When I first became interested in blackjack, everyone said there was no way to beat it. Winning systems, often involving complicated ways of varying the amounts wagered, were proven mathematically to be impossible for many of the classical gambling games. Besides, if someone could beat the casinos, the rules would be changed to stop them. When I became interested in the stock market, I heard the same claims about investing. Academics had developed a series of arguments known as the efficient market hypothesis (EMH). Using financial market data, they showed that tomorrow’s prices looked like random fluctuations around today’s prices, therefore they were not predictable.
Besides, if a price change were predictable, somebody would immediately trade on this until it was no longer so. This notion gave rise to an apocryphal story that all finance students have heard. Eugene Fama, father of EMH, was strolling across the University of Chicago campus with a graduate student. Looking down, the student exclaimed, “Look, there is a $100 bill on the ground.” Without a glance down or a break in stride, Fama replied, “No, there isn’t. If there were, someone would have picked it up already.”
The cards dealt at blackjack also seem to appear at random but not if you “track the shuffle,” which is a way to beat the game by watching the order in which the discarded cards are stacked, then mathematically analyzing the particular shuffling technique being used, leading to a partial prediction of the new ordering of the cards for the next deal. The likelihood of any card being dealt next at blackjack also is not random if you count the cards. What appears random for one state of knowledge may not be if we are given more information. Future prices are not predictable and no one can beat the market, but only when market prices “truly” fluctuate randomly.
Supporters of the efficient market hypothesis, really a collection of related hypotheses, generally believe that securities markets in advanced developed countries respond quickly and almost completely to new information. True believers originally held that most investors were rational and well informed over the decades. However, they have reluctantly yielded to the overwhelming evidence to the contrary, but they still say the collective impact of investors generally keeps current market prices close to the best possible estimate of the value, averaged over all future scenarios. Since the 1960s, academics in economics and finance have defended the various versions of the efficient market hypothesis as they churned out tens of thousands of articles, thousands of PhDs, and hundreds of books.
The classic view of the correct price of a common stock is that it is derived from the value of all the future earnings. These earnings are uncertain and subject to unknowable factors. Could anyone have known beforehand how to allow for the impact of 9/11 on the future earnings, hence on the then current market price, of firms headquartered in the Twin Towers of the World Trade Center? These future payoffs are discounted to a present value reflecting their various probabilities and risks. If the market does a good job of using today’s public information to set current prices, then the only investors who have an edge are those with material private information. The high-profile prosecution of investors in the 1980s for illegal trading on inside information makes the point.
The EMH is a theory that can never be logically proved. All you can argue is that it is a good or not-so-good description of reality. However, it can be disproven merely by providing examples where it fails, and the more numerous and substantive the examples, the more poorly it describes reality.
So far I’ve shown how markets were beaten in the past with examples from gambling, from the trading and results of Princeton Newport Partners, Ridgeline, and other hedge funds, and from the story of Warren Buffett and Berkshire Hathaway. Doing better than the market is not the same as beating it. The first is often simply luck; the second is finding a statistically significant edge that makes sense, then profiting from it. To illustrate, PNP did this in the 1980s when it exploited the large discounts to liquidation value that frequently appeared among closed-end funds.
Closed-end funds start out by selling shares to investors. They are called closed because this sale of shares happens one time only, at the launch of the fund. Management then invests the money in a stated category of securities, such as high-tech, Korean, junk bonds, green energy, or biotech. To illustrate how such a fund might work, suppose we’re in the midst of a precious metals boom. The promoters sell shares of stock in the “Pot of Gold” (POG) closed-end fund through brokerage firms, paying 8 percent of the proceeds to these firms and their sales forces. Investors buy ten million shares at $10 a share, for proceeds of $100 million less 8 percent, netting $92 million, which the managers of POG invest in listed gold stocks. Each share, originally costing $10, now represents $9.20 worth of stock, which is its net asset value (NAV) per share. The “sell side,” the Wall Street promoters, have just captured 8 percent of the money. Notice that an investor could have bought gold stocks directly and, for each $10, owned $10 worth of stock.
The shares of POG begin trading in the marketplace. Investors who are optimistic about the skills of management could bid these shares up to $11, $12, or even more, despite the NAV remaining at $9.20. Over time both the market price of POG shares and their NAV (the value per share of the underlying assets held by POG) will fluctuate. Any price for POG above NAV is called a premium to NAV and any price below NAV is a discount. One more thing—NAV represents the liquidation value of POG shares but, as long as management controls the fund, they are worth substantially less. That’s because management collects fees and incurs expenses, thereby reducing the benefits of ownership for the shareholders, compared with an investor who owns the underlying portfolio directly.
Because of management’s costs and fees, closed-end funds typically trade at a discount to net asset value. If management’s fees and expenses tend to run at, say, 15 percent of the wealth being created by the underlying portfolio, then the shareholders might expect 85 percent of the future stream of benefits, so a fair price to pay ought to be 85 percent of NAV, or a discount of 15 percent. In the case of POG, the first investors pay $10 per share. Wall Street’s selling charges cut this to $9.20. Then management takes 15 percent of future earnings, which reduces the value to the investor by another 15 percent, leaving a value per share for him of 85 percent × $9.20 or $7.82. He’s immediately lost $2.18 of his $10 or 21.8 percent of his investment to his helpers. It’s like having a brand-new car depreciate as soon as you drive it off the lot. As time passes, the market price, as a percentage of NAV, fluctuates and the pattern varies from fund to fund and with overall market conditions. I’ve seen discounts of 50 percent and premiums of 80 percent. To exploit this, an investor can seek to buy funds at deep discounts, relative to their histories and to that of comparable funds.
You can also sell short shares of funds trading at a high premium. Depending on their makeup, the long and short funds in your portfolio might hedge each other to some extent, with futures and options providing additional risk-offsetting possibilities. The returns from such a strategy can be fairly steady, but the long “workout” periods, during which premiums or excessive discounts tend to disappear, can make them modest. I once invested for a few years in an intelligently managed hedge fund that used this approach. Because of the slowness with which the mispricings diminished, our annualized return was 10 percent instead of the 15 percent we hoped for.
If POG was trading at a 40 percent discount with shares at $6 each and an NAV of $10, we could attempt to buy enough shares to force and win a vote to convert the fund to an open-end mutual fund, allowing shareholders to redeem at net asset value. Then we pay $6 a share and cash out at $10 a share, for a profit of $4 or 67 percent on our $6. A closed-end fund trading at a big discount was an opportunity for Princeton Newport. Despite fierce opposition from entrenched management, we succeeded in doing deals of this type profitably.
The differences between the market price and the net asset value of closed-end funds leave nowhere to hide for those who believe the market does a good job of setting prices correctly. Why do investors sometimes pay $1.80 for $1 of assets and other times offer to sell $1 worth of securities for 50 cents? It can’t be lack of information, since NAVs and calculated percentage price deviations are published regularly, along with actual portfolio holdings.
An unusual opportunity to buy assets at a discount arose during the financial crash of 2008–09, in the form of certain closed-end funds called SPACs. These “special purpose acquisition corporations” were marketed during the preceding boom in private equity investing. Escrowing the proceeds from the initial public offering (IPO) of the SPAC, the managers promised to invest in a specified type of start-up company. SPACs had a dismal record by the time of the crash, their investments in actual companies losing, on average, 78 percent. When formed, a typical SPAC agreed to invest the money within two years, with investors having the choice—prior to the SPAC buying into companies—of getting back their money plus interest instead of participating.
By December 2008, panic had driven even those SPACs that still owned only US Treasuries to a discount to NAV. These SPACs had from two years to just a few remaining months either to invest or to liquidate and, before investing, offer investors a chance to cash out at NAV. In some cases we could even buy SPACs holding US Treasuries at annualized rates of return to us of 10 to 12 percent, cashing out in a few months. This was at a time when short-term rates on US Treasuries had fallen to approximately zero!
For those who still believe that the market always prices securities properly, here’s a profit opportunity that arose because investors couldn’t even do arithmetic.
To see what happened, first picture two car dealers with stores side by side. The first dealer offers new Ford sedans for $9,000, plus a $2,000 rebate payable in six months. The second dealer offers the identical new Ford sedans for $14,850. Everyone who drives up can see both prices on huge signs. The higher-priced dealer has balloons flying over his lot and a band playing. The lower-priced dealer does a brisk business but the higher-priced dealer is mobbed. Most of our “rational” investors prefer to pay too much. Nuts? Not possible? It happens often. For instance, in the next example the $9,000 Ford plus a $2,000 rebate is like 100 shares of 3Com and the identical Ford for $14,850 is like 135 shares of PalmPilot. Now for the details.
Famous for its PalmPilot handheld personal organizer, the company 3Com, with stock market ticker COMS, announced that it was spinning off its PalmPilot division as a separate company. Some 6 percent of PalmPilot, ticker PALM, was offered to the public in an initial public offering at a price of $38 per share on Thursday, March 2, 2000. By the end of the day the 23 million shares that had been issued changed hands more than one and a half times, for a one-day trading volume of 37.9 million shares. The price peaked at $165 before closing at $95. The portion of PalmPilot sold in the IPO was deliberately set well below demand and led to a buying frenzy and price spurt typical at the time for tech stock IPOs. So far, this just repeated what we had often seen during the previous eighteen months of the tech stock boom.
Now for the market inefficiency. At Thursday’s closing the market priced PalmPilot at $53.4 billion, yet it valued 3Com, which still owned 94 percent of PalmPilot, at “only” $28 billion. But that means the market valued 3Com’s 94 percent of PalmPilot at $50 billion, so it valued the rest of 3Com at negative $22 billion! Analysts, however, estimated the value of the rest of 3Com at between $5 billion and $8.5 billion. And within six months or so, 3Com intended to distribute these PalmPilot shares to its shareholders. Anticipating this, my son, Jeff, had called me a few days earlier to mobilize capital for this possible opportunity. You could buy PALM directly in the IPO (to get IPO stock you had to be “connected”) or at wildly gyrating, much higher prices in the “aftermarket,” when it began trading. Or you could buy PALM indirectly by buying COMS and waiting a few months to get 1.35 shares of PALM for each share of COMS owned. Moreover, you would also have a share in the post-spin-off business of 3Com, which was profitable and would have $8 cash per share. Jeff estimated the stock would then have had a value of $15 to $25.
Analyst’s note: Jeff’s estimate of 135 shares of PALM to be distributed for each 100 shares of COMS was deliberately conservative—a “worst-case” choice—compared with the typical “street” estimate of 150 shares. Thus the street’s estimate makes the disparity look even wider than what we assumed. The uncertainty arose because the number of shares of PALM to be distributed to COMS shareholders depended on how many shares of COMS were outstanding at the time, and that would depend on how much dilution occurred in the interim from—for instance—outstanding options.
When Jeff and I were discussing strategy on the first day, at one point the prices were $90 per share for 3Com and $110 per share for PalmPilot. Buying 135 shares of PalmPilot outright cost $14,850, but if we paid $9,000 for 100 shares of 3Com we got both 135 shares of PalmPilot and 100 shares of the 3Com “stub” company. (Think of each 100 shares in 3Com as a ticket having two parts, one labeled 135 SHARES OF PALMPILOT and the other piece or stub labeled 100 SHARES OF 3COM POST-SPIN-OFF.) If you buy the hundred shares of 3Com you pay $9,000 and get $14,850 worth of PalmPilot and a 3Com stub with a current estimated value of between $1,500 and $2,500. Sell this for, say, $2,000 and the 135 PalmPilot shares only have a net cost of $7,000.
I challenge efficient market theorists to answer these questions: Why were people willing to pay $14,850 for 135 shares of PALM when they could have paid $7,000, and why were some investors buying PALM stock at a price that set a value of $53 billion for the company instead of acquiring it at a price of less than half as much by buying it via 3Com stock? It’s not a question of information. The terms were simple, public, and known in advance.
How could Jeff and I exploit this? One approach was to buy 3Com, wait six months or so, then sell off both the PalmPilot shares we would get from 3Com and the remaining 3Com stub. But what if 3Com and PalmPilot were both substantially overpriced now and their prices fell drastically by then? There was reason to believe this might happen. First, COMS had run from about $50 two months earlier to over $100 just before the IPO, in anticipation of the spin-off. Second, we believed tech stocks were in a speculative bubble driven by a large pool of irrational investors, many of them in the new day-trading “casinos.” We were right about the speculative bubble. The NASDAQ reached its all-time high at this time, then lost 75 percent in less than three years. Sixteen years later it still hadn’t fully recovered.
We could borrow and then sell short 135 shares of PALM at $110 for proceeds of $14,850, which would be held in escrow by our broker until we returned the borrowed shares. We could also buy a hundred shares of COMS at $90 for a cost of $9,000, setting up a nearly riskless hedge for an almost sure profit. In six months or so we would get 135 shares of PALM from our 100 shares of COMS and deliver it to clear our short position. Then the $14,850 short-sale proceeds would be released to us from escrow, leaving us with a net profit of $5,850 in cash and a hundred shares of the 3Com stub. If this were currently priced at $15 per share we could sell it for an additional $1,500, making a total gain in six months of $7,350 on a $9,000 investment, or 82 percent.
Such profits for ourselves and other arbitrageurs were limited by the amount of COMS our brokers would lend us to sell short. One of our friends, who runs a $2.7 billion convertible hedge fund, was able to short two hundred thousand shares of PALM and had previously bought COMS at a much lower price, anticipating the pre-IPO run-up.
As The Wall Street Journal pointed out, in the few days when arbitrageurs (hedgers) could borrow more shares of PALM, they might have been able to reduce the disparity if they sold short PALM and bought 3Com, as in our example. Here we see clearly a mechanism of market inefficiency, namely the different behavior of the “dumb” or irrational PALM buyers and the savvy arbitrageurs. The Journal went on to point out that a similar pricing disparity arose in mid-February when IXnet, Inc., was spun off from IPC Communications Inc. Even though IPC still owned 73 percent of IXnet, it was valued by the “efficient” market at less than half of IXnet. Jeff hedged this one, too.
Like members of the Flat-Earth Society, efficient market believers have no problem with the 3Com-PALM example. A leading advocate of the EMH explained that arbitrageurs couldn’t correct the price disparity because there wasn’t enough PALM available to sell short, and if there had been, the arbitrageurs (hedgers) would have brought the prices into a relationship consistent with the relative values. This is true. I and others would have bet a major part of our net worth if we could have borrowed the stock. However, the buyers of PALM could and should have corrected the mispricing themselves and by doing so substantially increased their holdings of PALM at no cost, simply by selling their PALM and reinvesting the proceeds in 3Com. Yet widespread public explanations of this, including a front-page story in The New York Times the day following the offering, had little immediate impact. Investors not only couldn’t do arithmetic, they apparently didn’t know anyone who could.
With the PALM/COMS example in mind, let’s take another look at the efficient market theory.
For a perfectly efficient market, one you can’t beat, we expect:
1. All information to be instantly available to many participants.
2. Many participants to be financially rational—for example, they will always prefer more money to less money, other things being equal.
3. Many participants to be able instantly to evaluate all available relevant information and determine the current fair price of every security.
4. New information to cause prices immediately to jump to the new fair price, preventing anyone from gaining an excess market return by trading at intermediate prices during the transition.
Note: Supporters of this theory realize, in varying degrees, that some or all of these conditions are unrealistic, but claim that they hold well enough to make it a good approximation.
Now let’s see how markets really operate, so we can understand how better to invest.
In our odyssey through the real world of investing, we have seen an inefficient market that some of us can beat where:
1. Some information is instantly available to the minority that happen to be listening at the right time and place. Much information starts out known only to a limited number of people, then spreads to a wider group in stages. This spreading could take from minutes to months, depending on the situation. The first people to act on the information capture the gains. The others get nothing or lose. (Note: The use of early information by insiders can be either legal or illegal, depending on the type of information, how it is obtained, and how it’s used.)
2. Each of us is financially rational only in a limited way. We vary from those who are almost totally irrational to some who strive to be financially rational in nearly all their actions. In real markets the rationality of the participants is limited.
3. Participants typically have only some of the relevant information for determining the fair price of a security. For each situation, both the time to process the information and the ability to analyze it generally vary widely.
4. The buy and sell orders that come in response to an item of information sometimes arrive in a flood within a few seconds, causing the price to gap or nearly gap to a new level. More often, however, the reaction to news is spread out over minutes, hours, days, or months, as the academic literature documents.
Our portrait of real markets tells us what it takes to beat the market. Any of these can do it:
1. Get good information early. How do you know if your information is good enough or early enough? If you are not sure, then it probably isn’t.
2. Be a disciplined rational investor. Follow logic and analysis rather than sales pitches, whims, or emotion. Assume you may have an edge only when you can make a rational affirmative case that withstands your attempts to tear it down. Don’t gamble unless you are highly confident you have the edge. As Buffett says, “Only swing at the fat pitches.”
3. Find a superior method of analysis. Ones that you have seen pay off for me include statistical arbitrage, convertible hedging, the Black-Scholes formula, and card counting at blackjack. Other winning strategies include superior security analysis by the gifted few and the methods of the better hedge funds.
4. When securities are known to be mispriced and people take advantage of this, their trading tends to eliminate the mispricing. This means the earliest traders gain the most and their continued trading tends to reduce or eliminate the mispricing. When you have identified an opportunity, invest ahead of the crowd.
Note that market inefficiency depends on the observer’s knowledge. Most market participants have no demonstrable advantage. For them, just as the cards in blackjack or the numbers at roulette seem to appear at random, the market appears to be completely efficient.
To beat the market, focus on investments well within your knowledge and ability to evaluate, your “circle of competence.” Be sure your information is current, accurate, and essentially complete. Be aware that information flows down a “food chain,” with those who get it first “eating” and those who get it late being eaten. Finally, don’t bet on an investment unless you can demonstrate by logic, and if appropriate by track record, that you have an edge.
Whether or not you try to beat the market, you can do better by properly managing your wealth, which I talk about next.