Commentary · Commentary
The Opportunity Of The (In)Efficient Market
Written by the William Allan team · Published
As many companies’ shares trade below last year’s levels, a question surfaces: Is the stock market accurate in its valuations? More to the point, what does the efficient-market hypothesis (EMH) tell us?
EMH says that prices reflect a specified information set. Different forms of the hypothesis refer to different information, such as past prices or publicly available information. Its investment implication is that consistently earning superior risk-adjusted returns from that information is difficult—not that no investor can ever outperform. Eugene Fama’s Nobel lecture discusses market efficiency and the challenge of testing it alongside a model of expected returns.
A Price Decline Does Not Settle the Debate
Large price changes across public companies illustrate the debate rather than resolve it. A falling price can reflect emotion, new information, changing discount rates, weaker expected cash flows, or some combination of those factors.
A company can be valued differently at two dates because the information and required return have changed. It does not follow that shares must have been overvalued before the decline or must be undervalued afterward. Both prices could be consistent with the information available at their respective dates.
What Value-Oriented Research Tries to Do
We believe market prices can sometimes differ from a reasonable estimate of a business’s long-term economics. That belief motivates company-specific research into cash flows, competitive position, financing, risks, and the price an investor would pay.
During uncertain periods, we may disagree with the market’s assessment. But the size of a price decline alone cannot establish that we are right. We need to ask what has changed in the business, what is already reflected in the price, and what evidence would disprove our view.
Our estimates are uncertain, can be wrong, and may remain wrong for a long time. A company may deteriorate, and an apparently inexpensive stock may become less valuable still. Company-specific losses and broad market declines remain possible after a substantial price drop.
We believe patient research is useful. It does not establish that a given security is mispriced or that a value-oriented investor will profit. Patience can support a plan, but it cannot turn an uncertain estimate into a guaranteed outcome.
This commentary is for informational purposes only and is not investment, tax, or legal advice. All investing involves risk, including the possible loss of principal, and past performance does not guarantee future results.