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The Opportunity Of The (In)Efficient Market

As stocks of large to small companies trade for a fraction of what they did last year, a question surfaces: Is the stock market accurate in its valuations? More to the point, does the efficient market hypothesis (EMH) hold water?

Per Investopedia: EMH, alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information. More to the point, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing. An investor can only obtain higher returns by purchasing riskier investments.

As value investors, we stand on the other side of the street. In our ethos, investors misprice stocks all the time and thus provide countless opportunities to buy stocks on the cheap (i.e., undervalued). And in uncertain times (like today), stocks’ pricing gets erratic. During these periods, the validity of EMH wavers and vice versa.

Look no further than the Metaverse for an example of market inefficiency, not efficiency. More specifically, Meta Platforms, Inc., formerly known as Facebook (FB). Currently, FB trades at $188 a share, less than half of the $384 a share it peaked at in September 2021. To put into value terms, the stock has shed more than $500 billion of market value in about six months. $500 BILLION! Um… what!

Let’s continue with the story. Remember, per EMH, a stock price reflects all information. All companies suffer somewhat from geopolitical unrest, rising interest rates, and inflation from a macro level. So, the effects of these events (pending events) have been priced into the stock. On a company-specific front, FB has come up against the “opt in” functionality regarding ads that phone makers (Apple and Samsung) have introduced (FB’s business is selling ads). So, the company is facing some headwinds. But… $500 BILLION!

Even in the EMH world, investors still need to recognize that FB has 3 billion monthly active users across its platforms. The company has $50 billion in cash and currently creates about $40 billion of cash flow annually. Six months ago, these metrics were the basis for a $1 trillion market valuation; now, they are worth half that. Was the company that much overvalued, or is it now that much undervalued? For full disclosure, we are not investors in FB and have not done a detailed analysis of the company, but on the surface, this price drop seems anything but efficient.

This inefficiency is not reserved just for FB. In our research, we have come across many stocks trading 30%+ below their 52-week highs. The chart below shows that nearly 45% of the S&P 500 Index is more than 20% below its 52-week high.

So again, this begs the question, how can someone think the stock market is efficient? Either stocks were way overvalued, or they are now undervalued because even with the current events, the future of these companies is not so much in doubt that their valuations deserve to be cut so drastically. Something has to give.

It is clear to us that the stock market is inefficient, and it is in these uncertain times where emotions take over for many folks driving them to sell stock resulting in a cheaper stock market. Ironically, this is when the most excellent investment opportunities present themselves… a fact that does not go unnoticed for us long-term investors.

Five years from now, we will be thankful for being patient, long-term value-oriented investors. Thank you Mr. (In)Efficient Market!

Note: Nothing contained herein in this letter should be considered investment advice, research, or an invitation to buy or sell any securities. Chart(s) source: Morningstar.


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