Everyone is an Efficient Market Theorist!

At some level, we are all believers in the Efficient Market Theory (EMT). When the mispricing of a stock persists for an extended period of time, most of us begin to believe that the markets are right and that the pricing of the stock is justified. This is true as much with overpriced stocks as it is true with underpriced stocks.

The longer the mispricing lasts, the easier it becomes to justify the price of the stock based on the EMT. Commentators explain valuations that don’t make any sense with the concept of a market rating and explain sudden (and sometimes explosive) changes in the price of a stock with extended concepts of de-rating and re-rating.

However, as Warren Buffet has said, Price is what you pay and value is what you get. I’ve researched, tracked, owned and at many times sold (sometimes in frustration) stocks that have compounded both intrinsic and book value at rates of 25% compounded continuously for periods of ten years or longer and have still traded at or below book value during the entire period. I’ve also watched in wonderment stocks (many of the franchise variety) that have traded for 30-40 times earnings consistently through the better part of a decade.

I’ve also seen many of the former stocks suddenly get re-rated and generate 10X or 20X returns in a span of less than two years and many of the latter stocks suddenly suffer a disappointment and lose 80% or more of their values due to a de-rating within a short time span.

It truly is possible to invest based on an internal scorecard if one has a sufficiently long time horizon (5 years? 10 years? longer?) and one does not carry any leverage. Buying stocks that compound their value at high rates of return consistently can not only be tremendously rewarding but can also be a relatively low-risk proposition. If the market fails to re-rate one’s holding then it provides one with the added bonus of allocating additional capital to the stock over time.

There is a paradox in my discussion. If the markets are never efficient and they never value stocks correctly then buying something at a discount to intrinsic value makes no sense; there is a possibility then that price will never converge with value. The answer to the paradox is that the market does recognize value over time. The challenge for investors remains that the time the market takes to recognize intrinsic value varies from stock to stock and it is foolhardy to make a holding time horizon generalization for the entire market. The consolation is that for stocks that compound intrinsic value at high rates, one is paid handsomely to wait!