A challenge to the efficient market hypothesis

5 mins. to read

by Frederik Vanhaverbeke

In the last of a series for SBM, Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.

The extreme efficient market theory is “bonkers”. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality. The efficient market theory is obviously roughly right meaning that markets are quite efficient and it’s quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way. The answer is that it’s pretty efficient and partly inefficient.
—-Charles Munger

Adherents to the Efficient Market Hypothesis (EMH) argue that people who beat the market are just lucky.

They say that the stock market is always efficient in every stock as all public information about companies is processed at the speed of light and gets reflected immediately in stock prices. They claim that every opportunity to beat the market is arbitraged away by the numerous rational investors with deep pockets. In their opinion, trying to beat the market is futile. As a consequence, they recommend that people invest in index funds and index trackers, and to give up on active investing.
They probably have a point… to some extent.

All great investors that I discussed in the previous twelve articles on top investors that are featured in my book Excess Returns: a comparative study of the methods of the world’s greatest investors admit that beating the market is difficult. And they believe that most stocks are priced quite efficiently most of the time. But they dismiss the idea that there is not a single mispriced stock. On the contrary, they are convinced that disciplined and talented investors who go the extra mile, and who can cope effectively with psychological biases can outsmart the market. And there is plenty of material to support their conviction.

In the figure below we show the annual excess returns over the S&P 500 of ten of the twelve investors that were the topic of my previous articles as a function of the duration of their track record. Most of these track records are so extraordinary that they cannot be explained by chance. Warren Buffet and Shelby Davis, for instance, beat the S&P 500 by more than 10% a year over periods of respectively 45 and 57 years. Although Joel Greenblatt’s investment career was shorter, it is at least as impressive as that of Buffett and Davis as he beat the market by a whopping 27% a year over two decades. And what are the odds that an investor beats the market by more than 6% a year over a period of 25 to 30 years, as did Prem Watsa, Seth Klarman and Anthony Bolton? Also the track records of Charles Munger, Benjamin Graham and Peter Lynch stand out by a very high annual outperformance of 10% to 15% over one to two decades.

Promoters of the EMH must be scratching their heads over these amazing track records.

Making things even harder to explain is that these twelve investors realized their exceptional track records through a similar investment method. Indeed, we have seen in previous articles that they looked at similar types of stocks (e.g., special situations, unpopular stocks, stocks that other investors overlook, etc.). They emphasize the same qualitative characteristics in their due diligence that most other investors pay no attention to (e.g., they look for management with a high level of integrity). They structure their portfolios in an unconventional way (e.g., most like to focus on their best ideas). And unlike most other investors they stress that discipline and effective coping with psychological biases are critical success factors. The fact that these top investors beat the market through a similar investment approach is completely at odds with the EMH as EMH’s claim that market-beaters are lucky individuals excludes the possibility of a structured approach by which the market can be beaten.

It must be said that my articles only scratched the surface of what can be said about the investment methods of the most successful investors in the world. The twelve top investors that I discussed in my articles were just a selection of a wide set of investors whose investment ideas were studied to develop the general framework that is the topic of my book Excess Returns: a comparative study of the methods of the world’s greatest investors. Other top investors that are featured in my book and whose track records are also shown in the figure below are, amongst others: Kevin Daly, Eddie Lampert, Philip Carret, John Neff, Glenn Greenberg, David Einhorn, Julian Robertson, Lou Simpson, Donald Yacktman, and Walter Schloss. The amazing thing is that if we compare the investment methods of all of these investors, we can see a lot of striking similarities. They look in the same places for bargains. They pay attention to the same subtle factors in their due diligence. They have similar buy and sell practices that fly in the face of conventional wisdom. And their risk management and portfolio construction run counter to academic theories on these subjects.

I believe that this observation combined with the extraordinary track records of all of these top investors is sufficient to silence the discussion about the efficiency of markets once and for all.

But then again, serious investors should appreciate the efforts of so many business schools to propound the EMH, as this reduces competition in the market. In the words of Warren Buffett: “It has been helpful to me to have tens of thousands [of students] turned out of business schools taught that it didn’t do any good to think.” Rest assured that the EMH, ignorance, and psychological biases are immutable forces that ensure that the methods of the greatest investors in the world will continue to work many years after they are gone.

Read more about Seth Klarman’s investment methods in Frederik Vanhaverbeke’s new book Excess Returns: A comparative study of the methods of the world’s greatest investors, published by Harriman House

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