CONCLUSION: The myth of efficient markets leads to bad investment choices
Real wealth accumulation requires recognition of inefficiency in markets
Eugene Fama became famous and won a Nobel prize for his 1965 theory that capital markets were efficient mechanisms for price discovery and his conclusion that it was virtually impossible to “outperform” market averages over a long period of time. Jim Simons, a mathematician, created Medallion Fund to capitalize on the reality that you could realize above market returns by applying probability and statistics to investment choices by seeking out anomalies in market pricing. Simons’ Medallion Fund earned a 66% annual rate of return for 30 years. Fama was wrong.
Harry Markowitz won a Nobel prize for his 1952 theory that a portfolio could be constructed that produced the maximum return for a given level of risk (Modern Portfolio Theory or MPT) if properly diversified. Warren Buffet, Peter Lynch, Jim Simons, Stanley Druckenmiller, and John Templeton all proved that wrong through stock selection rather than diversification and produced returns that outpeformed market averages over long periods. Markowitz was wrong. Markowitz fundamental error was confusing volatility with risk. Volatility is annoying to people who measure returns monthly or quarterly but irrelevant to those who invest to accumulate wealth over a long time. Real risk is the risk of either a loss or an inadequate return. Some of the most volatile stocks produce the highest returns over decades - companies like Apple, Microsoft, Amazon.com, Google, Facebook, NVidia, display high volatility and extraordinary returns.
Franco Modigliani and Merton Miller won a Nobel prize for proving that the value of a business entity was independent of its capital structure (the so-called “irrelevance theory”) which states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the enterprise value of a firm is unaffected by how that firm is financed. There are taxes, bankruptcy costs, agency fees (commission and fees in the secondary markets) and the market is demonstrably not efficient. They were right given their assumptions but since none of their assumptions prevail in the real world, it is apt that their theory was called the “irrelevance theory”.
William Sharpe won his Nobel prize for demonstrating that for any given level of risk a MPT portfolio combined with borrowing or lending at a theoretical risk free rate of return could produce returns higher than the MPT portfolio alone when debt leverage was used and with less risk than the MPT portfolio alone when negative debt (i.e. cash) was included. His theory called the “Sharpe Capital Market Line” is an example of an economist winning international acclaim for his blinding grasp of the obvious.
Inefficiency in markets is readily observed. Anyone who watches markets or follows market news recognizes that as soon as a takeover bid is disclosed, the board of directors of the target company immediately argues the bid undervalues the target company. This would be impossible in an efficient market unless the premium to market valuation entirely arose from potential synergies between the acquirer and target. In many takeovers, any synergies are incidental, particularly in resource companies where the acquirer has a different view of long term commodity prices than implied by the market price of commodity based companies shares.
Inefficiency of markets is pronounced in commodity based companies where the primary determinant of profits is the price of the commodity subject to a global auction outside of the scope of management influence. The Nobel prize winning work of Fischer Black, Myron Scholes and James Merton was an advance that (unlike many of the theories of their predecessor Nobel laureates) does apply to the real world and is useful not only for valuation of stock options but also for valuation of the reserves of commodity based companies since those reserves have the same properties as options on future commodity prices, and for valuation of the equity of distressed companies where the shares comprise a call option on the assets of the entity at a strike price equal to the value of the company’s debt.
Wide differences between trading prices and underlying option value result from market inefficiencies in valuing commodity based and highly leveraged companies and investors can arbitrage those differences if they take a patient approach to their investments and use Black Scholes methodology to come to a conclusion as to the degree of undervaluation or overvaluation that arises in day to day trading. As Jim Simons, Warren Buffett, John Templeton, Peter Lynch, Stanley Druckenmiller and Benjamin Graham have demonstrated over many years, it is possible to “outperform” market averages by recognizing that markets are inefficient mechanisms to value business entities and systematically capitalizing on those inefficiencies.
Nobel prize winner Richard Thaler added a valuable insight drawing on work by Daniel Kahnemann and Amos Tversky (both sadly now deceased) in demonstrating that investors over react to bad news and under appreciate favorable trends in a field now called “behavioural economics”. Nobel prize winner Bob Shiller developed mechanisms for determining when market sentiment has reached a point where markets in general are overly optimistic or overly pessimistic (on key such mechanism called the Cape Shiller Cyclically Adjusted Price to Earnings Multiple or “CAPE”).
Investors hoping to accumulate enough wealth to fund retirement are well advised to read the papers all of these Nobel prize winning economists have published and gain an understanding of how markets work that will improve their ability to do so. If I had to use one sentence to summarize the implications of their collective works, I would plagiarize comments of Warren Buffett and Charlie Munger who reportedly quipped “markets are an efficient mechanism for transferring wealth to the patient from the impatient”.
Excellent essay that stands out among the many you have shared with your readers, as it helps explain the background for your repeated writing about applying Black-Scholes to valuation of oil companies so often.
I have some questions.
Do you use actual or implied volatility for the stock price?
If actual, over how long?
What is your view on
a. deciding to buy undervalued (by B/S) options instead of stock options
b. buying the undervalued (by B/S) stock and hedging by selling overvalued (by B/S) options.
Thanks for the many interesting essays you have taken your time to share!