THE EFFICIENT MARKET THEORY
The financial and investment markets have an amazing ability to correctly anticipate official information flows. In addition, most major company announcements are already known by insiders, or half suspected by the market and therefore already factored into the stock price. This is especially true for top-tier institutional investors such as mutual funds, superannuation firms, banks and brokers who have a lot of money tied up in listed companies. They devote great volumes of time and energy into researching every move. The biggest investment firms will have a full-time researcher for each of the biggest companies. Because of this huge information flow, the old adage to “buy on the rumour and sell on the fact” is proved daily for these big companies. The information in most significant company announcements will be known by a sufficient number of insiders and avid company watchers to move the price before its arrival in the public domain.
Because of this amazing efficiency in getting and using market information by the big end of town, there has developed an academic theory taught across the world these days called “The Efficient Markets Theory”. In a nutshell it says that all publicly traded markets are highly efficient in their distribution of knowledge and therefore in their valuation of assets. Any person who then beats the market on a consistent basis is a statistical fluke. Warren Buffet, the world’s best investor is considered one such fluke. You, as a small punter obviously cannot beat the market because it is just too…well…efficient! The originator of this theory was Professor Eugene Fama from the University of Chicago. The emergence of the theory just happened to coincide with the establishment of the managed funds industry in the late 1960’s. Institutional fund managers and retail investment advisers are the greatest believers in the efficient market theory because it suits their interests.
Contrary to what is believed by the managed funds industry, publicly traded markets are not efficient and never will be. If they were then we would never have a boom or a bust. Even the former US Federal Reserve chairman, Alan Greenspan, said in his recent book The Age of Turbulence that the theory of efficient markets cannot explain stock market crashes. For a start, how could all market participants ever be equally aware of all the information available and have acted on it? Eugene Fama gave investment funds and financial advisers a great excuse just to track the overall market and charge you 1-2 per cent a year for the privilege. Unfortunately, his theory is still taught as “gospel” in many university economics courses, although with the global financial crisis of 2007-9 it is finally starting to lose some credibility. However, as long as it continues to be taught I won’t mind. It will simply mean there are less potential market investors who have their ears pinned back, looking for the inefficiencies I see every day. The less competition for me the better! Stock markets are inefficient for the following obvious reasons.
1. Psychological Blueprints
Every human will make financial decisions that flow subconsciously out of a deeply-embedded financial blueprint they developed in childhood. This emotional blueprint can, at times, lead to the most bizarre financial decisions imaginable. Fear of poverty, rampant greed, selfishness, impatience and a host of other emotional states determine our reaction to financial stimulus as adults. Two people can view the same information and make opposite decisions because of their childhood conditioning. Rational decision making flies out the window when financial survival is at stake. Fear will over-ride logic every time there is a crash. This will create entry opportunities for the well prepared. In my experience mini-crashes occur every six months or so, major crashes every few years, and mega crashes occur about once a decade. All of these are used by savvy individuals who can see an opportunity to buy a dollar’s worth of company for 10c, 20c or 50c. If you can live outside the investment heard and do the opposite then you will soon start to look like one of those statistical flukes.
Each and every player in an investment market also brings their unique previous financial buying and selling experience to the decision making table. These experiences will have created either pain or pleasure in their lives and these emotional reactions to previous experiences will create similar emotional reactions to new information. We humans are not that rational when it comes to money. Some market players are making their first decision while others have been around for 40 years. Each will react very differently to new market information. Newcomers will lose their head at the first market panic they experience, while seasoned investors have seen it all before and will be buying from these rookies at bargain-basement prices.
Information theory tells us that all information understood by an individual or a group consists of both sent knowledge and received knowledge, with each side bringing all sorts of assumptions to what they mean in that exchange. Just ask any married couple how easy is to send one message and watch another received! What “Mr Market” sends and what “Mrs Investor” receives is sometimes even more disastrous than a bad marriage, especially when “Mrs Investor” is highly emotional at extreme market tops and bottoms. The same set of GDP figures can send the market into a spin one year when near a top, while the next, when it is coming off a low it is largely ignored. Same information – different mood. In 2011 the US government breached its debt limit and the markets dived while gold skyrocketed. Yet in 2012 the next debt limit came up at the end of the year and there was barely a whimper. It was the same information but there was a different assumption as to what would happen next.
A few days is needed for information to flow through an entire market. If you get the new information first then you will have an advantage over those get their information later. If you have a large volume of information you will also have an advantage over those who have only a little. Those eager to gain information will naturally have an advantage over those who are lazy. It used to be that institutions, insiders, professionals and brokers had unfair access to information. But the internet has made the dissemination of information much more egalitarian. Large institutions no longer have an advantage as they once had over smaller players who have a keen eye for trends.
It is also often the case that it takes more than a few days for the market to fully appreciate a positive news announcement from a smaller company, especially if it is a little long-winded and about the mid-term future. It can take weeks or years for markets to appreciate new positive or negative global trends such as a shift from inflation to deflation. I remember seeing the rise and rise of China being dismissed as a passing fad from 2000 through to 2005. It is no longer taken so lightly, especially by the US government. From my extensive research I can remember only one journalist warning of the astronomical growth of derivative debt built around sub-prime mortgages in the early 2000’s. No one else thought it to be a problem!
3. Market Segment
There are different segments in every market and some are more efficient than others. The big end of real estate and stock markets is inhabited by professional decision makers. This institutional end of the market will be more efficient than the small end where amateur investors work. I have seen this over and over again in the junior mining sector. Residential property is likewise much less efficient than commercial, retail or office towers, because it is inhabited mainly by amateurs. Invest in the most inefficient ends of any market and you will soon develop the knack of finding inefficiencies! They will pop up almost daily to the experienced eye. I have a very technical term of for these inefficiencies: “bloody bargains!”
Let’s crunch some numbers for the Australian Stock Exchange and find the inefficiencies. There are several thousand companies on this exchange. The biggest 200 companies are considered blue-chip and make up the ASX 200 Index. Their combined financial value far outstrips the several thousand smaller of companies combined. The next 200 are covered by the Small Ordinaries Index. The original All Ordinaries Index covers the largest 500 companies. To look below that level is like entering the depths of the ocean where there’s no light and strange creatures live! There is virtually no brokerage or institutional coverage for these companies. The rise of discount internet brokers means even fewer full service brokers cover small companies.
American studies suggest that companies without coverage, though earning the same, typically trade at a 20-30 per cent discount to those that are covered. The smallest companies are typically capitalised at between $5m and $150m. If you can find one or two of these minnows that are growing robustly, and hang on long enough for them to grow into the Small Ordinaries Index or the ASX 200, you will actually benefit twice. The first kick-along comes from the natural organic growth of the company and its stock price. The second kick comes from the injection of institutional funds when it reaches “maturity”. This second wave of price growth will typically see the Price/Earnings ratio (PE) rise from single figures to healthy double figures. The PE is simply the price of the stock over the earnings of the stock. The higher the figure, the more expensive the stock, as long as all other factors are equal. The average PE ratio for large companies has been around 15.
A word of warning before moving on: Inefficiencies can work both ways. It can help you snap up a bargain but it can also mean you will take a bigger loss if you get it wrong. Inefficiency means extra volatility. Good for some, awful for others.
4. Future Focus
Today’s market decisions are not normally being driven by what information is already in the market. They are driven by a collective belief about the quality of information that will be in the market in 6-12 months’ time. Markets are predictive, not descriptive. For many years I had the habit of investing for a two year time frame only to see my stocks punished in the first year. After some time I realised that the best story in the world can go backwards if the market cannot see it materialising within 12 months.
I once bought a company called Pacific Hydro for $1.00, twelve months later it was worth 30 cents. Two years after that it was bought out for $5.00. The human mind has trouble trusting a longer-term story. It loves instant gratification, and one year is about the time limit people are prepared to wait for that gratification. Beyond that, they believe there are too many unknowns. This means that the most fantastic long-term story that is already locked in and under development can be bought for a fraction of its eventual value. You could end up seeing your original investment rising over 5 or 10 fold over a multi-year period. You only have to find one of these companies once in a lifetime and you will set yourself up nicely.
5. Indexes and Companies
Always remember that you are not buying the general market index or some other abstract number when buying stocks in a company. What you see on the evening news is not what you are investing in. The market index is simply the sum total of the specific group of large companies in the market. You are buying a small part of a real business and hope to prosper in its expansion. Smaller companies can grow faster than the index but they rarely ever rate a mention in the financial press and are definitely not in the major market index. Small companies often move independently to the giants at the top and are much more volatile. This means they can drop more quickly than the index, but very importantly for the astute investor, it means they can also rise much more quickly. This is the very reason why I averaged 65 per cent capital gains for the first nine years after I started to take stock market investing seriously, and this figure includes the global financial crisis.
Always remember your purpose as an investor is to buy a small stock of a growing company at a good price that will give you a healthy capital growth and profit in the future. Don’t fret when you see the market index down three days running. You didn’t buy the index. Futures traders buy the indexes. You bought a real business run by real people.
I could go on but suffice to say that those who believe in the efficient markets theory do not have the mindset to create their own wealth. They have a ready-made excuse not to. The theory also gives investment fund marketers a justification for believing their products are the best for Joe Public. As they explain over and over in slick sales presentations every day, Joe doesn’t stand a chance of making money in the shark-infested world of the deep blue markets. Don’t believe the sales talk for a minute. Get out there and begin to exploit the markets inefficiencies.
HOW TO BEAT AN “EFFICIENT” MARKET
Very early in my investing career I realised the stock market is an information weighing machine. It takes all the information at its disposal and uses it to make a judgement about the future prospects of businesses, currencies, commodities etc. The more information there is in the marketplace, the more accurate the forecast. However, most companies produce an intermittent information flow, so the smaller the company the more erratic the stream. This makes fast growing small companies the hardest to find and predict. However, there are ways of extracting extra information from the market if you are keen, and this will give you an edge. I have listed a few of these methods below. Like human communication, the stock market speaks through body language as well as words. Sometimes the actions of the market speak louder than the words of the individual companies, brokers or market commentators. I have also explained some of this body language so you can spot it when it comes up.
Information usually comes through in small segments. It is rare that a single piece of information is big enough to significantly and permanently move a stock price by itself. Most large pieces of information have already been anticipated by keen investors and the stock price has been bid up accordingly in anticipation. One of the signs of a novice investor is that they buy into one of these big news items. This usually creates a top from which the pros will take profits. “Buy on the rumour, sell on the fact” is as true today as it was 100 years ago.
The more typical “chicken scraps” of smaller announcements are numerous but relatively useless on their own. It is only when many continuous scraps of information come together like a jigsaw that a significant picture of what is ahead can be created. This big picture which you create in your mind from lots of often random snippets of information gives you an investment edge. This is why the stock market favours those who have a love of knowledge. For example, a good understanding of the implications of a mining drill result takes many exposures to previous drill results to develop. Knowing the implication for Australian zinc, iron ore, coking coal, nickel and copper miners of changes to interest rates in China takes a while to get your head around. The “gut feel” is much more than simple information. It is the same with technology businesses, retail chains, real estate investment trusts and every other component of the markets. The stock market is truly just an exchange of knowledge, but that knowledge is drip fed to you, one announcement at a time. This is where the avid reader and researcher has the advantage over others. Over time they learn the skill of putting small pieces of information together and can see the bigger picture that eludes the vast majority of lazier market participants.
2. Capital Gains & Dividends
Is the company paying dividends? This is a good sign, but the returns from capital gains are far more important to a serious investor than returns from dividends. Too many people make an investment decision based on the share of their profits that the company pays out to its investors. Companies giving a 7 % dividend are seen as a better investment than one giving 3 %. This way of thinking comes from the conditioning we get from depositing money in bank deposits and earning interest. Investing is not at all like this and you must change your mindset if you are to succeed.
The fastest growing companies rarely pay dividends so don’t look for them. Why would a fast-growing company with good management pay out some of their profits to you when they can keep them and grow the company even faster by reinvesting this cash? This fixation with dividend returns can be seen very clearly in the gold market. Many professional fund managers and indeed individual investors did not hold gold between 2000 and 2010 because it did not pay interest. But at the same time it moved from $US250 to $US1400 and was the best investment of the decade! For the sake of a total of 70 per cent in interest they threw away 500 per cent in capital gains. Always go for capital gains, not dividends. Think like an owner of the company who wants to become wealthy and not like a worker in the company who wants to be paid.
3. Ownership & Access
Does the management have a large personal stockholding? Always look for a fast growing company whose management owns at least 10-15 per cent of the company. This information can be found in their annual report on their website. A high stockholding by directors tells you that the management believes strongly in the future of their company, because they are a fellow owner. Their money is where their mouth is. They will work like an owner, spend carefully like an owner, and have the vision of an owner. It is even better if the CEO of the company is the founder. They are a rare breed of human who is gifted in business. Beware of companies whose management has very little ownership in the company. This is more often the case with larger, multi-billion dollar companies.
If you are interested in investing in a smaller company do not be shy in giving them a call. Smaller, single purpose companies who have few professional people interested in finding out what they do. In fact a simple phone call to the manager of a small-cap company will often elicit much more information than ever makes it to the company announcements. However, before phoning always have a list of intelligent questions up your sleeve and they will usually warm to you. I have seen these phone calls develop into a first name relationship with a key person in head office. Small company managers usually love what they do and are keen to share their insights with a stockholder who shares or appreciates their passion. However, don’t push them too hard though as they are not supposed to disclose specific information to you that has not already been announced to market. I use these calls to get hold of all the information that is left out of announcements because it is thought to be too trivial and which give you a far clearer picture of where the company is up to. Think of it like this: The company announcements are like a resume or CV, straight to the point. A phone call is more like the job interview where you really get a feel for the quality of the person, their heart for the business and their professionalism
4. Company Reports
As I have said before, the average stock market investor looks 6 to 12 months ahead of current economic conditions and invests accordingly. The fancy way of saying this is that the market “discounts” the future. Past performance means a little, but future performance is everything. If you invest by looking at past economic and/or company performance you will lose money most of the time. Past performance is no guarantee of the future. Company reports are snapshots of their past. Whatever you do, don’t use these to make your investment decisions. Use the internet to do your research about the future growth plans of the individual company, where its industry is going, where the local economy is headed, technological breakthroughs that may be relevant, anticipated debt levels, and what others are saying about that company. If your analysis of the future is sound, and the company’s past record shows a continual expansion of profits, the stock price is near a low, and the management are large stockholders, then go ahead with your investment. Just be aware that a glowing annual report or broker’s rap combined with an expensive stock price and PE ratio may be a hint that the company’s profits have peaked, the sector has peaked, or the market as a whole may be overvalued.
5. The Economic Cycle
Large market swings or trends will last several years and most companies will float up or down with this rising or falling “tide”. Up to 50 per cent of a company’s stock price movement can be due to the wider sector moving, the whole market moving, the entire economy moving, or changing international economic conditions. Your latest whiz-bang investment decision may make you look like a star, but it is often a matter of the tide lifting all boats in the harbour. This is why it is imperative that you research the global economy, the local economy, the market sector and the industry, as well as the company.
Sometimes the economy can still be expanding while the stock market is beginning to fall. This may seem odd to a new investor. This often happens when the market is expecting an economic contraction sometime in the next 12 months. The economic boom has matured to the point where interest rates are being tightened and borrowing is contracting. The stock market anticipates these future conditions and factors them into current stock prices. The world’s biggest mining company, BHP Billiton, suffered from this expectation in the latter half of 2006. Its profits were going to the moon but the stock price was contracting as investors anticipated the top of the commodities boom and lower earnings beyond 2007. We now all know what happened in 2008. When the bears have control of the market it can fall very quickly. Fear motivates selling much more potently than greed motivates buying. The old market saying is “up by the stairs and down by the elevator”. It simply means stocks drop faster than they rise.
On the other hand, sometimes the economy is slowing or contracting and the stock market is beginning to take off. This happens when the market is expecting an economic recovery sometime in the next 12 months. In the midst of a recession, when every newspaper is full of doom and gloom, suddenly the interest rate sensitive stocks, such as large home builders, will take off for no apparent reason. They are followed by others and gradually confidence returns to the stock market. A combination of buying the right company in the right sector at this time in the market cycle can reap enormous rewards over a 2-3 year time frame. The combination of a huge relief rally from the unexpectedly quick 1991 Iraq war and the end of the recession of the same year were a potent combination. Most western stock markets rose substantially in 1992. A mirror image event occurred in 2003 with the second Iraq war. Yes, sometimes history does repeat.
6. Go Where Institutions Can’t Go
As you learn to understand the workings of the stock market you quickly begin to understand that there are essentially two or three major sub-markets in operation. At the top of the market we have the heavyweights such as the big banks and multinationals. These goliaths dominate the stock market indexes and any movement in that index will largely be a function of what institutional buying and selling is taking place in those companies. Many countries now have massive savings industries called financial sectors and this money is constantly looking for a home. Institutions can only place their money in large companies that are actively traded. They need liquidity so that they can enter and exit easily when making their multi-million dollar transactions. This limits them to companies with a market capitalisation (value of all the stocks added up) of approximately $1 billion or more. This is what is traditionally called the “big end of town”.
This part of the market is controlled by the professional money managers and their army of analysts. The market is very efficient at this level of sophistication. By the time you, the small investor, find out about some significant company news, the institutions will have known about it for some time and taken up their positions accordingly.
There are several weaknesses to the institutional dominance of this part of the market that you need to be aware of. Firstly, large investment institutions are required to report their performance to their clients on a quarterly basis. This one requirement alone hinders their returns greatly. They must come up with a positive result each time or funds could be withdrawn. They therefore tend to track the overall market performance and when that turns negative, they can blame the market instead of their incompetence. This is how investment institutions come up with the mantra that you can only earn up to a maximum of 20 per cent each year in the stock market. Believe it if you wish but it is rubbish. Secondly, as alluded to already, these institutions can only buy and sell the top few hundred or so companies. This leaves the thousands of other companies to the small boutique investment firms and individual investors. People like you and I.
These smaller companies are often floated by a trail blazing entrepreneur who has built up a private business and taken it public in order to expand more quickly and take some profits. These people often own a significant chunk of the outstanding stocks which means they have a very strong personal interest in the fortunes of the company. They will frequently have a small board of like-minded people who also have significant stock holdings. They love what they do and love talking about their company. They are passionate, aggressive and full of dreams for their business. These are the fast growing businesses that attract the attention of the institutions once they come up toward the $1 billion market capitalisation level. The best time to by these companies is when they have finished the development phase of their technology, business or service, and sales are beginning to take off in a big way. This is also the time when trading volume increases and this will allow you to buy in and sell out more efficiently.
As a company grows beyond this $1 billion mark the stock price begins to move more slowly. Percentage price fluctuations tend to narrow as companies reach a size where they attract institutional investors. This is good for institutions and risk-averse investors, but not so good for those who are looking for outstanding capital gains. This is often the time when large multinationals buy out emerging companies. All the hard work is done and they can absorb the new enterprise as a division of their much larger company. The aim for the small investor is to try to find one of these future buy-out targets early on and ride them through to the end when the big boys pay a premium to take over your company. This type of investing can make you wealthy and you only need to find a few of them in your lifetime.
7. Combine Fundamental and Technical Analysis
Fundamental analysis is the study of things like economic behaviour, global trends, company reports, consumer trends and media comments about the financial markets. Technical analysis is the study of price behaviour on charts, pattern recognition and repetition. The bottom line is this: fundamentals tell you what to buy and technical analysis tells you when to buy. You need both and must master both. Once you have all the big picture global information on hand for the industry and have looked deeply into the chosen investment vehicle, it is then time to look at what the charts has been doing in the last six to twelve months to find the next likely sweet spot to buy in. Suffice to say that charts are fantastic instruments for timing your entry to a company. I will spend a whole essay showing you how to read charts.
I have friends who tend to think of an investment as the product of its chart. In other words they look at the charts more than the fundamentals. They inevitably get the jitters when the chart takes a tumble and ask me what is happening. With plenty of fundamental information about the markets, and also a long-term view of the market, I rarely get the jitters. For example, with the European economy in trouble from 2010, I was quite happy to see the European central bank printing money. Up went gold. Likewise every time the US stock market took a tumble after 2008 and my charts flashed red I was very confident their central bank would also print money. They did and up went gold. After all, this is what politicians and bankers have been doing for over 2000 years since Roman times. This type of fundamental knowledge keeps me calm when markets are collapsing. The great fiat currency experiment of the last 40 years since Richard Nixon forced the world off the gold standard might be in its death-throws but it isn’t dead just yet. They will kick the debt “can” down the road via inflating the world’s currencies and rob the middle class of their wealth again. They have always done throughout history. This type of knowledge can never come through a chart.
On the other hand if you are a gifted trader you could have seen that the charts were screaming to you that gold was shockingly overvalued when it touched $1,900 in late 2011. Many seasoned chart readers took their profits and ran. I should have but didn’t, being stronger in the fundamentals also actively trading large gold contracts at the time. I was emotionally involved which clouded my judgement. If it happens again though, I will be ready. Once bitten, twice prepared.
The next essay will discuss the two great roadblocks to wealth creation that governments put in place so they can put your money in their pocket.