Introduction
It would seem that the stock market, which is predominated by large, sophisticated institutions, sets stock prices to their appropriate level. For individual investors, it can seem pointless to compete with such institutions.
For value investors, however, the goal is not to compete directly with large institutions, but rather to focus on securities that are underfollowed and undervalued. Additionally, large institutional investors often create inefficiencies for reasons we will examine below. As famed value investor Seth Klarman has stated: “Picking through the crumbs left by the investment elephants can be rewarding.”
The efficient market hypothesis, or EMH, states that stock prices fully reflect all available information. The EMH implies that no systematic approach to stock selection can generate above-average performance over long periods. The EMH has led to the rise of index funds, which match the performance of a broad stock index, such as the S&P 500, and flows to these funds have increased significantly in recent years.
The prevalence of the EMH in academic finance and the trend toward index investing may dissuade some investors, who otherwise find value investing attractive, from doing research on individual securities or from hiring a value-oriented investment manager. I believe these concerns are misplaced.
In my experience as an analyst, individual investor, and portfolio manager, I have observed that markets create bargains frequently enough to justify the analytical effort. Additionally, the experience of many seasoned value investors has shown that the value approach can generate attractive long-term results.
While value investors mostly disagree with the EMH, their disagreement is one of degree. Markets are highly competitive and generally efficient, but they often misprice securities. However, investors should not discount the EMH entirely. Since the EMH presents the conditions under which assets are appropriately priced, identifying when markets violate these conditions can aid investors in identifying true bargains.
The EMH rests on three key assumptions. First, market participants — traders and investors — are rational. Second, some participants may be irrational, but their irrational trades offset each other such that their collective efforts are still rational. Third, participants may be irrational, but a small subset of smart traders can arbitrage away any price inefficiency.
Most contemporary proponents of the EMH disregard the first assumption and instead focus on the second and third key assumptions, which we can respectively call the “wisdom of crowds” and the “arbitrage” arguments.
A security’s fundamental value is a function of two components:
- A company’s expected future cash flows; and
- A rate of return that reflects the uncertainty of those cash flows.
In an efficient market, significant price changes should only occur when investors reassess one of these two components as the result of new information. Since the market aggregates investors’ opinions, an efficient price is one in which the current price reflects the best estimates for future cash flows and the appropriate required return.
Only when one or more of the conditions of price efficiency are violated should an investor expect to find a bargain. Generally, these conditions can be broken due to market psychology or institutional constraints.
Market Psychology
Behavioral finance is a relatively new field of financial economics that has been mostly at odds with the EMH. Behavioral finance studies the cognitive biases behind the investment decisions of individuals and firms. In short, behavioral finance relaxes the assumption underpinning most of orthodox economics: that of the rational economic man, or homo economicus, who objectively optimizes decisions.
The academic finance community has only relatively recently accepted the contributions behavioral finance researchers have made to capital markets theory. While behavioral finance has much to say about the behavior of individuals, our discussion is mostly concerned with what behavioral finance reveals about market psychology.
Stock prices are set by individuals collectively through the means of the market. A stock price, right or wrong, reflects the market’s consensus.
Behavioral Impediments to Price Efficiency
The wisdom of crowds argument states that when an adequately large group of independent and diverse individuals come together in a collective setting, such as a market, the aggregation of opinions is better than the opinions of the individuals themselves.
The rationality of the individuals themselves is less important, so long as these individuals are independently irrational. However, when the independence and diversity of the individuals break down, the collective outcome is unlikely to be rational.
In financial markets, one form of this breakdown in independence and diversity is a behavior known as herding.
Individuals display herding behavior when the behavior of others influences their decisions. When this occurs, individuals are following the herd rather than acting on their independent judgment. Professional money managers are not only as prone to herding as individual investors but are also affected by the short-term incentives inherent in the investment industry.
Herding occurs from both a career standpoint and a psychological standpoint.
From a career standpoint, money managers are less likely to be punished, or face redemptions, if their short-term performance is in line with everyone else’s. Behaviorally, following the herd is instinctive in the face of limited information.
One form of herding behavior is known as an information cascade. Information cascades occur when investors disregard their private information and instead follow the actions of other investors, even when that behavior contradicts the investors’ private information.
By assuming that “someone, somewhere knows something,” investors’ behavior becomes a wave of action not fully supported by changing fundamentals. For example, investors operating on an information cascade may overreact to events such as unexpectedly weak earnings.
This overreaction hypothesis has some empirical support. In a famous paper published in the Journal of Finance, researchers Richard Thaler and Werner De Bondt tested the hypothesis that investors overreact to new information entering the market. The authors observed that stocks that suffered large declines and stocks that experienced large increases showed a tendency toward mean reversion — the tendency of a stock price to revert toward its average price.
The authors concluded: “Consistent with the predictions of the overreaction hypothesis, portfolios of prior ‘losers’ are found to outperform prior ‘winners.’”
It is not just academic studies that support this conclusion. By looking at the trading ranges of even the most stable companies, investors can observe that stock prices often fluctuate far beyond what is justified by changing business fundamentals.
Markets are also filled with participants attempting to “guess” how other participants will respond to new information. The late economist John Maynard Keynes appropriately described the short-term behavior underlying speculative markets by comparing professional investment to a newspaper competition in which contestants must choose the faces they believe other contestants will find most attractive.
In other words, not all market participants are acting on their independent analysis to choose the best investments. Instead, many are attempting to choose those securities that they think others will think are the best investments.
This tendency is another reason for the breakdown of the independence of the crowd and can lead to mispriced stocks.
Underfollowed Stocks
Many stocks with market capitalizations of under $1 billion are underfollowed by institutional investors. Often, such stocks even lack analyst coverage.
In the context of the EMH assumptions presented above, information on such stocks is widely available but may not reach an adequately large group of investors. Value investors often look for bargains among these smaller, underfollowed stocks.
It is among small-capitalization stocks that sophisticated individual investors and smaller investment firms, unconstrained by portfolio size, have an advantage over institutional investors.
However, because fewer investors analyze these smaller stocks, the mechanism for bringing price in line with value is less reliable than among larger stocks. As a result, value investors in smaller stocks often look for catalysts — external or internal events that may lead to the market’s reappraisal of the stock.
Institutional Constraints
According to the EMH, a breakdown in the diversity and independence of the market, whether for a specific stock or overall, need not lead to an inefficient price. The theory states that a small subset of rational, unconstrained investors will quickly eliminate a bargain that occurs for behavioral reasons.
Large financial institutions, such as mutual funds, hedge funds, pension funds, and investment banks, account for most of the trading volume on the major U.S. stock exchanges. These institutions, in other words, are largely responsible for setting stock prices. For the EMH to hold, these institutions must set prices in a manner consistent with underlying business fundamentals.
Value investing is the ultimate application of fundamental stock research, but how many professional money managers follow the principles first espoused by Benjamin Graham?
Bill Ruane, the late founder of the Sequoia Fund, once suggested that value investors account for approximately 5% of professionally managed money. Whether this percentage is correct, there is little debate in the value investing community that few professional money managers follow a true value investing approach.
The underrepresentation of the value approach is a paradox of professional money management: the long-term record of value investing is hard to deny, yet few professional money managers consistently apply the philosophy.
Of course, plenty of mutual funds, hedge funds, and other institutions explicitly follow a trading-oriented approach and do not claim to conduct fundamental research. But many other institutions, perhaps most of them, conduct fundamental research and claim to focus on long-term appreciation of capital.
The reason for this paradox underlines an important but underappreciated truth: professional money managers do not apply their craft in a vacuum. Rather, they operate within the incentives and constraints placed upon them by their environment.
Looking at the money management industry at large, we see that these incentives generally do not favor the contrarian, long-term approach that is value investing.
Understanding the constraints behind the investment management industry aids the investor in finding mispriced securities. In some instances, the behavior of institutions creates bargains. In other instances, large institutions cannot invest in certain securities, which limits the market’s ability, at least in the short term, to price securities appropriately.
Short-Term Performance Orientation
A central condition of successful active management is that to beat the market, a portfolio must be different from the market. But for investors to generate above-average long-term returns, they must also accept the possibility of periodic underperformance.
Downward deviations from the market or peer group, no matter how short-lived, pose a level of career risk that few fund managers are willing to accept.
Most institutional money managers are judged on short-term investment performance against a benchmark, such as the S&P 500 index, or against a peer group of similar funds. Studies conducted by data and research firms such as Dalbar and Morningstar regularly conclude that mutual fund investors earn returns that are less than those of the mutual funds themselves.
This discrepancy occurs because fund investors engage in performance chasing, where they shift money into and out of funds based on short-term, recent results. This behavior creates a problem for fund managers because they are incentivized to focus on short-term performance, even at the expense of long-term results, while not deviating too far from their peer group or market index.
The industry’s lack of long-term focus, as evidenced by portfolio turnover and other metrics, is largely a symptom of the potential to lose clients if the fund underperforms. As one money manager stated: “It is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term performance, the long-term view may well be from the unemployment line.”
In addition to the external constraints from fund investors, many funds have embraced a team approach to managing portfolios. This approach creates the need for consensus behind individual investment decisions and further reduces the ability of a fund manager to make contrarian investments.
From a business perspective, the motivation to manage a fund with a team approach is to reduce the possibility of a fund’s collapse should a star manager leave the fund. According to Morningstar, investment teams manage the majority of actively managed stock and bond funds.
Size Constraints and Style Constraints
Another constraint in the fund industry is size. The fund industry is heavily biased toward large funds, often those with more than $1 billion in assets.
The costs of managing and administering a mutual fund are mostly fixed. They fluctuate very little in response to the size of the fund. Funds charge fees to shareholders based on a percentage of the fund’s assets. This compensation scheme, coupled with a fixed-cost structure, means that once a fund has reached a level of break-even revenue, additional assets generate greater profit.
Additionally, the fund industry has been under enormous pressure to reduce management fees, forcing further growth in the size of individual funds.
The size bias of mutual funds has at least two important implications.
First, it forces the fund to hold more stocks than needed for prudent diversification. By one estimate, the average domestic stock fund holds approximately 160 stocks. With such large portfolios, it is unlikely that fund managers have devoted sufficient analytical attention to the companies whose shares are in the portfolio.
The second constraint from fund size is that it limits the number of stocks in which a fund can invest. Consider, for example, a $2 billion mutual fund that holds 40 stocks. The fund may limit an investment to no more than 2% of a company’s outstanding shares to maintain liquidity — the ability to sell a stock without impairing value. In this instance, the fund must focus on companies with market capitalizations higher than $2.5 billion, thus excluding thousands of smaller companies.
Another constraint comes from the investment industry’s focus on investment styles. An investment style refers to a fund’s classification based on the characteristics of the stocks the fund holds. The two most widely acknowledged styles are “value” and “growth.” Mutual fund data providers, such as Thomson Reuters and Morningstar, make such classifications, which the investment industry widely follows.
The investment industry generally defines a growth stock as the stock of a company with high revenue and earnings growth and above-average valuation multiples. The investment industry defines a value stock, in contrast, as the stock of a company with low-to-declining revenue and earnings growth and below-average valuation multiples.
The value and growth styles, however, have little relation to the value investing philosophy. A stock’s value is derived from the future cash flows of the underlying company, and growth is a factor in such calculations. The investment industry, however, delineates styles based on observable statistical variables.
Fund managers generally try to invest in stocks consistent with their style and capitalization classification, because a reclassification of the fund can lead to investor redemptions.
The investment industry’s focus on style consistency imposes a further constraint on mutual funds. For value investors, however, this constraint can become an opportunity. Stocks once coveted by growth investors can reach maturation and be sold off by growth investors. Such stocks can trade at depressed levels relative to intrinsic value but may not yet possess the statistical characteristics of a “value” stock.
This changing shareholder base is an inefficient process, leaving ample opportunity for alert investors who are unconstrained by style considerations.
Indexing and Quantitative Investing
Over the last several years, the investment industry has experienced massive flows from actively managed mutual funds into passive funds, such as index funds and exchange-traded funds, or ETFs. These instruments are constructed to match the performance of a market index, such as the S&P 500.
Similarly, many ETFs assemble portfolios based on certain statistical factors, such as momentum or price-to-book ratios. Other ETFs are designed to hold stocks in certain sectors.
The result of index funds and ETFs is that stocks are often purchased and sold regardless of their underlying business fundamentals. The increased use of passive instruments can create the same outcome as herding, albeit for mechanical rather than psychological reasons.
The mechanically driven volatility of index funds and ETFs is another potential source of opportunity for alert value investors.
Conclusion
The experience of many value investors in identifying and profiting from securities mispriced by any objective measure has, in their collective opinion, falsified the claim of perfect market efficiency. Despite this experience, most value investors do not dismiss the EMH in its entirety.
The EMH is a proposition that should be neither fully accepted nor rejected. Price efficiency is a matter of degree.
While rational, fundamental investors may ultimately set prices, momentum traders and other short-term speculators can move prices significantly below underlying business values. Behavioral motivations and institutional constraints can also cause price inefficiencies.
By identifying the sources of price inefficiencies, investors can focus their attention on potentially attractive opportunities.
Sources
Belsky, Gary, and Thomas Gilovich. Why Smart People Make Big Money Mistakes: Lessons from the Life-Changing Science of Behavioral Economics. New York: Simon & Schuster, 2009.
Fox, Justin. The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. New York: Harper, 2009.
Keynes, John Maynard. The General Theory of Employment, Interest, and Money. New York: Harcourt, 1964.
Klarman, Seth. Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. New York: HarperBusiness, 1991.
Lowenstein, Louis. The Investor’s Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It. Hoboken: Wiley, 2008.
Shleifer, Andrei. Inefficient Markets: An Introduction to Behavioral Finance. Oxford: Oxford University Press, 2000.
Surowiecki, James. The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations. New York: Doubleday, 2004.
Thaler, Richard, and Werner De Bondt. “Does the Stock Market Overreact?” Journal of Finance Vol. XL, no. 3, July 1985.
