Implications of the Efficient Market Hypothesis for Investors

The question for investors is, “How efficient is the market?” If the market is truly efficient, no information will be of any use to you, not even monopolistic information. In this case, the only way you can beat the markets is to become clairvoyant! However, the studies cited herein show that the market is not absolutely efficient because investors have in some cases beaten the market averages.

If investment strategies can beat the market averages consistently over long periods, the markets are inefficient. The next question is, “What is the degree of the market’s inefficiency?” If you start with the extremes of the theory as shown in Figure 12–2, you can then move back to the center of the argument with the more debatable aspects of the degrees of inefficiency.

Figure 12-2
Degrees of Efficiency of Information in the Stock Market


If the market is totally inefficient, all information is useful. You know that the market is not totally inefficient because none of the analysts and investors who analyze information has been able to consistently earn returns in excess of the market averages. Thus the question remains about how efficient the market is in processing information between the extremes of all and none, namely, historical, public, and private information.

If you are averse to number crunching, you can heave a sigh of relief from saving all those hours spent analyzing financial statements to determine numbers on sales, earnings, and growth figures of a company. Similarly, you do not have to waste the gas in your car to go out to buy graph paper in order to plot stock charts. According to the weak and semistrong forms of the efficient market hypothesis, the use of technical and fundamental analysis does not consistently produce superior returns. This statement may be disconcerting to you, but what about the technical and fundamental analysts whose occupations have been deemed to be worthless? It is no wonder that Wall Street has not embraced the efficient market hypothesis.

The two seemingly sure ways to earn returns in excess of the market returns are to obtain insider information and to become a specialist. This statement is not by any means a suggestion to prompt you to gain access to corporate privileged information, and neither should you change your existing professional occupational plans to become a New York Stock Exchange (NYSE) stock specialist.

The efficient market hypothesis suggests that all information (public and private) is incorporated into the price of the stock and that the prices of stocks with good fundamentals will be bid up to reflect this situation. Similarly, stocks that are in trouble will be sold to bring their stock prices in line with their intrinsic value. In other words, no undervalued or overvalued stocks exist.

If an even chance exists of stock prices rising or falling because of new information, it doesn’t matter which stocks you choose or which stocks anyone else chooses for that matter. The random walk theory implies pure luck in picking stocks.

The efficient market hypothesis is hotly debated, and the jury of academicians is still undecided about the degree of efficiency of the market. Even though the efficient market hypothesis has not aroused the enthusiasm of most investors, the implications are important because they shatter any illusions of creating overnight wealth in the stock market. The efficient market hypothesis suggests that few investors will beat the market averages consistently over a long period. If the market increases by 10 percent over a one-year period, most investors will not earn more than an average of 10 percent. In fact, most investors earn less than the market average because of transaction costs and fees charged. However, this does not mean that some investors will not do much worse than 10 percent or will not earn abnormally high returns.

The following are some anomalies to the efficient market hypothesis whereby investors have been able to generate superior returns to beat the market:
* Small-cap stocks. A study by Avner Arbel and Paul Strebel (1982) suggests that undervalued stocks of small companies that have been neglected by the investment community may provide greater returns than the market averages. Analysts do not cover many of the small firms owing to their larger perceived risk. This lack of attention to these neglected small companies means that investors can find stocks that are trading below their intrinsic value. When such stocks are discovered by analysts, their prices are bid up and tend to outperform the larger company stocks. The result from this study suggests that the securities markets may not be equally efficient.
* Low P/E ratio stocks. Studies done by S. Basu (1975, 1977) show that portfolios of stocks with low P/E ratios outperformed portfolios of stocks with high P/E ratios on a riskadjusted and non-risk-adjusted basis. This outcome refutes the semistrong form of the efficient market hypothesis because P/E ratios of stocks can be obtained from publicly available information.

* Benjamin Graham, who did the pioneering work that forms the basis of fundamental analysis, realized that markets were becoming more efficient, thus making it more difficult to find undervalued stocks. One of his guidelines was to select low P/E ratio stocks. Table 12–2 lists Graham’s guidelines for selecting stocks. The greater the number of yes answers, the more ideal is the stock choice, according to Graham’s model.
* Other possible market anomalies that suggest inefficiencies in the market that result in superior returns. One of these is the January effect, which finds that stocks that have done poorly in December may produce superior returns in January owing to tax selling.

These anomalies should not lead investors to think that the markets are inefficient. Rather, the anomalies should be viewed as exceptions. Academic studies lend support for the weak and semistrong forms of the efficient market hypothesis, which lends support to the conclusion that very few investors outperform the markets over extended periods. For investors who feel that the efficient market hypothesis is not equally efficient with regard to the pricing of the smaller, lesser-known stocks, fundamental analysis has a role.

Table 12-2
Benjamin Graham’s Guidelines of Stocks to Buy
Stocks that conform to the following criteria would be bought.
Rewards
1. Is the stock’s P/E ratio less than half the reciprocal of the AAA corporate bond yield? For example, if the current AAA yield was 5.7* percent, it would make the reciprocal 17.054 percent (1/0.057), The P/E ratio of the stock would have to be less than 8.77 percent (1/2 * the reciprocal, or 1/2 * 0.1705) to be bought.
2. Is the stock’s P/E ratio less than 40 percent of the average P/E ratio of the stock over the past five years?
3. Is the stock’s dividend yield equal to or more than two-thirds the AAA corporate bond yield? If two-thirds of the current AAA corporate bond yield of 5.7 percent was 3.8 percent, for the stock to be rated a buy, its dividend yield should equal to or be greater than 3.8 percent.
4. Is the stock price less than two-thirds of the stock’s book value?
5. Is the stock’s price less than two-thirds of its net current asset value per share?
Risks
1. Is the stock’s debt-to-equity ratio less than 1? The total debt of the company should be less than its total equity.
2. Is the stock’s current ratio equal to 2 or more? The total current assets divided by the total current liabilities should equal 2 or more.
3. Is the total debt less than twice its net current assets?
4. Is the company’s 10-year average earnings per share (EPS) growth rate greater than 7 percent?
5. Did the company experience earnings declines of greater than 5 percent in no more than 2 years out of the past 10 years?

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