Efficient Market Hypothesis and Fundamental Analysis
An article entitled “It’s fundamental why Buffett beats the market” appeared in The Globe and Mail last Thursday. It considered the Efficient Market Hypothesis (EMH), which states that security prices accurately reflect all publicly available information.
If the EMH is strictly followed there should not be any unrealized value i.e. price inefficiency. But, if there is some variance or lag in the EMH there may be an opportunity to buy a security that has not been efficiently priced. To jump to the end, a bit of number crunching in the article found that there are pricing inefficiencies, providing opportunities to buy underpriced securities. Despite already knowing the answer, I want to explore the EMH a bit more.
In order to derive value there have to be inefficiencies in pricing i.e. the EMH is not strictly followed at all times. These inefficiencies then have to be spotted and the market has to reprice the security. At the moment I only want to think about the presence of these inefficiencies. The article indicates that they can be observed “by carefully scrutinizing publicly available information”. What is this overlooked information? The article does not say specifically, but it does indicate “any techniques that consistently extract valuable but unrecognized information from balance sheets, income statements and the likes” are applicable and useful. So all the article, presumably the EMH itself, and many professional investors likely consider are financial details found on a balance sheet.
Is this really the beginning and end of how one might find unrecognized value?
Let’s think about a technology company. For the sake of argument let’s say this company manufactures solar cells. In fact, they developed a cell structure and chemistry that can double cell efficiency. This cell is not in production, but it is disclosed in numerous patents over the last few years. Further, these patents, when considered as a whole, point to further efficiency advances. So, the information is publicly available, but those pricing the company’s stock do not have the ability to extract it. The security may well then become inefficiently priced. What about the other side of the ledger? Here, the company routinely publicizes how many patents it has. However, upon reading the patents one finds that some-to-many of the patents are peripheral to the company’s core technology. In the end, if the market solely relies on information from the company, or its balance sheet, there is a higher likelihood of an inefficiently priced security.
Technology is something that can be fundamental to the prospects of a company and its value. Technology is also something that can be understood. It is though not something that is adequately considered by those that focus on the balance sheet, leading to inefficiently priced securities and, in turn, the opportunity to derive value from this oversight.