Tuesday, 15 October 2013

Passive Offensive


The 2013 Nobel Prize in economics has been awarded to Eugene Fama, Lars Peter Hansen and Robert Shiller, three economists with highly divergent views.   Most attention seems to be being heaped on Eugene Fama whose pivotal work on the efficient market hypothesis is often cited as sounding the death knell for active management and, for that matter, heralding a bold new world of indexing.

The efficient market hypothesis (EMH) is a rather dry concept which basically states that stock prices reflect all publicly available information on their respective companies instantly. By implication: seeking to outperform the market is a fool's errand.

There are a host of reasons why investors should tread warily down such a path. The first of which comes from the Nobel committee itself.  By awarding the prize to Fama they might appear to be acting as final arbiter in an ongoing debate over the EMH, but in truth they have actually ducked the issue, as the prize was also awarded to Robert Shiller, who has pointed out on countless occasions that the volatility of stock prices is so much greater than volatility of the dividends which they ought to reflect, that the EMH is implausible.

Professor Fama's colleague at Chicago Booth, and golf partner, Richard Thaler has become one of EMH's most ardent critics.  His provocatively titled paper, "can the market add and subtract" compares the prices of Palm and 3com during the tech bubble.

In that paper Professor Thaler recites the time when 3Com a computer networks and services company, sold 5% of its stake in Palm (an ill-fated provider of handheld computers). At the same time 3Com promised to spin off the remaining 95% later in the year with every share of 3Com yielding 1.5 shares of Palm. Immediately after the 5% stake was sold, 3Com shares traded at $80 while Palm shares traded at $95, despite maths telling investors that 3Com shares were definitely worth at least at least 1.5 times whatever Palm traded at.

Professor Fama, quips his friend, "is the only guy on earth who doesn't think there was a bubble in Nasdaq in 2000."

Of course the fact that markets are occasionally wrong, doesn't mean that they can be outperformed.  It is certainly true that most funds do underperform and mathematically half the funds invested actively against the market ought to underperform, adding in fees that ought to happen to more than half.  But it's far from impossible to uncover the gems that do beat the index.

Instead of discussing the process we follow to do just that it is more interesting to consider the record of the most famous active investor in the world.  Warren Buffett, in an event staged to celebrate the 50th anniversary of Graham & Dodd's seminal work on investing, Security Analysis, rebuts the EMH using his own record and that of other first generation and beyond alumni of the Ben Graham school of value investing to show that various forms of active management can yield excellent results based on just the simplest principle: seek to buy $1 of assets for 40 cents.

The essay Mr Buffet wrote to make this point (The Superinvestors of Graham & Doddsville) is as well-written as it is persuasive.

Guy Foster
Head of Portfolio Strategy


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