As a portfolio manager, this is somewhat disheartening. The EMH implies that I can't beat the market no matter how hard I work. The irony in this argument, however, is that the market would no longer be efficient if all the analysts and portfolio managers closed up shop. This is hardly a stable equilibrium. Companies only hire analysts if they believe the markets are inefficient, and the EMH can only hold true if the analysts are doing as much research as possible.
The data doesn't exactly support the EMH either. Stocks with low price-to-earnings ratios, price-to-book ratios, and price-to-cash flow ratios all beat the market on average. Nevertheless, virtually every academic institution preaches the merits of the EMH, on the basis that mutual funds don't beat the market on average. I clearly have my doubts regrading the EMH. Anyone else have any thoughts?
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Tyler, what if we went with a less pure version of the EMH? One where bubbles are possible, but where the market prices assets correctly over the long run?
ReplyDeleteI've been reading A Random Walk Down Wall Street and the argument he makes is that over the long run and after subtracting out brokerage fees, the market will beat 99+% of managed portfolios. As you point out, you can look at the performance of mutual funds to verify this fact. Malkiel acknowledges that there are some exceptional money managers who will consistently outperform the market, but it wouldn't be possible to validate this point except after years of successful money management (judging sooner may lead you to LTCM), at which point they are out of reach to the layman. Fundamentally, he wants to make an argument that the market is efficient by the fact that you cannot look at a stock's historical performance to predict its future performance.
You argue that stocks with a low p/e ratio etc. consistently beat the market. Malkiel also addresses this scenario by saying that greater returns are only achieved by taking on greater amounts of risk. Stocks with a low p/e have that for a reason - they cannot currently justify a higher one because investors are not optimistic about their prospects. Stocks with a high p/e have that for a reason - they can currently justify it because investors are (rightly or wrongly) optimistic about their prospects.
To validate this point, take industries that are transforming and look at the p/e ratio for those companies that are waning vs. those companies that are waxing. Blockbuster (who is posting losses and doesn't currently have a P/E) vs. Netflix (32.6). Books A Million (9.9) vs. Amazon (77.0). If you bet on Blockbuster or Books A Million right now, you will look like a genius if they have a huge turnaround in a year. They have low p/e ratios because not many are optimistic about their prospects.
Thoughts?
Tyler, two things from your post strike me as interesting. First, as Chad rightly implies, bubbles should disprove that "assets instantly price in all available news" - unless assets instantly price to something other than their actual value. I have significantly less faith in the markets than the EMH implies. The market might eventually price assets correctly, but there's nothing instantaneous about it.
ReplyDeleteSecond, I think that the value of EMH is the very thing you resent. Analysts and portfolio managers ought to be quite a bit more humble about their ability to manage the market. I'm not implying that you have an inflated understanding of your own abilities (that could be a fun conversation for another time), but I imagine that most analysts and portfolio managers do. EMH forces them to recognize that they are almost certainly not going to be geniuses who beat the market - well, it ought to.
Chad, your less pure version of the EMH is the fundamental concept behind value investing. Value investing can't work if assets are always priced correctly, but they eventually need to reach fair value or else there is no point in research/modeling to determine a price target. Naturally, I agree with this concept. I would expand your bubble argument to suggest that stocks deviate from fair value by only 10% or 20% some times--not quite a bubble, but still an irrational movement. You also have to consider the opposite of bubbles. Last March was clearly an irrational move to the downside.
ReplyDeleteAs for your other point, you argue that low valuation stocks are riskier. Let me clarify that I meant that these stocks outperform on a risk-adjusted basis (measured via Sharpe Ratio or Treynor Ratio). The stocks do have a bit higher probability of bankruptcy, but assuming you have a diversified portfolio of these low valuation stocks (the EMH and always assumes diversified portfolios), this portfolio will outperform on average. The big downfall with the Amazons of the world is that when growth decelerates, their multiples plummet.
So if it's supposed to be this easy why do managers underperform? Trading costs are certainly one issue. I'm not sure what the average hit managers take from trading costs is, but let's assume you pay 2 cents per share and a typical stock price is $20. That's a tenth of a percent loss on the position just for starters. If 10% is the average market return and you turnover the portfolio about once per year, you're throwing away about 1% of your expected return (one tenth of a percent dividend by ten percent). Brett is also right that many managers have an inflated opinion of themselves and don't play the odds. Most people that think they can trade growth stocks with a high turnover tend to underperform (growth stocks underperform, coupled with higher commission from high turnover). I don't think it's a coincidence that most of the investors that have reached celebrity status over the years have a value focus.