Inefficient markets leave room for active management

The random walk

Studies done in the 1950s and 1960s “documented seemingly random characteristics to common share price changes, reporting that stock price patterns may not be distinguishable from randomly generated patterns,” says Eric Kirzner, professor of finance at the University of Toronto’s Rotman School of Management.

He notes these notions eventually morphed into EMT, which has three forms:

• Weak: analysis of past data is of no use for generating excess returns;
• Semi-strong: superior returns can’t be achieved through analysis of publicly available financial statements and economic forecasts;
• Strong: managers don’t have any edge when using specialized data.

Return on inefficiency

Markets tend to be inefficient in the short term, but settle down in the long term.

Ming Dong, associate professor of finance at York University’s Schulich School of Business, says, “We know during the tech bubble prices were inflated and during the crisis of 2008 they were well below true value.”

Even when prices are pretty close to true value, there’s still variation across stocks. At any given point there’s misevaluation—and therefore inefficiency—somewhere in the market, Dong explains.

Managers looking for inefficiencies should focus on stocks with low P/E ratios. “There’s enough evidence to show they tend to outperform,” says Western University’s George Athanassakos, adding this is especially true of smaller companies analysts don’t follow too closely.

“Many of the big institutions and high-calibre investors aren’t interested in these smaller stocks,” he explains. “They have a lot of money to invest and these companies don’t have enough depth to accommodate their buying power. So these stocks tend to be neglected, resulting in undervaluation.”

Kirzner notes one study, spanning returns over nearly 60 years, found small stocks outperformed the S&P 500 Index by about 5.79% per annum.

Some managers can make money on higher P/E stocks, but that’s difficult because they’re on everyone’s radar.

“Take General Electric, Johnson & Johnson and other stocks that trade several million shares. Typically the price will reflect all publicly available information,” says Athanassakos.

Kirzner was a strong supporter of EMT until fairly recently—evidence of inefficiency turned him into a proponent of value investing. He notes the typical mutual fund doesn’t outperform the index. If you’re going to beat the market, you need to look for opportunities “in highly specialized areas—you probably won’t find them in U.S. large caps,” he says.

Anomalies rule

Opponents of EMT cite some well-established anomalies:

• Neglected-Stock Effect: stocks that aren’t popular among big investors, or neglected by investors in general, pull in higher-than-expected returns;
• End-of-the-Year Effect:
  securities prices typically fall in December, and rise in January;
• Day-of-the-Week Effect: prices tend to be lowest on Mondays, and highest on
  Fridays.

Kirzner notes about 45 such anomalies have surfaced, “providing grist for the view that superior investment analysis and investigation can yield positive returns.” He also cites recent research that shows momentum-based strategies are effective.

“This is inconsistent with market efficiency. The strategy involves building a portfolio of top-performing stocks over the past year or so. You’d think the winners in one period would be losers in the next. These studies show otherwise.”