(Bloomberg View) -- Eugene Fama and Richard Thaler, two legendary finance professors at the University of Chicago, recently had a debate about whether markets are efficient. Fama was generally perceived to have gotten the better of the exchange, and I tend to agree with him -- the efficient markets hypothesis isn’t strictly true, but it’s a great baseline for thinking about markets.
But Thaler was probably being too nice in the debate. There are a number of holes in the EMH that go beyond the problems that the two brought up. One of these is the persistent success of investors who rely on fundamental analysis -- the technique of making bets about companies’ true value by looking at their financial statements.
The so-called semi-strong form of the EMH says that market prices already reflect all publicly available information. In other words, making a profit just by looking at a company’s income statement and balance sheet should be impossible, unless the market is somehow dysfunctional.
That semi-strong thesis contradicts some of the most classic investing advice. Benjamin Graham and David Dodd’s book “Security Analysis” has been the bible of stock-pickers for almost a century. Titans of investing such as Warren Buffett have very explicitly made their fortunes using techniques based on its principles. As Buffett explained back in 1984, an efficient market wouldn’t have allowed this kind of success:
Buffett...presents nine different funds that have beaten the market averages over long periods, all sharing only two qualities: a value strategy and a personal connection to Buffett. He emphasizes that they weren’t cherry-picked with the benefit of hindsight. In closing, he boldly predicts “those who read their Graham and Dodd will continue to prosper.”
Buffett, who said this in a debate about the efficient market hypothesis, wasn't being as gentle as Thaler.
Fundamental analysis succeeds if two things are true. First, the market has to have overlooked important things about a company’s value -- things that can be observed by carefully scrutinizing publicly available information. Second, the market has to eventually realize the company’s true value. This second step is important because if the market never catches on, you would have to hold the stock for a very long time in order to make a profit from dividends and share buybacks. If the market catches on, maybe even slowly, you can cash out and get your profits in a year or two -- very important if you’re managing a fund and need to show annual gains.
Now, there’s no reason that fundamental analysis should be restricted to the value investing techniques outlined in Graham and Dodd. In principle, any technique that consistently extracts valuable but unrecognized information from balance sheets, income statements and the like counts as a big violation of the efficient markets principle. And a couple of financial economists have a new paper showing that a very simple, general fundamental analysis technique -- perhaps even more universal than Graham and Dodd’s -- consistently predicts the way that a stock’s price will change during the next two years. If this result holds up, it’s a big blow to Eugene Fama’s side of the debate.
Sohnke Bartram and Mark Grinblatt simply took a bunch of stocks, and correlated stock values with the 14 most commonly reported items on the companies’ balance sheets and the 14 most commonly reported items on their income statements. That’s all. A simple regression analysis. Then they took the results of that regression and used them to predict what each stock’s “fair” market capitalization should be. If a company had a market cap above the “fair” value predicted by the regression, it was judged to be overpriced; if below, it was judged to be underpriced.
The authors then looked at the subsequent years, to see what would have happen if they had traded based on these indications of overpricing and underpricing. They found that doing this would achieve returns of about 4 percent to 9 percent a year, after accounting for all the standard risk factors. That’s a hefty haul. During a period of a little less than two years, each stock tended to converge to the fair value predicted by the regression, yielding profits for anyone who followed the researchers’ method. Just as proponents of fundamental analysis would predict, the market seems to always make mistakes but to correct these errors over time.
If this result holds -- that is, if Bartram and Grinblatt haven’t made a big, critical mistake in their statistical procedure -- then it’s a pretty serious blow to the idea that markets take advantage of all publicly available information. It means that there are some pieces of information sitting right there on corporate balance sheets and income statements, free for all the world to see, that aren’t being fully incorporated into market prices for almost two years after they appear. Whatever that information might be, these calculations suggest it’s available for the taking.
Of course, the EMH may get the last laugh, in a way. As often happens, money managers will read this paper and write code to do more sophisticated versions of what the professors did. They will trade on the mispricing, and it will mostly vanish, allowing proponents of efficient markets theory to declare victory. But this is a very big thing for the market to have missed for so long. The acolytes of Graham and Dodd were on to something.
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