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“Financial statements are like fine perfume; to be sniffed but not swallowed.”
Abraham Briloff
One of the ongoing debates in finance is regarding how good markets are at pricing securities. The implications of the debate are truly profound. Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill. If markets are efficient, long-term investors can effectively ignore most of the information about individual securities and focus on broader questions.
The Efficient Market Hypothesis (EMH) evolved in the 1960s from the Ph.D. dissertation of Eugene Fama. Primarily as a result of Fama’s work on the EMH, he was awarded a share of the 2013 Nobel Prize in Economics.1 The Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information (see quote below). Fama persuasively made the argument that in an active market that includes many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information. If a market is efficient, no information or analysis can be expected to result in outperformance of an appropriate benchmark.2
"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."
The random walk theory asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements. Much of the theory on these subjects can be traced to French mathematician Louis Bachelier whose Ph.D. dissertation titled "The Theory of Speculation" (1900) included some remarkable insights and commentary. Bachelier came to the conclusion that "The mathematical expectation of the speculator is zero" and he described this condition as a "fair game." Unfortunately, his insights were so far ahead of the times that they went largely unnoticed for over 50 years until his paper was rediscovered and eventually translated into English and published in 1964 (see Peter Bernstein's Capital Ideas for more on these topics.)
There are three forms of the efficient market hypothesis.
Securities markets are flooded with thousands of intelligent, often well-paid, and well-educated professionals and investors seeking under and over-valued securities to buy and sell. The more participants and the faster the dissemination of information, the more efficient a market should be. The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact "efficient" and if so to what degree. Many novice investors are surprised to learn that a tremendous amount of evidence supports the efficient market hypothesis. Early tests of the EMH focused on technical analysis and so-called chartists seem most challenged by the EMH. And in fact, the vast majority of studies of technical theories have found technical strategies to be useless in predicting securities prices. However, researchers have documented some technical anomalies that may offer hope for technicians (discussed in detail in chapter 23), although transactions costs may reduce, or eliminate any advantage.
Researchers have also uncovered numerous other stock market anomalies that seem to contradict the efficient market hypothesis. The search for anomalies is effectively the search for systems or patterns that can be used to outperform passive and/or buy-and-hold strategies. Theoretically though, once an anomaly is discovered, investors attempting to profit by exploiting the inefficiency should result in its disappearance. In fact, numerous anomalies that have been documented via back-testing have subsequently disappeared or proven to be impossible to exploit because of transactions costs. The paradox of efficient markets is that if every investor believed a market was efficient, then the market would not be efficient because no one would analyze securities. In effect, efficient markets depend on market participants who believe the market is inefficient and they trade securities in an attempt to outperform the market.
Larry Swedroe is in the camp that doesn’t worry much about the impact of the increase in indexing and passive management in recent decades, as he summarized recently - "My guess is that at least 90% of the active management industry could disappear and the markets would remain highly efficient."3 Researchers have argued that the shift to passive funds is increasing some types of risk, while diminishing others.4
Many believe that markets are neither perfectly efficient, nor completely inefficient. All markets are efficient to a certain extent, some more so than others. Rather than being an issue of black or white, market efficiency is more a matter of shades of grey. In markets with substantial impairments of efficiency, more knowledgeable investors can strive to outperform less knowledgeable ones. Government bond markets for instance, are considered to be extremely efficient. Most researchers consider large capitalization stocks to also be very efficient, while small capitalization stocks and international stocks in some countries are considered by some to be less efficient. Private real estate and venture capital investments aren't publicly traded so they are considered to be less efficient, partially because different participants may have varying amounts and quality of information.
The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for outperformance by skillful managers. However, it’s important to realize that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether markets are or are not efficient, because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to have losses. However, when costs are added, even marginally successful active managers may underperform.
I believe a third view of market efficiency, which holds that the securities market will not always be either quick or accurate in processing new information. On the other hand, it is not easy to transform the resulting opportunities to trade profitably against the market consensus into superior portfolio performance. Unless the active investor understands what really goes on in the trading game, he can easily convert even superior research information into the kind of performance that will drive his clients to the poorhouse . . . why aren't more active investors consistently successful? The answer lies in the cost of trading.
Jack Treynor5
If markets are efficient, the serious question for investment professionals is what role can they play, and be compensated for. Those that accept the EMH generally reason that the primary role of an advisor consists of analyzing and investing appropriately based on an investor's unique circumstances, risk profile, and tax considerations. Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion, and employment. The role of the advisor in an efficient market is to tailor a portfolio to those needs, rather than to beat the market.
Faced with the inference that they cannot add value, many active managers argue that the markets are not efficient (otherwise their jobs can be viewed as nothing more than speculation). Similarly, the investment media is generally considered to be ambivalent toward the efficient market hypothesis because they make money supplying information to investors who believe that the information has value (beyond the time when it initially becomes public). If the information is rapidly reflected in prices, there is no reason for investors to seek (or purchase) information about securities and markets.
While proponents of the EMH generally don't believe it’s possible to beat the market using skill, some believe that stocks can be divided into categories based on risk factors (and corresponding higher or lower expected returns). For instance, many believe that small cap stocks are riskier than large cap stocks and therefore are expected to have higher returns. Similarly many believe value stocks are riskier than growth stocks and therefore have higher expected returns.6
Contrary to majority opinion in university departments of finance, markets are not efficient; they are inefficient. Furthermore, the safest stock portfolios have the highest expected returns, and the riskiest portfolios have the lowest expected returns.Robert Haugen7
While many argue that outperformance by one or more participants in a market signifies an inefficient market, it's important to recognize that successful active managers should be evaluated in the context of all participants. It’s difficult in many cases to determine whether outperformance can be attributed to skill, as opposed to luck. For instance, with hundreds or even thousands of active managers, it’s common and in fact expected (based on probability) that one or more will experience sustained and significant outperformance. However, the challenge is to identify an outperformer before the fact, rather than in hindsight. Additionally, in many cases, strong performers in one period frequently turn around and underperform in subsequent periods. A substantial number of studies have found little or no correlation between strong performers from one period to the next. The lack of consistent performance persistence among active managers is further evidence in support of the EMH.
Critics of the EMH have cited many cases of illogical stock market reactions to various announcements or conditions. For instance, during the internet bubble, stocks adding ".com" to their name experienced seemingly illogical price appreciation following the announcement. There have also been many cases where investors have traded the wrong stock following news. Wall Street Journal columnist Jason Zweig (author of Your Money & Your Brain) discusses other examples including a study by Kee-Hong Bae and Wei Wang that found China-name stocks significantly outperformed non-China-name stocks. Researchers also recently documented cases of similarly named stocks moving partially in tandem, which implies mistaken trading may account for 5% of activity on the respective stocks.8
Professor Robert Shiller (who ironically shared the 2013 Nobel Prize with Fama and Lars Peter Hansen) has even gone so far as to say "The Efficient Market Hypothesis is one of the most egregious errors in the history of economic thought."9
"If academics are just saying that the efficient market hypothesis means the market is hard to outsmart, then, no, it has not been discredited at all. But if academics are saying that the efficient market hypothesis means markets behave rationally, then they do not have good explanations for what went on the past couple of years."10
Justin Fox (author of The Myth of the Rational Market)
Andrew Lo proposed the “Adaptive Markets Hypothesis” in which markets are neither efficient nor irrational, but some combination of both. He suggested "There are periods when the market is highly efficient, and there are those that aren’t . . . The better question is: What is the relative efficiency at a given point in time? That is something that can be measured."11
"It is time to declare that the efficient market hypothesis (EMH) and rational investor are dead, inasmuch as they are meant to imply consistently correct market pricing. That sense of market efficiency should have died with the 1987 crash. There is no excuse today for investors, investment professionals, or regulators to assume that market prices always represent 'true' values for every asset, to assume that such prices will move in a continuous fashion consistent with a normal distribution, or that investors, unlike any other group of people, will always act rationally."
Bruce Jacobs, Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes
While critics are quick to point to the preceding (and other) examples, there are plenty of other individual examples that strongly support the market efficiency argument. In one stunning example of the ability to market to quickly analyze an emotional and completely unexpected event, Michael Maloney and Harold Mulherin found that following the Challenger space shuttle disaster "the market pinpointed the guilty party within minutes."12
Meir Statman elaborated on the debate about the financial crisis and market efficiency by defining informationally efficient markets, rational markets, random-walk markets, and importantly unbeatable markets. While markets may not be completely efficient, rational, and/or random-walk markets, and while markets may be beatable by some skilled money managers, they still tend to be unbeatable to their clients because the cost of exploiting deviations is so high that those seeking positive alphas end up with zero or negative alphas net of costs. Statman summarized "A demise of the rational markets and the informationally efficient markets hypotheses does not necessarily imply the demise of the unbeatable markets hypothesis, since knowledge that bubbles exist does not necessarily imply that investors can identify them as they occur and generate positive alphas by trading on them."13
"Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are - plausibly enough - the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence."
Robert Higgins, Analysis for Financial Management (May 2009 edition)
When private companies decide to go public and list their shares on a public market, they must disclose their financial information. Researchers can then analyze the information to estimate the value of the company and its shares of stock. Financial information disclosures often include much of the same information as tax fillings, but they usually include much more information that is useful to investors. In the United States, data should follow generally accepted accounting principles (GAAP), which are standards and procedures that are generally static, but can evolve over time.
Financial statements include the Balance Sheet, Income Statement, and Cash Flow Statement. The financial statements are interrelated and should be used and analyzed together. Financial Statements are useful because they provide information which allows investors and creditors to make better decisions. However, because of selective reporting of economic events as well as non-comparable accounting methods and estimates, financial statements are only an approximation of reality. In addition, because of the tendency to delay accounting recognition, financial statements also tend to lag reality.
A primary objective of financial analysis is to determine comparable risk and returns of companies and their securities. I'll be mentioning some general topics like price to earnings (PE) ratios and book to market for those that are more advanced in valuing securities and asset classes, but novice investors can take comfort in knowing that the efficient market hypothesis implies they don't need to worry much about understanding the valuation measures. Those that do engage in financial statement and securities analysis need to understand the complications and nuances inherent in the practices.
Larger and more prominent publicly traded companies (Like Apple, JP Morgan Chase, Google's parent Alphabet, and Johnson & Johnson) may have dozens of professional analysts and thousands of shareholders, while smaller companies may have few or no professional analysts. Professional analysts tend to have formal training including higher degrees or credentials (discussed further in chapter 30). Less experienced investors that are active in the markets should just keep in mind that financial statement analysis can be extremely complicated.
There are many ways in which management can manipulate earnings. An example is "income smoothing" which refers to depressing earnings in good years (typically through deferred gains or recognition of losses) and inflating earnings in bad years (typically through recognition of gains and deferring losses).
Differences in accounting methods can cause wide differences in comparability among individual companies, industries, and countries. Keep in mind that the financial reporting system in the United States is considered the most complex in the world. If you plan on doing your own research of financial statements you should be prepared and educated in interpreting those complications. Inventory methods, capitalization, depreciation, and off balance sheet financing are some of the examples of areas that could easily be overlooked resulting in incorrect analysis and valuations. Even the footnotes in financial statements can contain critical information that should be thoroughly examined.
Fortunately for most, the efficient market hypothesis and random walk theories can be assumed to be good enough, even if they are not strictly accurate descriptions of securities markets all the time. Investors that use appropriate diversified investments and focus on the long term can filter out most of discussions about valuation and what is under or over-priced (according to market commentators). I'll elaborate on data that does contradict the theories later (see chapters 20-24), but next we will focus on the costs involved in investing and how those costs impact returns.
"There is no behavioral finance. It’s all just a criticism of the efficient markets, with no evidence."
Eugene Fama, November 5, 201914
Notes - The Footnotes in the Book are sequential and for this chapter start at #98 and end at #112.
1. Eugene Fama, Random Walks in Stock Market Prices, Financial Analysts Journal, September/October 1965 (reprinted January-February 1995).
2. Appropriate benchmarks refer to comparable securities of similar characteristics. In other words, it’s important to compare apples to apples and oranges to oranges. For instance, small stock fund performance is best compared to an index of small stocks and growth stock fund performance is best compared to a growth stock index.
3. Larry Swedroe, "Swedroe: ‘Passive’ Market Efficiency Works" March 25, 2019 https://www.etf.com/sections/index-investor-corner/swedroe-passive-market-efficiency-works
4. Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe, Emilio Osambela and Chaehee Shin, The Shift from Active to Passive Investing: Potential Risks to Financial Stability? 2019 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3321604
5. Jack Treynor, What Does It Take to Win the Trading Game? Financial Analysts Journal, January/February 1981
6. Value stocks are generally defined as stocks with a high ratio of book value/market while growth stocks have low book value to market ratios. Investment Gurus by Peter Tanous includes thorough discussions of these topics (see interviews with Eugene Fama and Rex Sinquefield).
7. Robert Haugen, The Inefficient Market and the Potential Contribution of Behavioral Finance: Case Closed, June 2010
8. Vadim Balashov, Andrei Nikiforov, How Much Do Investors Trade Because of Name/Ticker Confusion?, May 25, 2019 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3394300
9. Using Behavioral Finance to Better Understand the Psychology of Investors, Institutional Investor, May 2010
https://www.institutionalinvestor.com/article/b150qd3bzzzl2p/using-behavioral-finance-to-better-understand-the-psychology-of-investors
10. Justin Fox (author of The Myth of the Rational Market) Are Finance Professors and Their Theories to Blame for the Financial Crisis? CFA Institute Conference Proceedings Quarterly, June 2010 (ahead of print) http://www.cfapubs.org/doi/pdfplus/10.2469/cp.v27.n2.1
11. Using Behavioral Finance to Better Understand the Psychology of Investors, Institutional Investor, May 2010
12. Michael Maloney and Harold Mulherin, The Stock Price Reaction to the Challenger Crash: Information Disclosure in an Efficient Market, December 7, 1998, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=141971
13. Meir Statman, “Efficient Markets in Crisis,” the Journal of Investment Management, Second Quarter 2011
14. This quote is from a video interview with Barry Ritholtz and also includes Fama’s statement "I'm the most important person in behavioral finance. Because most of behavioral finance is just a criticism of efficient markets. Without me what have they got?" The transcript can be read at https://ritholtz.com/2019/11/transcript-fama-booth/ and the video can be found in several locations including https://www.bloomberg.com/news/videos/2019-11-08/bloomberg-opinion-masters-in-business-eugene-fama-and-david-booth-11-05-2019-video
https://ritholtz.com/2019/11/mib-live-eugene-fama-and-david-booth-full-video/
https://twitter.com/i/broadcasts/1vOGwaYnyOvxB
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