager's fee, and not his skill, plays the biggest role in performance. Since mutual funds report performance after deducting fees, the bigger the fee, the worse the performance. Aside from that, expert investors with nearly unlimited resources working around the clock can't seem to outpredict the market.
> 
> This means investors are better off avoiding active managers—especially pricey active managers. History shows that in the long run a thoughtfully designed, diversified strategy of "passive" funds typically beats all but a few active managers. It's not easy to structure and maintain such a strategy. It requires some initial research and discipline to stay the course. But it's much easier than predicting which active managers will randomly beat this approach.


I wouldn't disagree that most fund managers make most of their money on their fees, but that doesn't mean that you cannot assess the success of their stock picking. Yes, looking at just the fund performance will often reveal a below market performance because of the fees. But we are not just talking about people investing in funds. A more accurate assessment would be an evaluation of the underlying asset values of value funds or investors.



Marc said:


> Chris
> 
> Your comments point to Ben Graham's margin of safety concept.
> 
> Basically if you buy a stock that is cheap you build in a margin of safety and so the investment is less risky.
> 
> The problem with this logic is that it doesn't discuss why the stocks got to the price they are now.
> 
> One camp says that these stocks are unloved, ignored by the Market and are trading at a discount to their true value. Seek out these stocks that are mis priced and you can make money.
> 
> This suggests that there is money on the table. The Market has screwed up and left the prospect of a higher expected return for no more risk.
> 
> The informed investor doesnt buy this argument. There is no free lunch in economics.
> 
> If the price of a stock is down then it is some manifestation of risk that is being priced by the market and typically associated with distress (but not always).
> 
> So we say compared to growth stocks these unloved stocks or value stocks must carry more risk otherwise why would an investor expect a higher return? Risk and return are related. Value stocks on average do better therefore on average they must be more risky.


Risk is always a subjective assessment and I think it is not very sensible to generalise risk in this way. The majority of people would argue that my current portfolio is way too risky, but in my interpretation of the available information I have reduced my risk. When I find an undervalued stock, I look at it in the same way. I do not see myself taking more risk than others.


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## ringledman

Marc said:


> This means investors are better off avoiding active managers—especially pricey active managers. History shows that in the long run a thoughtfully designed, diversified strategy of "passive" funds typically beats all but a few active managers. It's not easy to structure and maintain such a strategy. It requires some initial research and discipline to stay the course. But it's much easier than predicting which active managers will randomly beat this approach.


 
Marc, investing in index funds mid way through a secular bear market will produce below average and likely below inflation returns. 

We are many years away from entering a new secular bull market for the West based on emperical evidence. You only want to own index trackers during secular bulls. 

Also invest on the basis of dividend. In a world lacking real growth (not QE binge growth) and in a negative interest rate world dividends are king. 

Agree on fund management, 95% are a complete waste of money and fees are usually 1-2% over the TER as they unfortunatey dont tell you all their hidden costs. 

I think the way to proceed in today's market is selectively owning value stocks in defensive industries that have been ignored by the market for a while. Those with excellent fundamentals and won't collapse as much as cyclical growth stocks once the tightening begins. 

In today's market it is as much about 'return of capital' than 'return on capital'. I agree with Chris and the works of Montier and Grantham that say risk decreases the lower tha valuation (still doesn't mean you wont buy value traps occassionally). 

So firms paying a dividend are lower risk than those that don't, firms that have a high dividend cover are lower risk than those that don't, firms that are on low P/Es are lower risk than those on lofty P/Es based on a mere promise of future growth. Usually value stocks have higher cash reserves and better ROCE than growth stocks. 

In today's volotile globally imbalanced world these sort of fundamentals matter. Reducing risk through value is a way of preserving capital which I believe to be the number one issue at present. Over time value should outwin growth due to the lower risk profile in general and better/quicker return of capital to shareholders.

Rather than buy trackers that buy into the whole secular bear market, I believe a better approach is to selectively buy ETFs investing in core secular bull markets is the better choice. I.e. commodities, energy, and I think soon to join this secular bull - pharmaceutical.


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## ringledman

Chris said:


> I think that value investing is often over simplified when it comes to the work involved. I also think that just looking at institutional investors is a poor yardstick, even if it is the only practical one really. My personal portfolio has at times been very un-diverse and an institutional investor would probably never be able to sell such a portfolio as a fund. But taking the value investment approach to choose stocks has given me an above average return in 9 out of 10 years. Now of course this is a pretty short time period, and that theoretically could reverse. But applying the same rules my dad has "beat the market" in 26 or 27 out of 30 years.


 
Chris, what is your value approach currently - sectors, fundamentals that you buy on, countries, etc?

Cheers.


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## Chris

ringledman said:


> Chris, what is your value approach currently - sectors, fundamentals that you buy on, countries, etc?



First things I look at are price/earnings and price/book along with the level of debt. Obviously the lower these are the better. Dividends factor significantly in my assessment, especially fluctuations in dividend history and the dividend to net earnings rate.
Geography: heavily focused on Asia directly and indirectly; I generally like large European companies with significant export revenue to Asia; I don't have direct investments in Japan, but I am looking.
Industries: pharmaceutical, precious metals, industrial materials (steel, chemicals, plastics), gas and oil; no financials at all; on the cyclical side I do own a luxury car manfuacturer with very big growth in China.

As already mentioned I am currently looking for exposure to Japan but will probably wait until mid year to see how things turn out there. Rushing a decision has cost me more than any other mistakes.
I am also looking at increasing small to mid cap gold/silver mining stocks, which is proving quite difficult on a traditional value approach. Agriculture is also something I want to increase my exposure in.


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## davegaa

No matter how much is pumped into Irish banks, I still think the markets will be overly cautious in the future.


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## Marc

http://www.sensibleinvesting.tv/Default.aspx


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