Monday’s post set out to use a reasonably obscure study on the success of Warren Buffett [hint: it’s NOT due to luck] to ‘prove’ that the efficient market theorists are wrong …

… but, first, what is Efficient Market Theory, anyway?

Well, our trust Wikipedia entry says:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or newsin the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

The principle is that there are thousands of stocks to choose from and each company is divided into millions of pieces (i.e. each piece of stock) with millions of individual buyers and sellers (from large institutions to small, individual buyers and sellers) all operating in a regulated, open market that ensures that all information that may affect the current or future share price is published.

Therefore, everybody should be factoring all of the same information to come up with a fair value for each stock, all of the time …

… or, so the theory goes.

But, there are some obvious ‘cracks’ in this theory:

Enron

When a company like Enron misreports its numbers and misrepresents its business prospects and business model, the price of the stock can be widely different to its real (or, intrinsic) value. We know the result of this one 🙂

Martha

When a person has access to special information about a company – that may affect its current or future price – through ‘inside’ contacts … and, that knowledge has not yet been published … then they can purchase (or sell) a stock a a price that may change dramatically once that information does reach the market. Of course, this is not legal; it’s called ‘Insider Trading … and, we know the result of this one, too 😉

Warren

The study that I mentioned yesterday clearly shows that Warren Buffett’s success is NOT the result of luck, or taking additional risks, but clearly and unequivocally due to his “superior stock picking skills” …

… but, how is this possible if Warren is acting legally, ethically, and with the SAME information available to everybody else?

It’s simple: efficient market theory is wrong … SOME of the time. In fact, often enough to allow investors like you and I – and, especially Warren Buffett – to make a killing … IF we are patient in both buying and selling:

Warren Buffett’s mentor, Benjamin Graham, discovered that some stocks were priced less than their current book value and he bought those stocks, typically looking to make a quick (< 2 year) killing and move on … he was successful enough at this that Warren, as his star pupil, took notice.

Warren soon found that he could simply buy and hold such stocks – and, look for ANY stock trading below it’s ‘intrinsic value’ (the discounted value of its future cashflows, as compared to treasury bonds + a suitable ‘risk’ margin).

Needless to say, student eventually outperformed teacher … but, BOTH outperformed the Efficient Market Theorists.

Here’s how YOU can do the same:

Pick up a book such as Rule #1 Investingby Phil Town (which, despite the title, is NOT Warren Buffett’s OR Benjamin Graham’s methods) or any other credible book on Value Investing (which simply means to buy a stock at less than its ‘true’ value).

Use that book to help you find stocks that some Efficient Market Fool is willing to sell to you for current market price, which HE believes is also fair market price (after all, if its that price, efficient market theory says it MUST be fair), but YOU know is a helluva bargain, and …

… wait until time and circumstance reprices that stock dramatically upwards, so that its market price and your estimate of its true/intrinsic value pretty much match.

What should you do then? Simple.

Sell it back to the same (or some other) Efficient Market Fool!

You see, you rely on these few facts:

1. Efficient Market Theory IS correct MOST of the time,

2. But, it is wrong SOME of the time,

3. And, when it is wrong – as long as the business of the underlying stock is sound – the Market will (eventually) correct its mistake!

The trick is simply to have the time and energy – and, the simple tools – to find such stocks, and the patience and discipline to wait for the correction …

… it makes Warren 21% a year; it should make you at least 15%

I love it when a scientific study – that cost goodness-knows-how-much – produces a result that is, well, kind’a stating the obvious …

Take this paper as an example; it finds that Warren Buffett’s success with stocks is not due to luck or taking higher risks, rather – surprise, surprise (!) – it’s due to superior stock picking skills:

The stock portfolio of Berkshire Hathaway, comprising primarily of stocks of large-cap companies, has beaten the S&P 500 index in 20 out of 24 years for the time period 1980-2003. In addition, the average annual return of Berkshire Hathaway’s stock portfolio exceeds the average annual return of the S&P 500 by 12.24% over this time period.

We examined various potential explanations for Berkshire Hathaway’s investment performance. We first explored the explanation that Berkshire Hathaway’s performance may be due to pure luck. We find that while beating the market in 20 out of 24 years is possible due to luck at a 5% significance level, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely.

After employing sophisticated adjustments for risk, we find that Berkshire’s high returns can not be explained by high risk.

Ruling out the major alternate explanations to Berkshire’s investment performance leaves us with the potential explanation that Warren Buffett is an investor with superior stock-picking skills that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.

Well, d’ah …

So, let me tell you – and, I’ll accept a $1 Mill. federal government grant to write the obvious up as a paper, if you like – that Warren Buffett makes his money essentially in two ways:

As Businesses

Contrary to popular belief that Warren Buffett is a vulture who swoops in when there is carnage all around to pick up businesses at bargain prices, Warren actually patiently waits to buy sound businesses at fair prices.

These are usually private/family businesses that need to be sold for reasons other than the soundness of the business itself … for example, the largest family business in Australia was split up to avoid squabbling by the ‘next generation’ … succession is usually the major issue facing such private/family businesses. Warren did not buy this Aussie business, but you get my point …

Warren, to the best of my knowledge, rarely bargains on the price of a business and has even been known to overpay; for example, when the Sees family wanted $30 Million for the Sees Candy business, Warren nearly walked away, thinking it was worth only $25 Million …

… Warren is glad that he bought it anyway, as the business returned Warren’s $30 Million in only a few, short years and is worth over $1 billion today.

You see, a business grows and produces continuing cashflows – even if you never sell (and, Warren NEVER sells!), so the price you pay is secondary, IF the business produces outstanding returns. That’s why Warren says:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

In Defiance

So, Warren Buffett wears two hats, with his first hat (surprisingly) being business owner … but, it’s his second hat as the World’s Greatest Stock Investor seems to be the most fascinating to most people.

Well, I’ll let you in on a ‘secret’ … there is no great secret here, at all: Warren simply makes a ton of money by proving that the so-called Efficient Market Theorists are fools … time and time again!

Given that luck and all the other explanations have been rigorously and scientifically ruled out, what the study has ‘proved’ – at great expense, I might add – is not that Warren Buffett is right …

… but, that Efficient Market Theory is wrong!

Now, THAT is a breakthrough of gargantuan proportions, and tomorrow, I’ll tell you how you can exploit it 😉