January 2017

As Howard Marks famously observed, investors must “dare to be great.”

There’s little doubt that the Efficient Market Hypothesis (EMH) has had a revolutionary impact on the practice of investment management.

The concept, which was introduced by the Nobel-prize winning economist Eugene Fama in the 1960’s, holds that the market incorporates all relevant information, thus resulting in the accurate pricing of securities. The takeaway of the EMH, therefore, is that “beating the market” is impossible. Academic circles, in recent years, have treated the theory as unimpeachable dogma. But is it?

In this article, I challenge the conventional wisdom that surrounds the EMH, and explain how, with the right focus, active management provides an attractive option for investors to outperform the market.

Ben Graham

Is Outperformance Possible?

The equity market is unique in its ability to provide instant liquidity to thousands of companies with very little commissions, and no contingencies. As an investment, this is a remarkable and often overlooked property. The catch, however, is that such easy access to liquidity results in volatility.

As investor and economist Ben Graham famously remarked, “In the short-run, the stock market acts like a voting machine, tallying up which firms are popular and unpopular. But in the long-run, the market is like a weighing machine, assessing the substance of a company.”

The day-to-day volatility of equities can be staggering, but is the actual underlying value of the businesses changing? Not really.

There are 4,000 exchange-traded equities in the United States, all of which are subject to varying degrees of volatility. These securities all correspond to businesses whose value is relatively stable day to day. And when securities are priced correctly, wild swings that occurred in the S&L Crisis, Japanese Equity Bubble, Tech Bubble and Great Recession simply shouldn’t happen.


Beating the Market

In opposition to the EMH, there are several reasons why, with high levels of diligence, it is indeed possible to outperform the market.

The first is the previously alluded to volatility of prices, compared to the relative stability of underlying business value. While it may be argued that capitalizing on pricing inefficiencies is impossible, claiming that prices are always accurate is a tougher pill to swallow.

Let’s take the example of JDS Uniphase who, in the late 1990s, topped out with a market cap of $125 billion and a split-adjusted share price of $1,170. The stock crashed spectacularly, and by early 2002 was trading under $10. There are many stocks during this period with the same trajectory. Was the split-adjusted price of $1,170 an accurate pricing of the security? I think it’s fair to say most rational people would say no.

Another advantage that an investor possesses is the ability to retain a large degree of anonymity. Investing is a zero-sum game with two players, a buyer, and a seller. Over time, one side will ultimately prevail as the “winner” in the trade. In an ordinary contest, if a player has developed an edge, they will find it more and more difficult to attract opponents. The investment game, however, provides the ability to remain anonymous. This is a tremendous advantage.

Again, at its most fundamental level, the EMH assumes that all information is immediately and accurately incorporated into the asset price. If this is the case, beating the market is impossible. This core tenet should be questioned, however, is this true — or even plausible?

Investing is a zero-sum game with two players, a buyer, and a seller. Over time, one side will ultimately prevail as the ‘winner’ in the trade.

While earnings announcements, for better or worse, generally have an immediate effect on the price of a security, other information can lay dormant for years. Furthermore, large-scale trends are often ignored, as most analysis tends to focus on backwards-looking formulas. If formulas were successfully able to predict returns, then markets actually would be efficient.

Especially in areas of technological disruption, backwards-looking formulas simply don’t generate accurate pricing of securities. Within the past twenty years, we have seen venerable institutions in print, media, retail and technology all go by the wayside. By and large, the market has failed to predict these outcomes and price them accordingly.

This leaves a significant opportunity for investors.

When investing in the market, investors can also play to their strengths. Peter Lynch’s famous maxim “invest in what you know” rings true. While often misunderstood, Lynch’s message was to invest in areas where you have an intimate knowledge. If you work in a specific field, your ability to see the day-to-day machinations and developments is a tremendous advantage.

In contrast, most Wall Street analysts are spread a mile wide and an inch deep. One does not need to know of a vast array of sectors in detail. Rather, focusing on core areas of expertise could lead to the possibility of informational advantages. While perhaps this is a simple concept in theory, in practice this expertise requires years of intense dedication, focus, and education many investors are unwilling to perform.


Where Is The Outperformance?

If beating the market is indeed possible, then why do the vast majority of investment managers underperform their respective indexes? It’s a good question.

Most Wall Street analysts are spread a mile wide and an inch deep.

By and large, the academic research done in this area concerns the performance of mutual funds. It is true; the vast majority of mutual funds do underperform their benchmark. I would argue, however, that this event is largely explainable.

Mutual fund managers are generally investing to retain their job. They are highly paid professionals whose success is measured by their ability to attract and retain assets. There is no real incentive to make bold, high conviction, investments. Hovering around the benchmark has far less career risk.

To beat the market, you by definition must hold assets that are different from the market. This involves a high degree of career risk as you are, by necessity, making unconventional bets. As Howard Marks explained in his “Dare To Be Great” memo, “Unconventional behavior is the only road to superior investment results, but it isn’t for everyone. In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes.”

Most managers are unwilling or unable to make unconventional bets, all but guaranteeing average or below average results.

Because of fear of mistakes, funds also tend to have a very high amount of holdings. If a mutual fund has 50 equity holdings, how is it possible that they have identified 50 mispriced securities? Furthermore, this amount of holdings in a portfolio will naturally produce market-like returns minus expenses.

Most managers are unwilling or unable to make unconventional bets, all but guaranteeing average or below average results.

The default argument by academics, when faced with long-term outperformance, is that statistically, in a large enough sample, simply by sheer luck, some investors will outperform for extended periods of time. The problem in that line of logic is that there tend to be patterns of outperformance, as Warren Buffett explained in “The Superinvestors of Graham-And-Doddsville.”

Long-term outperformance tends to go to those with deep knowledge of what they are investing in, a knowledge-set that is difficult to acquire. It’s no coincidence that the managers with multi-decade track records of performance also tend to have sound investment theory and high intellectual acumen.

The beauty of investing is that no formula can accurately predict future results.

In this market, an investor is left with two options. First, if one believes in the EMH, they should attempt to minimize all costs and replicate the market, a feat that Vanguard and other companies have made admirably easy in the past three decades.

The other option is a dismissal of the theory, and an attempt to outperform the market through an accumulation of some form of informational advantage.

The efficient market hypothesis is by and large fairly accurate. With that said, its elevation to gospel has been unwarranted and occasionally dangerous.

In finance, mathematicians and economists strive to produce elegant formulas for an inelegant universe. The beauty of investing, though, is that no formula can accurately predict future results. Asset mispricings do occur and they can be exploited. While far from easy, outperformance can be achieved by concentrating on areas of core expertise, making high-conviction bets, and learning from mistakes.

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