The Inefficient Market Hypothesis

Includes: CVX
by: Brendan O'Boyle

The efficient market hypothesis states that financial markets are informationally efficient and consequently individual investors cannot hope to exceed the return of an index fund. There is an informative paper by Robert A. Haugen and Nardin L. Baker that takes the efficient market hypothesis head on and demonstrates how inefficient the market actually is. Haugen and Baker traverse the history of the market by analyzing a number of metrics and demonstrate the outperformance of stocks that have optimal pricing and other characteristics. I would contend that the market is only efficient in the long term and the greed of performance chasing or fear of immediate losses blinds market participants and cause pricing irregularities that can be capitalized on in order to outperform the market.

Haugen and Baker identify a number of factors that they use to separate stocks into deciles, the lowest of which can be expected to reliably underperform, while the highest can be expected to reliably outperform. These deciles are formed from the following considerations:

  1. Residual Return (last months stock return)
  2. Cash Flow-to-Price
  3. Earnings-to-Price
  4. Return on Assets
  5. Residual Risk (variance of the preceding 24 month return)
  6. 12 month prior return
  7. Return on Equity in the prior 12 months
  8. Book-to-Price
  9. Profit Margin
  10. 3 month return
  11. Sales to Price

Last months return has negative predictive power for return over the following 3 months. In short, investors tend to overreact to news (good or bad) and following a significant run up in price a period of mean reversion takes place. The old adage: buy the rumor sell the news works well here. If a stock you own jumps after a good earnings report, you may consider selling as more often than not a period of mean reversion will take place. Conversely, buying a beaten down stock following a bad earnings report is often an easy way to make money as the overreaction of the market will abate moving the price higher. Interestingly, last years return has a positive impact over the expected return in the following month. Momentum investors who change holdings regularly are taking advantage of a trend that is real, thus if you prefer short holding times focus on the return over the last year and then purchase on shorter term pullbacks.

The market also tends to underestimate the likelihood of positive earnings surprises from companies that have exceeded expectations consistently or negative earnings surprises from companies that have missed expectations consistently. If an outperforming stock trades down going into earnings the market is likely underestimating the chance of a positive earnings surprise. Thus buying before the earnings report can be an efficient trading strategy or a good entry point for a long-term investment. Conversely, when the stock of a good company implodes after a slightly less than expected earnings report buying once the price has stabilized is also a good strategy, as reversion to the mean will carry the price up. For companies that have underperformed consistently, the market is constantly surprised when it is reminded of this at an earnings conference call. Something an investor should check is the history of earnings report hits and misses. Companies with a history of poor earnings reports and deteriorating business models should be avoided; companies that have consistently exceeded expectations and have strong business models should be bought.

The four measures of cheapness all have positive association with high stock returns. A portfolio of undervalued stocks can be expected to outperform over time. Profit margin, return on assets and return on equity are positively correlated with return. Strangely, the market is constantly surprised to find that overpriced stocks underperform, as do stocks with poor return on investment or return on equity. For example, I was warning investors about the price of Chipotle Mexican Grill (CMG) not two days ago. Furthermore, don't sacrifice return on equity for cheapness, for example many investors have been lured by the cheapness of Nokia (NOK). In their opinion it was cheap at $5/share, cheap at $3/share and now it's cheap at $1.70/share. Unfortunately, their initial entry point has now lost 66% of its value. Thus investors should prefer cheapness, but not at the expense of return on equity.

In my opinion the most interesting correlation that Baker and Haugen have found was explained more fully in a subsequent paper in which they ranked deciles of the highest and lowest beta stocks. There was a remarkable performance advantage and lower risk characteristics for stocks with lower levels of risk as measured by beta. For the purposes of this article it should be noted that lower beta stocks tend to have slow but steady business models. They are unlikely to double in value quickly, but are also unlikely to fall 50% in value quickly. All the evidence points to the fact that purchasers of stocks, like purchasers of lottery tickets, tend to overpay for a smaller chance of a large payout. So the buyer of a high beta/high risk stock focuses on his or her chance of a large return, but ignores the more likely scenario of a considerable loss. Because investors as a whole overpay for an assumed high reward investment, high-risk investments generally underperform. Finally, beta is only a numerical metric to evaluate risk based on price fluctuation relative to the market. Low beta stocks can have high-risk business models and analysis must be done on a case-by-case basis. The figure below shows the findings of Baker's analysis that low beta quintiles of the market outperform over time with lower risk.

A summary of these findings that should be used to screen potential stock picks are:

  1. Low Beta/Low Risk stocks outperform. Beta is only a quantitative framework to judge risk. Qualitative assessment of risk should be performed for each individual stock. High-risk stocks with unproven business models should be avoided. However, when the market is in a very risk-averse mood higher beta stocks with proven risk-adjusted return and strong business models may become desirable. So don't shun any stock with a beta > 1, but insist on more undervaluation from your higher beta selections.
  2. Dividend paying stocks outperform, but the highest dividend paying stocks underperform. So any holding you buy should pay a dividend or return funds to shareholders through repurchases. Take note that repurchases are used to lower the share count and concentrate your shares. Don't blindly chase the highest dividend paying stocks. There is academic evidence indicating that 3% dividend paying stocks outperform >5% yielding stocks when you get more dividend growth in the lower paying stock.
  3. Holdings should be scrupulously evaluated and purchased only when a case can be made for undervaluation. My preferred method of valuing stocks is discounted cash flow, but the other metrics advocated above are a strong framework to judge a potential buy against its peers.
  4. The company should have a strong business model, which will be made evident by a high return on equity, return on assets and profit margin. As you use these quantitative measures also evaluate the stock qualitatively. Ask yourself what the competitive advantage of this particular company is? Why will it be maintained? As the market under-discounts stocks that have low performance you should never buy a stock counting on a turn around (bottom-fishing).
  5. Entry points should be chosen carefully. Holding cash, bonds or index stock funds is a desirable strategy while you wait for a good entry point. They can be exchanged for a desirable stock when the moment is right.

Keeping these principles in mind, what is a stock that fulfills these criteria? One stock that I would nominate is Chevron (CVX). In terms of pricing characteristics, Chevron trades for 7.9x earnings, price to sales of 0.91, price to book of 1.71, return on equity of 23% and a 3.33% dividend yield. Revenue and EPS have grown strongly over the past 10 years as has the dividend from a $1.40 paid in 2002 to $3.09 in 2011. The dividend has been raised 11% since then. The payout ratio is low at 23%, thus there should be ample room for further dividend increases in the future. The company has a low debt load with debt/EBITDA of 0.2 and a beta of 0.77. EV/EBITDA captures characteristics of price to book and price to earnings and is plotted below. Chevron thus seems to satisfy all of the characteristics outlined above. It is a strong buy on pullbacks and any price below 100 should give an investor the opportunity to lock in >3.5% yield.

Baker and Haugen summarize their findings noting that measures of profitability and cheapness are highly significant in long-term stock returns, value investors have intuitively grasped something that proponents of the efficient market hypothesis could not: low priced stocks yield better returns. The statistical significance of risk payout is high, but the payoff to risk has the wrong sign. While the market loves risk in the short-term, the payoff to taking risk (as measured by beta) is negative. Thus the safest (low-beta) and most attractive (low-priced) stock portfolios have the highest expected returns, while the scariest portfolios have the lowest expected returns.

An efficient market doesn't simultaneously exhibit strong levels of risk loving in the short-term and strong levels of risk aversion in the long-term. The market is inefficient: case closed.

Disclosure: I am long CVX.

Additional disclosure: See Baker and Haugen's paper on the inefficient market: ""And their paper on the outperformance of low-beta stocks:""Ploutos published an article on Seeking Alpha about the outperformance of low-beta stocks: ""