Last October, the Nobel Prize in Economics was given jointly to three economists, two of whom are on polar opposite spectrums with regards to their views on the Efficient Market Hypothesis (EMH). One, Eugene Fama, is the godfather of the EMH, coining the term in 1969, while the other, Robert Shiller, once wrote that the assertion of an efficient market was “one of the most remarkable errors in the history of economic thought.”
A quick primer: EMH is the theory that financial markets are “efficient”, and that no one can consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. Informally, it’s the assertion that you will never stumble upon a pile of cash on the sidewalk because if such a pile existed, it would have been picked up long before you saw it.
First of all, let’s quickly disprove the idea that the market can be perfectly efficient. Assume that it is. In which case there is no reason for any active stock picker to be in business. In which case everyone is invested in index funds. In which case… how would the index themselves be priced?? It quickly becomes a paradox. The “efficiency” in markets is created by those who don’t believe it is efficient. In other words, someone’s gotta pick up that pile of cash on the sidewalk first.
However, the market is pretty darn efficient. A lot of smart people are in it, viciously weeding out the inefficiency, picking up those piles of cash almost as soon as they drop. Thus, I find it much more prudent to assume the market is efficient, assume the security I’m analyzing is priced correctly, and not to make a move unless I can credibly explain otherwise. For every buyer, there is a seller, and on balance, those who are selling likely have more experience with what they’re selling than those who are buying. Understanding your counterparty’s motive is crucial during due diligence.
Which is all to say, both Dr. Fama and Dr. Shiller are worthy of the Nobel Prize despite their seeming contradictory stances (Efficient versus Not Efficient). The question of “is the market efficient?” is an academic red herring, because the market is an interplay between both forces. Inefficiency breeds efficiency. Indeed, it is the very cornerstone of capitalism, which incentivizes human beings to be ever more productive, ever more efficient.
The added value of an active manager like Incandescent Capital is to direct capital to businesses that are, in my estimation, mispriced. We are doing our part to close the mispricing by providing liquidity to those wishing to sell the security, who can then go forth and redeploy that capital elsewhere. Meanwhile, if my assessment in the mispricing is correct and it closes, we earn a satisfactory profit on our endeavor. Although admittedly abstract, this is not zero sum over the long run. Capital incentivizes people, and the flow of capital directs how and where our innovations come from (e.g. Industrial Revolution -> steam engine; Dotcom Bubble -> Pets.com). Picking stocks may seem like an infinitesimally irrelevant cog in the global economic machine, but as Barack Obama recently mused in The New Yorker, “At the end of the day we’re part of a long-running story. We just try to get our paragraph right.”
