Download Value Investing vs the Efficient Market Hypothesis

Value Investing in the context
of the Efficient Market
Hypothesis
What is the relationship and how to optimize
returns?
By Nawar Alsaadi
How can they be reconciled?


As value investors we are naturally skeptical of
EMH.
Without EMH we can not realize the value inherit in
a value investment.
So how to reconcile them?


EMH is ultimately true long term, but is flawed short
term
“In the short run, the market is a voting machine but
in the long run it is a weighing machine.” Benjamin
Graham
Why is the EMH flawed in the short term?



EMH is based on the premise that a security
price is reflective of all available information
at any moment in time, and thus miss pricing
can not occur.
The performance of successful value
investors indicate the contrary. (Warren
Buffett, Seth Klarman, Martin J. Whitman)
What is behind such flaws?
Three Underlying flaw drivers



Not all investors reach the same conclusion based
on the same information at the same time.
Not all investors are in a position to act on a given
piece of information.
Not all information is disseminated at the same
speed to all investors, and most importantly not all
information reaches the investors who can and want
to act at the same time. (especially for information
dealing with small cap stocks and less widely
followed securities)
Company X just released positive financial
information.
Information Processing:
 Investor A: believes that information enhances the value of the
company.
 Investor B: is undecided, maybe waiting for more evidence.
 Investor C: is not yet aware of the information.
 Investor D: believes the information is negative to the future of
the company.
Acting:
 Investor A: would like to act, but he has no funds to do so.
 Investor B: can act but is not yet willing to do so.
 Investor C: is able to act but he is not aware of the information.
 Investor D: has acted on the information.
Are company X shares correctly priced?
The actions of A, B , C and D are repeated thousands
of times, thus creating a market, but not necessarily
an efficient market.
An efficient market is when:
 Investor A and D act.
 Investor B takes a decision.
 Investor C receives the information and acts.
At some point this would happen, however as new
information is released this cycle will re-start, and
will lead us to :
Cyclical Efficient Market Hypothesis
Is the point where the intrinsic value of a
security converges temporarily with the
security’s market price.
Cyclical EMH in Action
CEMH Points
30
25
Price
20
intrinsic value
market price
15
10
5
0
1
2
3
4
5
6
7
8
9
10
11
12
Time


Consider at which point in the cycle you are buying?.
Constantly analyze the movement of the intrinsic value and the market price
Real Example

Between September 2004 and December 2009 the divergence in Pine tree stock (TSX: PNP) ranged from a 53%
discount on the low end to 241% premium, keeping track of the relation between net asset value and price is
essential in choosing an entry point and an exit point out of the stock.
Conclusion
Optimum Value investing can be simplified to:
 Buying at the biggest divergence point
(discount) between the company’s intrinsic
value and the company’s market value, and
selling at the point of convergence (CEMH) or
overpricing of the company, depending on
the investor strategy of either buying long
term and riding the cycles, or exploiting
temporary price inefficiencies.