|  Martin J. Whitman is Chairman of the Third Avenue Value Fund. The investing principle of the Fund is to acquire common stocks of well-financed companies at a substantial discount to their private market value or takeover value. The Fund also seeks to acquire senior securities, such as preferred stocks and debt instruments, that have strong covenant protection and above-average current yields, yields to events, or yields to maturity. Books Value Investing - a Balanced Approach , John Wiley, 1999 Active Investing , John Wiley, 1998 A fresh look at the Efficient Market Hypothesis Introduction Since the 1960's the theories embodied in Academic Finance have taken over security analysis almost completely. At its core is the Efficient Market Hypothesis which assumes that the market is efficient in its pricing. Put another way - security prices quickly and accurately reflect all the relevant information that might affect them, and it is pointless for ordinary investors to try to outperform the market consistently. At TAVF we have a markedly different view of market efficiency than the academics . The difference is partly explained by the tale of the finance professor and the student who came upon a $100 bill lying on the ground. The student stooped to pick up the bill. "Don't bother," says the professor , "if it really were a $100 bill, it wouldn't be there." The observations below explain how our view departs from that of the academics and why it is possible, in certain markets and using certain techniques, for investors to consistently beat the market. -
While markets tend towards efficiency, very few ever achieve instantaneous efficiency. The Efficient Market Hypothesis (EMH) argues that the market is efficient, or achieves instant efficiency, and that 'Outside, Passive, Minority, Investors'(OPMIs) should acknowledge this by using indexed portfolios, top-down market strategies and valuation methods based strictly on forecasts of discounted cash flow. While there are some 'special cases', in most markets the tendency towards efficiency is quite weak, especially where efficiency is defined as appraising a business or a security at a price that approximates to underlying value. -
There exist myriad markets, not one. One of the failings of the Efficient Market Hypothesis is that it fails to recognise that there are many different markets, not one. There are OPMI markets, hostile takeover markets, leveraged buy-out markets, strategic buyer markets, m&a markets based on 'paper' not cash, and so on. And - critically - each market has its own pricing parameters. -
An efficient price in one market is often an inefficient price in another market. The efficient price of a security depends on your perspective: for example an activist operating in an LBO market knows that in the vast majority of cases a buy-out will not be a do-able transaction unless the price offered in the takeover process represents a meaningful premium over the OPMI market prices. The OPMI market price may be 'efficient' within its own parameters, but it is an inefficient price as far as the LBO operator is concerned . -
If you are an OPMI you should not generally participate in the markets that tend towards efficiency. As noted, there are many different markets and some tend towards efficiency more than others. The markets that are most efficient are characterized by short term trading, and the securities being traded can be analyzed by reference to only a limited number of computer variables . Examples are the markets for credit instruments without credit risk (e.g. U.S. Treasuries), derivatives (e.g. options, convertibles, warrants , swaps) and risk arbitrage. Except in rare cases, the OPMI should steer clear. -
The path to earning excess returns for OPMIs is not to obtain superior information, but rather to use the available information in a superior manner. One of the tenets of the efficient market hypothesis is that OPMIs cannot consistently outperform the market, or relevant benchmarks, unless they have access to superior information. For 'activists' - the promoters, investment bankers, lawyers , and management who drive market actions - having this superior information can be the route to outperformance, but for OPMIs it is difficult to access the information. That does not mean outperformance is impossible . It just means that the route is to use available information better, rather than to obtain superior information. -
The main item of underused information is the balance sheet. Most analysts, most of the time, ignore the corporate balance sheet in their analyses, focusing instead on earnings growth. If you are an OPMI, and you are looking to buy $100 bills for $50, it is much easier to do so using a balance sheet, rather than an income account or cash flow statement. -
The market's long term tendency towards efficiency will reward purchases at a discount. The main problem for fundamental investors is not in identifying $100 bills that can be bought for less, but rather in getting enough efficiency back into the price such that you can sell your $100 for its 'true' value - or at least, for more than the $50 you paid for it. Some funds try to force a market revaluation by identifying catalysts or becoming catalysts themselves (e.g. Gabelli in encouraging a bidding process at Paramount) but at TAVF, we spend little time identifying or seeking catalysts. We rely instead on a long-term tendency towards efficiency. Our view is that while it is difficult to time when individual situations will work out, enough situations in the Fund's portfolio are likely to work out on a lumpy, rather than consistent, basis, so that overall the portfolio ought to perform okay. -
Fundamentals matter. I started my observations about EMH with a story about a finance professor and a student picking a $100 off the sidewalk. The story highlights one weakness of EMH, but it misses the main point: Neither by training nor background would the finance professor have been able to identify what the piece of paper lying on the ground was - a $100 bill or a scrap of worthless paper. You have to be literate about fundamentals if you are to have any hope of distinguishing between $100 bills and garbage in the field of security analysis. www.mjwhitman.com 'Consider selling short to reduce exposure and to create outperformance. There are always many stocks that reach outrageous price levels, that can be sold short. One great attribute of selling short is that it reduces overall equity allocation, which reduces portfolio risk and equity exposure.' ”David Tice |  |
