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 will 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 an inefficiently priced security. Jumping to the end, a bit of number crunching found pricing inefficiencies, providing opportunities to buy underpriced securities. Despite already knowing the end result, I want to explore the EMH a bit more.
In order to derive value there must be pricing inefficiencies i.e. the EMH is not being followed. 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 they can be observed “by carefully scrutinizing publicly available information”. What is this publicly available 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 (to be incorporated into panels). In fact, they developed a cell structure and chemistry that can double cell efficiency. The 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 may 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 them are peripheral to the company’s core technology and products. 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. Unfortunately, it is not 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.