Making Money in an "Efficient Market"

Hey everyone! Sorry I have not posted in a little bit here, school is underway. However, I had some time in literature class to daydream and I found myself, unsurprisingly, thinking about stocks. So instead of analyzing Washington Irving and Rip Van Winkle, I analyzed the theoretical side of making money in stocks in today’s day and age.

This write-up may not be very practical to some, since it is pretty much what everyone knows. Yet, I have found it helpful to articulate what you intuitively know as it may bring some deeper understanding and clarity.

So how do we make money in today’s market? I believe the market is mostly efficient but the performance of the members of this board shows that the efficient market theory is not entirely true. Outperformance is possible. It just takes work and patience. I’d like to boil down the theoretical side of just how to make money in this so called “efficient market.”

THE BASICS

First of all, what makes a stock go up? There are two main factors in my opinion.

  1. Performance of the business (it makes more money!)
  2. Multiple expansion (the company is viewed more positively)

So how do our stocks go up more than everyone else’s when everyone else has access to the same information as we do?

TWO MAIN WAYS

  1. You think a company will perform better than the consensus. (business performance, excellence of management, analyzing competitive advantage)
  2. You think the potential red flags keeping a company down aren’t as bad as the consensus. (multiple expansion)

In an efficient market, there are only two real edges left that both apply to these two main ways.

  1. Time edge
  2. Analytical edge
  1. You can think a company will outperform, in terms of business performance, LONGER than everyone else thinks (i.e. have a longer time horizon) or you can simply be a better analyzer of businesses than everyone else (this one is just a tad harder :p)

  2. Also, you can have conviction and wait long enough for those red flags to clear up and expand the multiple or you can simply have better analytical insights into why those red flags won’t be a big deal.

Ok to re-state the two main ways:

  1. You think a company will perform better than the consensus.
  2. You think the potential red flags keeping a company down aren’t as bad as the consensus.

EXPECTATIONS (valuation) vs. RESULTS

First, we need to know what everyone else thinks.

  1. Understanding expectations is important (i.e. valuation). But more importantly, it is key to know, specifically, why your company will do better than those expectations (i.e. drivers).

  2. What are the red flags keeping the multiple down. How probable are they? Why do we believe, specifically, the company won’t be as affected as everyone else thinks?

PORTFOLIO MANAGEMENT

Now that we have uncovered why we think the market is wrong and we are right, we need to have an idea of quantifying this in order to build out a stellar portfolio. Here are a couple questions I think about.

  1. How much better will your company do than is currently expected/priced in?

  2. Relative to all the other options that I am familiar with, is my expected premium for this stock higher even considering the red flags? This question is not as numerical because it is very hard to put a number on risk premium.

These questions do not have to be calculated out to three decimal points, the point is not false precision, but an understanding of the numbers so we can from a portfolio around opportunity cost and risk management.

It is important to make a decision in a portfolio relative to the other pieces. The idea of opportunity cost is very real in a portfolio. Sometimes the best buy might be a stock you already own.

I once heard someone say that there would be little risk in a stock if you knew everything about it. Risk lies in the stuff hidden from view. So with this in mind, how many companies should we hold so we can keep tabs on the evolution of our companies? This answer is individual to the person but, essentially, the more work you do the less risk there is.

SUMMARY

Making money in stocks isn’t easy, especially when you are up against professionals and very smart people. If the market is largely efficient, how can we outperform?

  1. Independent thinking
  • You think a company will perform better than everyone else thinks this company will perform.
  • You think the potential red flags keeping a company down aren’t as bad as everyone else thinks.
  1. Humility
  • Knowing stuff happens we can’t control and all we can do is learn from it, then make the best decision for the future.

Conclusion: This exercise may have been a giant waste of time because truly all you need to know is: buy great companies and you’ll probably turn out all right. However, I hope this gave you a mental model for viewing outperformance.

  1. Basically, I think it’s better than everyone thinks and/or I think it’s not as bad as everyone thinks keeping in mind time and/or analytical advantage.
  2. Quantifying it in order to put the pieces together accounting for red flags.
  3. Keep in mind opportunity cost.
  4. Outperform.

Fool on,

Ryan (XMFish)

9 Likes

I thought the market wasn’t efficient. Maybe it is on average over a long period of time, but there are plenty of anomalies. I remember a very interesting academic paper showing what some stock charts would look like if pricing were rational, and they were much less volatile.

It does help a lot to buy great companies, but you also have to pay attention to price. I think that’s one weakness in most of TMF’s services - they say next to nothing about a buy or sell price. (The one exception I found was Inside Value, and there I questioned many of their picks.)

1 Like

I thought the market wasn’t efficient.

The Efficient Market Hypothesis is not fact but a hypothesis as the name of the academic paper says…

The efficient market hypothesis (EMH) is an investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

Read more: http://www.investopedia.com/terms/e/efficientmarkethypothesi…

In my view its BULL-CRAP. Take Friday’s Off Wall Street report on BEAT. It didn’t go out to all market participants but only to their clients. Only on Monday did various sources reveal its existence. That breaks the key assumption:

to always incorporate and reflect all relevant information.

End of story.

Denny Schlesinger