A core concept in investing, and a key foundation of the book, is market efficiency. The discussion of market efficiency forms the backbone of the book’s content and permeates all the other topics we discuss. Unfortunately, market efficiency cannot be taught by simply stating the basic laws on a single page and then showing how those laws work in all possible circumstances (unlike with Euclidean geometry, where the axioms are stated up front and then used to make all sorts of deductions). Instead, we need to explain market efficiency in pieces, starting with the core building blocks and then adding critical facets with increasing complexity as we further the discussion.

Market Efficiency Is More of a Concept Than a Law

Richard Feynman is one of our intellectual heroes. Although he displayed no knowledge, or any interest for that matter, in investing, he cared a lot about knowledge in general, learning, and teaching. Feynman was a theoretical physicist known for his work in quantum mechanics, for which he won the 1965 Nobel Prize in Physics. He was a professor, author, safecracker, artist, and avid bongo player. He assisted with the development of the atomic bomb during World War II and was a member of the panel that investigated the space shuttle Challenger disaster. Sometimes called “the Great Explainer,” he wrote The Feynman Lectures on Physics, often referred to as “the Red Books,” which have become among the most popular physics books ever written.

Feynman makes a statement in the Red Books that draws an interesting parallel to the concept of market efficiency:

Each piece, or part, of the whole of nature is always merely an approximation to the complete truth, or the complete truth so far as we know it. In fact, everything we know is only some kind of approximation, because we know that we do not know all the laws as yet. Therefore, things must be learned only to be unlearned again or, more likely, to be corrected.

For example, the mass of an object never seems to change: a spinning top has the same weight as a still one. So, a “law” was invented: mass is constant, independent of speed. That “law” is now found to be incorrect. Mass is found to increase with velocity, but appreciable increases require velocities near that of light. A true law is: if an object moves with a speed of less than one hundred miles a second the mass is constant to within one part in a million. In some such approximate form this is a correct law. So in practice one might think that the new law makes no significant difference. Well, yes and no. For ordinary speeds we can certainly forget it and use the simple constant-mass law as a good approximation. But for high speeds we are wrong, and the higher the speed, the more wrong we are.¹

Market efficiency is similar to the concept of mass. For instance, as Feynman explains, the constant mass law holds most of the time, except in special circumstances. The same dynamic applies to market efficiency—the rules of the efficient market hypothesis hold most of the time, except in special circumstances. We will show when the rules hold, and the circumstances when they do not.

To return to Feynman discussing the laws of mass:

Now, what should we teach first? Should we teach the correct but unfamiliar law with its strange and difficult conceptual ideas, for example the theory of relativity, four-dimensional space-time, and so on? Or should we first teach the simple “constant-mass” law, which is only approximate, but does not involve such difficult ideas? The first is more exciting, more wonderful, and more fun, but the second is easier to get at first, and is a first step to a real understanding of the first idea. This point arises again and again in teaching physics. At different times, we shall have to resolve it in different ways, but at each stage it is worth learning what is now known, how accurate it is, how it fits into everything else, and how it may be changed when we learn more.²

We follow Feynman’s approach by discussing the aspects of market efficiency that are “easier to get at first” and “the first step to a real understanding.” But don’t worry, we will get to, as Feynman puts it, “the more exciting, more wonderful and more fun” stuff as well. Just as Feynman taught his concepts step-by-step, we have split the discussion of market efficiency into several parts as well. First, we present the efficient market hypothesis, which establishes the rules for market efficiency. Next, we show that the wisdom of crowds is the mechanism by which the rules of market efficiency are implemented in the stock market. Third, we demonstrate what happens when human behavior stretches and contorts the market price, putting strains on the rules. Finally, we discuss how an investor can identify, and then take advantage of, mispricings to outperform the market. The road map is as follows:

• Chapter 5, “How to Think About Market Efficiency”: the rules of market efficiency.
• Chapter 6, “How to Think About the Wisdom of Crowds”: the mechanism by which the rules of market efficiency are implemented in the stock market.
• Chapter 7, “How to Think About Behavioral Finance”: how human behavior can foul up the wisdom of crowds and create errors in market prices.
• Chapter 8, “How to Add Value Through Research”: how investors can use market distortions to their advantage and gain an “edge” to outperform.

The Holy Grail of Money Management: Generating Alpha

A money manager’s sole purpose is to earn an investment return greater than the market, adjusted for risk, which is known in the investment business as “generating alpha.” If a fund manager cannot beat the market after accounting for fees, an investor would be better off putting his money in a low-cost index fund. The true measure of investment success on Wall Street is not just making a positive return; rather, it is delivering a return greater than the overall market or a specific benchmark. For most investors, the benchmark to beat is one of the broader market averages such as the S&P 500, Dow Jones Industrial Index, or the Russell Microcap Value Index. The ability to outperform over long periods of time is the holy grail of investing, and history has shown that very few professional money managers have achieved this goal.

One of the first papers to highlight the difficulty of outperforming the market, titled “Can Stock Market Forecasters Forecast?” was written in 1933 by Alfred Cowles III. He tracked the investment performance of 20 fire insurance companies, 16 financial services firms, and the recommendations from 24 financial publications to see if they outperformed the market. The average performance for the fire insurance companies and financial services firms underperformed the market by −4.72% and −1.43%, respectively, while the results for the group of 24 financial publications—more than 3,300 forecasts in total—were equally disappointing, at −4% per year over a 4 year period.

More recently, a report issued by Vanguard in March 2015 showed that approximately 85% of managed funds underperformed the stock market over a five-year period. The 2016 year-end edition of S&P Dow Jones Indices SPIVA U.S. Scorecard shows that over a 15-year period ending December 2016, “92.2% of large cap, 95.4% of mid-cap and 93.1% of small cap managers trailed their respective benchmarks.”³ Another report, titled “Does Past Performance Matter?” shows that not one of the 703 top performing domestic mutual funds measured (over a five-year period) remained in the top quartile five years later.⁴

Generating Alpha Is a Zero-sum Game

Why is it so difficult to beat the market? For starters, generating alpha in the stock market is a zero-sum game,⁵ meaning that one participant’s gains result only from other participants collectively losing an equivalent amount. In the immortal words of Gordon Gekko:

It’s a zero-sum game, somebody wins, somebody loses. Money itself isn’t lost or made, it’s simply transferred from one perception to another.⁶

A simple example of a zero-sum game is the classic Friday night poker game, where four buddies, each starting with $250, or $1,000 collectively, sit down at a table for a friendly evening of poker. If, at the end of the night, one person has won the entire $1,000, then each of his friends will be $250 poorer. The amount of money that leaves the room, however, is the same amount that entered—$1,000. Poker is a zero-sum game. In this example, one person won, three people lost, and although money was transferred between them, no new money was created.

William Sharpe, who won the 1990 Nobel Prize in Economics for his theories of pricing financial assets, published a paper in the Financial Analysts’ Journal titled, “The Arithmetic of Active Management,” in which he demonstrates that the stock market is also a zero-sum game, like the Friday night poker game.

Sharpe’s argument starts with the simple observation that the holdings of all investors in a particular market aggregate to form that market. In other words, all investors taken together are the market. Therefore, for every investor who wins, there is at least another investor who loses. In the aggregate, it is impossible for the collective of all investors to beat the market.

In fact, active investment management is worse than a zero-sum game; it is actually a negative-sum game because of transaction costs and the fees active managers charge their clients. Returning to the Friday night poker game, let’s assume that the four friends decide to play at their local country club, which charges $100 ($25 per person) to use a table in the card room for the evening. The total available pot is now $900 instead of the original $1,000 when the friends were playing at home, making it a negative-sum game when the fees for using the table are included. If the pot is split evenly at the end of the evening, each player would leave with $225 instead of the $250 they arrived with. The most alpha that can be generated by any single player is $675. However, for someone to win, someone else must lose, and because of fees, the collective always walks away with less money than when the evening started.

Another factor making it challenging to generate alpha and outperform is the fierce competition among professional investors. Financial markets are populated by an abundance of intelligent, well-educated, highly motivated investors with significant resources at their disposal, all trying to outperform. As a new entrant to the business, you are not competing against amateurs when you invest in the stock market; rather, you are battling to capture alpha against investors who are among the best in the business. The equivalent in the world of poker would be competing against players who have the skills to win the World Series of Poker.

Defining Market Efficiency

Market efficiency¹² is the proposition that, at any given moment, a stock price properly incorporates all available information about a company and is the best estimate of its intrinsic value at that point in time. The theory is easy to conceptualize but gets messy in the real world.

In 2013, Eugene Fama, a finance professor at the University of Chicago, shared the Nobel Prize in Economics for his groundbreaking work in market efficiency, a term he coined in 1965. Subsequent academic research has fueled a five-decade debate around this concept. Although details of this debate are beyond the scope of this book,¹³ we use Fama’s theory as a foundation to help us develop a working definition of market efficiency. Fama states in his 1991 paper, “Efficient Capital Markets II”:

I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information.¹⁴

It is important to note that Fama says nothing about valuation in this statement. In fact, he says nothing about what information must be reflected in security prices. He also says nothing about whether the price that reflects all available information represents a logical price!

We can use Zoe’s Lemonade Stand to illustrate this point. In chapter 4, we arrive at a value of $1,412, or $9.41 per share, when we assume a 20% return on invested capital and no growth. Assuming the market for Zoe’s Lemonade Stand’s common stock fully reflects all available information, the stock would be efficiently priced and equal the intrinsic value:

Market Price = Intrinsic Value = $9.41

Since the market price equals the intrinsic value in this scenario and no mispricing exists, there is no alpha available to an investor interested in buying the stock. To estimate the intrinsic value of Zoe’s Lemonade Stand, we used information about factors such as lemon prices, weather, and the number of glasses sold. If we assume the market has all available information concerning these factors, and the security price fully reflects this information, then, according to Fama, the result will be an efficient market price for the stock of Zoe’s Lemonade Stand.

There are two important issues with Fama’s theory that need additional explanation. First, we need to understand what constitutes “all available information,” and second, how do we know if that information is “fully reflected” in the stock price?

To define what comprises “all available information,” we first need to define information and discuss certain words and phrases that we use to avoid confusion.¹⁵

Defining Information

We start with the term information, which we define using the definitions found in the U.S. Securities and Exchange Commission’s Regulation FD, issued in August 2000.¹⁶

Pursuant to Regulation FD, “Information is nonpublic if it has not been disseminated in a manner making it available to investors generally.”¹⁷ Regarding information originating from a company, a press release over a wire service or a filing made with the SEC (and made available on the SEC website) is generally considered adequately disseminated. Other types of information would be considered adequately disseminated if a sufficient number of participants have the information.

According to Regulation FD, “Information is material if ‘there is a substantial likelihood that a reasonable shareholder would consider it important’ in making an investment decision. To fulfill the materiality requirement, there must be a substantial likelihood that a fact ‘would have been viewed by the reasonable investor as having significantly altered the ‘‘total mix’’ of information made available.’”¹⁸ In our opinion, a good measure of materiality is if the information is reasonably certain to have a substantial effect on the price of the company’s securities. As we discuss in the footnote below, while we are not legally correct with this statement, we believe it is a good measure for the discussion.¹⁹

While non-material, nonpublic information is not specifically defined in Regulation FD, we can infer that this is information that has not been disseminated, but, by itself, would neither influence a reasonable investor’s investment decision nor have a substantial effect on the price of the company’s securities if made public.

For instance, using these definitions as a guide, if you knew that a company was going to report disappointing earnings or heard from the CEO that his company received a buyout offer before the information was released publicly, you would possess material, nonpublic information.²⁰ It should be clear in both cases that the information will have a material impact on the stock price once it is released. Conversely, the same CEO telling you that his company is expanding the size of its parking lot at a facility to hire additional employees in response to the higher revenue the company recently reported to shareholders, most likely, is non-material, nonpublic information. The litmus test to see if the information is material or non-material is to ask, “Would the stock price change in response to the news?” Generally, answering yes makes the information material. As Paul S.’s friend Jeff Plotkin would say to the class, “You know when you have material, nonpublic information. You get that little tickle in your gut, that feeling.”

The three different types of information, contained within the overall information set for any given security, are presented in Figure 5.2.

What Happens When Material Nonpublic Information Is Disseminated?

Adhering to the SEC’s definition, material information is information where “there is a substantial likelihood that a reasonable shareholder would consider it important.”²¹ Material information includes, although it is not limited to, earnings releases, winning or losing a substantial customer, acquiring or divesting of a major asset, or some other significant corporate action or development. When a company releases new information, it spreads, or propagates, to all interested parties. Although the information may be only partially disseminated initially, it will spread quickly as investors realize its importance. The new information, however, will not be considered fully disseminated until a sufficient number of market participants are aware of it. This process is rapid in most modern-day situations because most companies employ national news services to distribute important corporate news instantaneously to all interested parties. The information becomes part of the public information set once it is fully disseminated, as demonstrated in Figure 5.3.

Defining “All Available Information”

Now that we have a reasonable, working definition for information, we can discuss what constitutes available information. All public information by definition is available. There is also information that is available to the public, although it is hard or costly to obtain. We refer to this as quasi-public information²² because, although technically public, it has many of the same characteristics of non-material, nonpublic information. This type of information includes data gleaned from satellite images, the use of web-scraping software,²³ conducting consumer surveys, Freedom of Information Act (FOIA)²⁴ requests, court documents, or other similar sources. This information is available for a price, as shown in Figure 5.4.

There is also a portion of the non-material, nonpublic information that is available to some investors, but it is not available to all of them. The price for that type of information is measured in units of time rather than money. For instance, there are certain investors who have greater access to company management, competitors, customers, suppliers, and other industry experts, because of relationships they have cultivated over time. Examples of this advantage are evident during investment conferences hosted by brokerage firms where only clients of the brokerage firm are allowed to attend management presentations and one-on-one meetings with company management. These clients get access to management while non-clients are excluded from the meetings. Anyone can pay to attend these conferences, although long-standing relationships with management can be hugely beneficial in these discussions because these relationships are based on familiarity and trust, and cannot be bought with money. The price of the information in these situations is time. While Regulation FD does not allow selective disclosure of material information in any situation, it does not prohibit disclosure of non-material information, which is often obtained in these meetings. We show available non-material, nonpublic, and quasi-public information in Figure 5.5.

In Figure 5.6 we show all material, nonpublic information behind bars to emphasize the legal restrictions associated with this type of information (and the consequences if one trades on it). We also show a portion of non-material information behind a chain-link fence because it is difficult to obtain (although resourceful investors spend considerable money and effort trying to acquire it).²⁵

Finally, we show the full set of Fama’s all available information in Figure 5.7.

Now that we have defined all available information, we can turn to the next question: Is the information fully reflected in the market price?

The Rules of Market Efficiency

There are three conditions that sufficiently describe a market where all available information has been fully reflected in the price of a stock:

1. All available information is (or has been) disseminated to a sufficient number of investors.
2. The information is processed by a sufficient number of investors without any systematic error.
3. The information is expressed and thereby incorporated into the market price by a sufficient number of investors trading the security.

While we characterize these tenets as rules, the reality is much subtler. As said by Professor Roger Murray, the efficient market hypothesis can be thought of as “a magnet in a rational world that pulls market price toward . . . intrinsic value.” The efficient market hypothesis reflects a process of spontaneous, emergent, unintentional order. To paraphrase Adam Ferguson in The History of Civil Society, the rules are a result of human action rather than the result of human design. Unlike the Ten Commandments, no entity, divine or otherwise, gave us a list of rules governing market efficiency, they emerged spontaneously. We lay out the progression of the three rules in Figure 5.8.

Notice that each of the preceding market efficiency rules depends upon a sufficient number of investors for the rule to be satisfied. Although there is no simple measure as to what constitutes a sufficient number of investors, the following analogy should provide additional insight.

Pharmacology defines a threshold dose as the minimum amount of a medication or substance that will produce a desired effect. For example, say you need to stay awake for a few hours to finish studying for an exam. You need to drink just enough coffee to keep you awake, but not so much that you are jittery while you study. A typical cup of coffee contains 95 milligrams of caffeine and there are roughly 16 sips in a cup of coffee, so each sip contains about 6 milligrams of caffeine. You know one sip will not do the job. A pharmacologist would tell you the threshold dose equals the minimum number of sips necessary to keep you awake.

For the purposes of market efficiency, we use the concept of a threshold dose, which equates to the number of investors required to reach the threshold for information to be adequately disseminated, properly processed, and fully incorporated in the stock price. Although it is often impossible to know when this threshold is met, and the number of investors is sufficient to satisfy the rules, we explain in the next chapter how the market gets closer to the threshold level as the number of market participants increases.

The following discussion foreshadows what we cover in the next few chapters as we explore what happens when the tenets do not hold:

• Rule 1: Dissemination
• For the market to arrive at an efficient price, all available information must be disseminated to a sufficient number of market participants. This rule necessitates that investors have the information or are aware that it exists. A stock may become mispriced if critical information has not been fully disseminated.
• Rule 2: Processing
• The market participants need to process the information to determine what impact it has on their estimate of the stock’s intrinsic value. The rule necessitates that this calculation be done without any widespread systematic error among investors. Although investors have processed the information and have calculated their respective estimates as to the stock’s intrinsic value, these estimates are not yet reflected in the stock price until they are incorporated. A stock may become mispriced if there are not a sufficient number of investors processing the information, resulting in some form of neglect, or there are a sufficient number of investors, but they have all been influenced by a similar bias resulting in systematic error in in their intrinsic value estimate and that error has become incorporated into the stock price.
• Rule 3: Incorporation
• These estimates must be expressed in the marketplace for the information to be fully reflected and incorporated in the stock price. As we discuss more fully later in the book, the only way for an estimate to be incorporated is through trading activity. For example, if there is a research report recommending the purchase or sale of the stock, or someone expresses their opinion on a company in another venue such as on TV, a blog, or an investing website, their opinion will only be incorporated if other market participants take action and trade on the information. A stock may become mispriced if there are impediments preventing investors from trading the stock and incorporating their estimates. If these estimates are not expressed, the information contained in those estimates will not be incorporated into the stock price.

When the Rules of Market Efficiency Operate Flawlessly

We can use the following example to highlight the three market efficiency rules in practice. Before the markets opened on February 23, 2016, MKS Instruments announced its intent to acquire Newport Corporation for $23.00 per share in cash, which was a significant premium to the closing price of Newport’s stock the previous day of $15.04 per share. There was no unusual price movement or increased trading volume in Newport’s stock leading up to the announcement, which indicates that information about the deal had not leaked to market participants prior to the official release. A surprise takeover clearly surpasses the threshold of material, nonpublic information, and all investors would naturally expect the information to have a significant effect on the stock price once investors were notified of the deal.

MKS announced the details of the proposed transaction at 7:00 a.m. Eastern Time and Newport’s stock repriced immediately to reflect the announcement when the stock markets opened for trading at 9:30 a.m., as demonstrated in Figure 5.9.

The press release issued by MKS adequately disseminated the new information, satisfying the first rule of market efficiency. A sufficient number of market participants processed the new information without any systematic error, satisfying the second rule. The new information was incorporated into the stock price almost immediately, as investors exploited the difference between the market price and the value (the takeover price), satisfying the third rule.

The Mechanism That Implements the Rules of Market Efficiency

While we have outlined the rules that describe market efficiency, we have not explained the mechanism by which those rules are implemented to produce an efficient market price.

The Individual’s Process

In practice, individuals purchase a stock because they believe its price will increase in the future, which implies that their estimate of intrinsic value is greater than the market price. By simple correlation, investors must have their own estimate of the stock’s intrinsic value to make this determination.

Figure 5.10 illustrates a rudimentary process by which an individual calculates their estimate of a stock’s intrinsic value. We expand on this model in more detail in later chapters.

As the model in Figure 5.10 shows, the investor begins by observing events about a company, which may include a recent press release, an interview with the company’s CEO, a news blog, or any other information about the company’s fundamentals. The investor then processes that information with a model²⁶ in order to generate an estimate of the company’s value. The investor takes action based upon whether the current stock price is lower (higher) than his estimate of the stock’s intrinsic value. His view will be expressed and incorporated into the stock price when he trades the security.

The Individual Process, Multiplied

The stock market aggregates all the individual trades, each representing a different estimate of the stock’s intrinsic value, made by thousands, if not hundreds of thousands, of investors all over the world (which we refer to as the collective or the crowd), into a single market price that represents the consensus estimate of the company’s value. When the tenets of the efficient market hypothesis are satisfied, this collective produces an efficient stock price, which we represent in Figure 5.11.

This collective process is the mechanism governing the three tenets of market efficiency. When this process functions properly, the stock market produces an efficiently priced stock, eliminating any mispricings, which makes it impossible to outperform the market and generate alpha.

This governing mechanism is known as the wisdom of crowds. We explain in the next chapter how the theory operates and demonstrate how the crowd implements the rules of market efficiency to produce an efficient stock price.

Gems:

• The markets need to be efficient to generate alpha. A temporary inefficiency or mispricing will be corrected only if the market is ultimately efficient. The alternative would be a market where a mispricing could persist forever. In such a world, no one could reliably generate alpha and outperform.
• A portfolio manager’s sole purpose is to earn an investment return greater than the market, adjusted for risk. If a manager cannot beat the market after accounting for fees, an investor would be better off putting his money in a low-cost index fund. The true measure of investment success on Wall Street is not just making a positive return; rather, it is delivering a return greater than the overall market, or a specific benchmark.
• Outperforming the market over long periods of time is extremely difficult to accomplish. The evidence of success, in fact, is quite dismal for active investment management.
• The fact that the stock market is a zero-sum game (actually, it is a negative-sum game) coupled with intense competition from highly motivated, intelligent investors makes it extremely challenging for any investor to beat the market. The only way for an investor to outperform is to systematically and repeatedly identify situations where the market has not priced a security correctly.
• If the security’s price fully reflects all available information, it will be efficiently priced and the resulting market price will equal the company’s intrinsic value.
• There are three conditions that must be met for all available information has been reflected in the price of a stock:
  1. All available information is (or has been) disseminated to a sufficient number of investors.
  2. The information is processed by a sufficient number of investors without any systematic error.
  3. The information is expressed and thereby incorporated into the market price.

At the risk of overstating this point, there are various rules and regulations issued by the SEC, as well as state and other federal laws that are critical to understand and comply with. These restrictions evolve constantly with new legislation and related court decisions. It is a murky area that is beyond the scope of this book. Nonetheless, Paul S., from his experience of working at the SEC and the compliance department at Goldman Sachs, thought this issue important enough that when he taught his security analysis classes at Columbia Business School he would bring to class as a guest lecturer his dear friend, Jeffrey Plotkin, a former SEC attorney, to discuss various issue regarding insider trading, the work of an analyst and related compliance issues. Despite the warnings contained in these lectures, one of Paul S.’s former students, years after graduation, was convicted of insider trading.