In the 1960’s the market was taken by storm by the efficient market hypothesis. Most colleges would teach students that systematically beating the market was not possible; it was taught that if you saw a $20 note on the floor there was no point picking it up, if it were really a $20 note someone would’ve picked it up by now…
This theory is of course flawed, and as great investors have argued — and proved — markets are not efficient, in fact they can be extremely inefficient. Over the decades the market opinion has again begun to change; it’s now accepted that, for various systematic reasons, outperformance is possible.
However, I can’t help but feel this belief has swung so far to the other side of the pendulum that people now believe inefficiency is constant, and it’s everywhere. With our heroes like Buffett, Greenblatt, Munger and so on preaching market inefficiency, we now presume markets are so inefficient that every stock we purchase must be mispriced.
Every move that goes against us is Mr. Market miscalculating. We use inefficiency as a way to protect our egos when we suffer large losses; surely being down 40% is a market miscalculation, surely I could not make such a mistake? Right…? Whilst markets are inefficient, I think we’ve taken the statement so far in that we presume everything is inefficient.
Hence I think a discussion on market efficiency is due. You may disagree with this article, and that disagreement is exactly what makes a healthy market. This is not an attack on anyone’s strategy or philosophy, it’s more of a note to myself that I now want to formalise through public discussion.
Today, we’re going to navigate a few main ideas.
Market efficiency,
how to think about inefficiency,
where to look for mispricings, and
how hard investing is.
It’s all too easy to underestimate the markets ability to discount the future. It’s a well-oiled machine most of the time, and we often don’t give it the credit it deserves. This article is my own reminder of how to think about efficiency, and how to find inefficiencies among it all.
Etorre’s Observation
Back in 2002, Howard Marks wrote a memo that’s gone completely under the radar. No one talks about it. In this memo lies the best analogy of market (in)efficiency I’ve ever come across.
The memo is called “Etorre’s Wisdom”, and it’s fantastic.
One very frustrating law of life is known as Etorre’s Observation: the idea that the other line moves faster. And as Marks drove along a highway back in 2002, his son questioned, “Dad, why do you always have to drive in the slow lane? Why don’t you switch to that one; it’s moving faster?”
The conversation that resulted from this question sparked something utterly brilliant: the analogy of the crowded highway.
When driving on a crowded highway, we’re often frustrated by how fast the cars on the adjacent lane seem to travel. We then move over, only for the lane to slow down, then the lane we left begins to speed up. Sometimes someone tries to weave their way through each lane, but we know it never really amounts to much at all; I always have a smug smile arriving next to them at the nearest stop.
The Crowded Highway
The driving experiences on a busy highway are a perfect explanation of the efficiency of markets. We all want to get from A to B quickly and safely. Some go extra slow, some go very fast without a care. But for the most part, we want to be reasonably safe and reasonably fast. Often, we notice the other lane is moving much faster than ours, but we know that switching lanes won’t result in much net improvement.
This is where the genius of Marks’ analogy comes in. If all else remained the same and you could switch to the fast lane, you would reap the rewards. But this doesn’t happen. This is because everyone sees the fast lane, everyone switches to it, and that makes it the slow lane. It’s the behaviour of the collective that alter the environment. It’s a dynamic system that is made by the decisions of the drivers — what works on a given day will entirely depend on the drivers around you at any given moment. When people flock to the fast lane, they slow it down, hence the slow lane naturally becomes the fast lane. This is the function of any efficient system — it works to reduce outperformance. An efficient highway works to equalise the speed across the various lanes, rendering ‘lane-picking’ an ineffective method. It is this process that equity markets follow to eliminate excess returns. Investors chase the hot stock, which makes brings down its prospective return…
Marks notes that a lesser appreciated investment concept is how past returns influence behaviour, which in turn influences future returns.
It’s easy to see what has been outperforming — to see massive outperformance in a certain area — you also know it won’t last forever, so you know you better than to dive in head first. What requires more skill, however, is knowing what’s going to outperform before it starts outperforming. In essence, it’s hard to correctly switch lanes before it’s clear which one is going to be faster. Or as Marks puts it:
The highway mirrors markets because “when people switch to the better performing group, their buying bids up the prices of those securities. That bidding-up prolongs the outperformance somewhat, but it also reduces the prospective return and increases the probability of a correction.
…
At the same time the switchers will sell worse-performing securities to finance their move into the hot group. That will lower the prices of the laggards, and at some point they’ll be so cheap that they become destined to outperform.”
When people forget the cyclicality, they’re presuming the fast lane will be fast forever; for investors, this is in forgetting that 1) stocks bid up to high prices means a crash is inevitable, and 2) ignored stocks that are sold-off will inevitably become primed for massive acceleration.
There is no rule that tells us when each lane is going to change speed. The only rule is that nothing works forever, and nothing doesn’t work forever; every area of the market has it’s time in the sun, if enough people leave the slow lane it eventually has the perfect set up to become the fast lane again. In fact, it is only by becoming the slow lane that it can ever become the fast lane again. The two speeds are reliant on eachother.
But what about the talented lane-weavers?
Once in a while you get a driver who can weave through lanes effortlessly, beating traffic without breaking a sweat. They seem to be at the right place at the right time. Naturally, other drivers see this and try to copy them.
And this is where Marks’ analogy grows in brilliance: copying them is futile. It is of no use to us to know which lane has been going the fastest, to be fast we have to know which lane is about to go the fastest, before other drivers figure it out. We must see the future better than others. We know this is hard, but the majority will always believe they are the few.
Most drivers that try weaving through the lanes will occasionally end up going faster, and occasionally slower. The net result is often zero, they just take on more risk by driving recklessly in the process.
In spite of the mass of investors that believe they can see the future, markets — just like crowded highways — are pretty efficient. In fact, for every great driver there is a poor driver who made the wrong choice; these poor drivers end up leaving the slow lane just as it’s about to speed up, joining the fast lane just as it’s about to slow down. In effect, buying high and selling low.
How to make good time in spite of the efficiency
There’s one major question that comes from this: if there isn’t a way to get from A to B in a dependably fast way, is there no way to win at all?
The key word in the analogy just explained is “crowded.” It’s thanks to it’s crowded nature that every opportunity for outperformance is sniffed out quickly — the moment a gap forms, it is filled.
With this in mind, you have to find the inefficient roads,
the roads others won’t travel,
using the road that their cars can’t fit down,
taking the route that has a few hazards on it that others are scared of, once you’ve made sure you can drive around them,
taking the lesser known back-roads,
the industrial park that feels like a dead-end,
using the roads with ugly scenery people don’t want to see,
or even driving at night, where others prefer daylight.
Every way to make good time on the road is analogous to finding an inefficiency in the stock market. You might find an inefficiency through looking in these kinds of places:
Industries with negative sentiment like tobacco, oil, or defense contractors that ESG investors avoid.
Micro-cap stocks too small for institutional investors whose fund size prevents them from taking positions.
Distressed debt or bankruptcy situations where understanding the legal process gives you edge over investors scared by the complexity.
Foreign markets or exchanges with less analyst coverage.
Companies with messy financials, complicated structures, or recent scandals that deter investors.
Investing during market panics when others are paralysed by fear, or holding positions through volatility when others need immediate liquidity.
One way or another, these methods do their best at capitalising on a market inefficiency — whether psychological or systematic.
Playing in inefficient markets is akin to playing unfair games. It’s the trick to achieving superior returns without too much risk. As Howard says, “a shortcut that everyone knows about is an absolute oxymoron… The route that’s little known, unattractive or out of favor might not be the one that’s most popular or least controversial. But it’s the one that’s most likely to help you come out ahead.”
Remember, it’s lack of popularity is the very reason that it has high prospective returns.
There isn’t a no-risk-fast-lane
I’m now extending Howard’s analogy to explain a few additional critical ideas.
If you’re on a crowded highway and someone tells you there’s a lane that is going fast, there’s no risk, and that it’s going to get faster — you just have to act fast. In other words, when someone offers you a free lunch, you should ask yourself these kinds of questions:
Why is the lane going to continue being fast?
If it’s going to continue being fast, why are other drivers not switching?
Is it not true that me joining the lane would only lead to it becoming slower at some point?
If it’s true, why is anyone telling me about it?
If I knew there was a free-fast-lane, would I preach about it or would I just switch over and drive like hell? I’d shut up and drive.
Going fast will always come with risk, no matter what anyone says. Anytime you see a no-risk-fast-lane, you have to be extremely skeptical. Free lunches are never free, you just receive the bill at a time you don’t expect…
Learning to respect (in)efficiency
All too often, we dehumanise the market. It’s some mechanical system that occasionally slips up. It’s made up of people. For the most part, these are smart people.
In order for excess return to exist, people have to be making mistakes. You have to understand that in every investment you make, you are saying the insight you have is superior to the entire collective of smart individuals working together to create the going price. You are saying “hey guys, I don’t care how long you’ve been investing for, how many thousands of you there are, or how models you’ve made on this; you’ve got it wrong, I’ve got it right.”
That feels extreme, but that’s effectively what we say when we click buy.
In another of Marks’ memos, “Whodunit?”, he mentions how investors who presume excess return is readily available often fail to ask a few fundamental questions:
Why should a free lunch exist despite the presence of thousands of investors who’re ready and willing to bid up the price of anything that’s too cheap?
Why is the seller of the asset willing to part with it at a price from which it’ll give me an excessive return? Do I really know more about the asset than he does?
If it’s such a great proposition, why hasn’t someone else snapped it up?
If the return appears so generous in proportion to the risk, might I be overlooking a hidden risk?
Similar to the questions our previous highway driver should be asking, these questions are so simple and so often ignored. Remember that it is the function of a market to eliminate excess return. This is fundamental to my investment philosophy and it brings a much needed element of skepticism to every opportunity that looks too good to be true.
Investing is hard.
Charlie Munger once said “(Investing) is not supposed to be easy. Anyone who finds it easy is stupid.”
Investors work tirelessly to find bargain opportunities, and it is this tireless work that drives the bargain opportunities out of the market. Investing involves substantial nuance, understanding, experience, and complexity; to claim it’s easy is quite frankly stupid. As I keep reiterating, it is the function of the market to drive out excess return, to think you can be handed it on a plate is wrong.
I remember Buffett once saying something like this: if you’ve been at the poker table for 30 minutes and you still aren’t sure who the patsy is, you’re the patsy.
Similarly, if you’re buying stock and are wondering who’s on the wrong end of the deal, you probably are. The best investors only open positions in which they know they have some sort of advantage which gives them the clarity of knowing they’re on the right side of the deal.
In 2015 Howard Marks gave us another quality memo. It’s called “It’s Not Easy.” In this memo he explains the counter-intuitive approach to looking at ideas that everyone likes. Marks notes that people don’t understand the fundamental process by which opportunities come to have high return potential, they also don’t understand that the very notion of popularity behind an investment is likely to eliminate its profit potential.
He uses the example of that one stock everyone seems to agree is a great opportunity. But by definition, it simply cannot be so.
If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages sub-par performance from here on out.
If everyone likes it, it’s likely that the price has risen to reflect a level of adulation from which relatively little further appreciation is likely.
If everyone likes it, it’s likely the area has been mined too thoroughly — and has seen too much capital flow it — for many bargains to remain.
If everyone likes it, there’s significant risk that prices will fall if the crowd changes its collective mind and moves for the exit.
There’s no such thing as a bargain that everyone knows about. If everyone has realised something’s a bargain, they would have bid up the price to eliminate said bargain.
Successful investment is about buying something lower than it should be, and by definition this is typically found in ideas where people can not see the merit, hence undervaluing the proposition.
Ultimately you have to see things other investors don’t or can’t, and you have to have the market agree with you about your conclusion in reasonable speed. This takes heaps and heaps of hard work to achieve.
When we talk about exceptional investment returns, it is the exceptions that prove the rule. The returns are exceptional because the investors that achieve them are the exception. They are the 1 in 1000 that smash the market. They are called exceptional returns for a reason, they are an exception.
This article is not meant to be pessimistic, only realistic. It’s easy to get carried away as an active investor and revisiting the topic of efficiency every now and then is, in my opinion, a critical thing to do to remain humble.
Anthony Bolton once gave the wise advice to never underestimate the markets ability to discount the future. I live by this advice. The moment you think the market is stupid is the moment you’re about to do something stupid.
The market does makes plenty of mistakes, but you have to give it the respect it deserves if you’re to capitalise on those mistakes.
Thank you for reading, I hope you enjoyed this article.
I’ll see you at the same time next week.
Best,
The Intellectual Edge
Timely reminder (I'm in oil... go figure) - thank you sir! Hope you've been well.