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Value investing, efficient markets and CAPM

Posted by Graeme in Business & Investment at 7:00 am on Thursday, 12 November 2009

The value effect, does not cast doubt on the efficient market hypothesis (as Richard Beddard suggests), but on CAPM. Nonetheless, I still think investors should use CAPM, or something very like it.

I have previously said here “I personally think that the key to explaining what is wrong with the market lies in agency theory.”. I will elaborate on this (I was sure I had done so previously, but cannot find anything).

Pretend you are a fund manager. You do not want to take too much of a risk that you will under-perform really badly and get fired, so you do some closet tracking with most of the fund. That’s your core, so what about the satellite?

What you need is something with the potential to get spectacular performance, reasonably soon. Value investing is likely to out-perform, but over the long term. Use an approach like this, and by the time your out-performance is good enough to make you a significant amount of extra money, you will be most of the way to retirement.

So, what you do is try to pick shares that will perform really well over the next year or two. That usually means growth.

Add to this that active investors in general (whether investing their own money or other people’s), are more likely to be risk-loving than the population at large — otherwise they would be passive investors. I do not mean that all active investors are gamblers, but that the proportion of gamblers is higher among active investors.

We can explain the value effect as the result of investors not being consistently risk averse, as CAPM assumes (in fact CAPM assumes a particular form to the risk aversion). As I have said before, this is a dubious assumption, but the correct formula will be something similar to CAPM.

In fact, if CAPM fails to explain prices because some investors are risk lovers, it is all the more reason to think that it is a good way for risk averse investors to value securities. If something better comes along, I would be quite happy to switch to it.

None of this affects the efficient markets hypothesis, or any of the other fundamental assumptions of financial theory (such as no arbitrage). Some people take too high a risk, often with other people’s money, which gives the rest of us some opportunities.

Comments (5)

Comments(5)

Comment by Richard Beddard at 9:28 am on 12 November 2009 at

Sooo frustrating!!! I absolutely agree with you that the majority of the market (institutional investors) has a big incentive to behave in what might be described as an irrational manner (though its rational from their point of view). So how can the market be efficient, when there’s a huge bias mispricing stocks? Is it back to this argument that the efficient market reflects all public information, but it can systematically misinterpret that information. That’s obviously true, I just don’t think it’s very useful!

Comment by Graeme at 11:13 am on 12 November 2009 at

It think it matters because the reasons for mispricing matters, if only because we should try to understand what is going on as well as we can.

From a practical point of view, it helps us work out how to profit.

Accepting that EMH is usually true warns investors that it is very difficult to profit from better interpreting information that is know to the market. Identifying particular flaws, identifies particular opportunities, so we should be clear about what exactly the flaws are.

The market is not misinterpreting the information: it is simply more willing to take risks than it would if it priced in line with CAPM.

Comment by Richard Beddard at 3:47 pm on 12 November 2009 at

Well I suppose this is where we differ. I see the EMH as a mathematical abstraction that describes how markets would work in idealised conditions. It’s interesting (and worthy of study), but it’s not true, not in any scientific sense. So I don’t see any need to accept it as true.

I don’t think we need the EMH to tell us it’s difficult to beat the market. Since the market is an average, to beat it you have to make investments that do better than average, consistently. In fact, given the resources available to institutional investors it would probably be nigh-on impossible for private investors if it weren’t for the fact, as you yourself say, they’re hamstrung by the need to perform in the short-term and other factors (e.g. being restricted to larger companies).

On the other hand we do know that in the long-run value beats the market. And we know the tools – price to book, price earnings etc. that enable us to decide when shares are cheap or expensive. This is public information, and has been explicit for many decades.

So I think the value effect challenges the semi-strong form of the EMH (you can’t profit from public information). Nobody accepts the strong form (you can’t profit from inside information – you can, but hopefully you’ll go to prison). So that just leaves the weak form (you can’t profit from past price patterns).

That may be true – I’m open minded but fairly disinterested.

One other thing. You say the EMH is usually right. What exactly do you mean by that? That usually the market price of a company is the best estimate of its value? Can you actually demonstrate that?

I see the market as a mass of mispricings, some microscopic, some massive, many in-between. Massive mispricings being more likely in times of excessive confidence, of lack of confidence.

Comment by Graeme at 5:26 pm on 12 November 2009 at

By EMH is usually right, I mean that market prices reflect all publicly known information (semi-strong, strict definition) with some possible exceptions such as the lag with small companies you mentioned on your comment on your blog.

The other aspect of whether those prices are correct that we are discussing here is whether the prices correctly reflect risk. This is subjective, because not everyone has the same appetite for risk. Value shares are a bargain for you and me because we are risk averse, but they are not a bargain for a gambler.

It is not just that it is difficult to beat the market. It is particularly difficult to beat the market on the basis of better information gathering (excluding non-public information) or analysis.

Incidentally, it just stuck me that the value effect does undermine portfolio theory, because it implies that the market portfolio is not on the efficient frontier.

Comment by Graeme at 5:31 pm on 12 November 2009 at

I also regard the metrics you mention as proxies for a DCF. A DCF needs a discount rate and I would use CAPM for want of anything better.

It is very hard to escape the conclusion that DCF is the correct approach if you accept the money has time value and that higher risk require higher returns.

I suppose you could use different relationships between risk and return, or for time value (e.g. non-linear risk/return or non-exponential time value).