Warren Buffett has always been open about his approach to investing, singing the praises of focusing on business fundamentals to find strong stocks at good prices. However, in a recent BloombergView article, columnist Noah Smith outlines some reasons why the Buffett philosophy actually contradicts the efficient market hypothesis (EMH), an investment theory that says it’s impossible to beat the market because existing share prices reflect all relevant information.
A recent debate between University of Chicago finance professors Eugene Fama and Richard Thaler addressed the issue of whether markets are in fact efficient. Smith admits to agreeing more with Fama, who argued against the EMH. He notes, however, that the argument is undermined by the “persistent success of investors who rely on fundamental analysis—the technique of making bets about companies’ true value by looking at their financial statements.” This has clearly worked for Buffett, who contends that an efficient market simply wouldn’t have allowed the investment success he has achieved.
Smith explains that the argument was recently tested by two financial economists using commonly reported (but not readily recognizable) items on companies’ balance sheets and income statements. The team performed a regression analysis correlating stock values with these items and then simulating trading activity based on the information. The results demonstrated an ability to achieve annual returns of “about 4 percent to 9 percent a year, after accounting for all the standard risk factors. That’s a hefty haul,” argues Smith. The results of the study, reports Smith, “means that there are some pieces of information sitting right there on corporate balance sheets and income statements, free for all the world to see, that aren’t being fully incorporated into market prices for almost two years after they appear”.
However, “EMH may get the last laugh”, because when research like this is uncovered professional investors often try to replicate and enhance it as an investment strategy. As more and more investors exploit the mis-pricing, any outperformance tends to diminish over time proving the EMH supporters more right than wrong.