Prologue: Eugene Fama admits markets are not efficient

But hangs on to the belief they are "almost" efficient

The concept of “efficient markets” arose when Eugene Fama wrote his famous piece claiming that markets at any given point in time reflected all the information in the hands of investors which manifested itself in market prices for securities more or less in line with the underlying value (the “intrinsic value”) of the particular security. Fama admitted to a class at University of Chicago that markets are not “perfectly efficient” but come close and for all practical purposes are efficient.

Underlying this thesis but not explicitly dealt with is the question of valuation. What is the “intrinsic value” of a given company or its related securities? The idea of “fair value”, often used in Court proceedings, is defined as what a willing buyer would pay a willing seller with both buyer and seller possessed of all relevant information and under no compulsion to trade. It is an elegant concept, itself grounded on the associated theory that investors are rational. The recent emergence of the field of “behavioural economics” throws a bit of cold water on that theory, since it is not hard to demonstrate that investors are not always rational either as individuals or as a class. The “dot com” bubble is an exmaple of what has been described as “irrational exuberance” among investors, and I suspect the current artificial intelligence (“AI”) boom is somewhat similar.

Corporations must be profitable to exist. The level of profitability must be sufficient to provide a return capable of supporting enough investment to sustain the corporation, and if a given corporation is to grow in line with the economy in general, profits must be high enough not only to sustain output but also to fund growth. If corporate profits are sufficient only to provide the capital to maintain output that grows in line with the economy in general, no surplus will exist to be distributed to shareholders as dividends or otherwise. It is hard to imagine a rational investor who is satisfied to own an interest in a business that at no time distributes any of its profits to that investor unless the investor is employed by the business. A couple of hundred years of market history point to the conclusion that investors expect to earn a return on their investment and not simply hold investments because they employ others.

Once a company “goes public” and issues shares to investors that trade in the so-called “secondary markets” the only income investors receive is distributions from that company in the form of dividends or interest. A rise in the trading value of a public company’s shares may make investors feel warm and cuddly, but to realize any benefit they can use to pay their rent, put food on the table, or retire and rely on passive income, that rise is valueless unless they sell all or a portion of their investment unless the company pays dividends.

Secondary trading creates no value - all gains by one investors are matched by a similar loss (or loss opportunity) experienced by another investor and the transactions attract costs. Interest is paid on the debt securities of an issuer and the amount of interest is a matter of contract. Holders of corporate debt can only get the amounts contracted for and no more, but possibly less if the issuer fails. Secondary trading of debt instruments can result in gains for one investor but always at the expense of a loss for another, since the total amount available is that contracted for as defined in the terms of instrument.

The intrinsic value of debt is its face value adjusted for the risk of default.

For shares (also called equity) value is entirely related to dividends, either current, future or eventual on “winding up”. Valuation models (like the Gordon Dividend Growth model) apply pretty basic arithmetic to estimate the present value of future dividends based on assumptions about a “required rate of return”, a dividend “payout ratio” and a growth rate for the issuer. These models explicitly recognize that value is entirely a function of dividends.

The “required rate of return” is problematic. Two hundred years of history provide evidence that on average over the long haul, investors receive about 9 to 10 % on their investments in shares, ignoring the deleterious effects of inflation. Adjusting for inflation, investors get about 3 to 4% “real returns” which (as should surprise no one) is more or less the same as economic growth in real terms. Traders necessarily get less on average, since their returns are reduced by fees and commissions.

A better approach to “intrinsic value” might be to consider the minimum price at which a corporate entity goes public raising enough capital to fund its business with enough capital that it is self-sustaining and can grow with the economy based on reinvestment of profits yet high enough to attract investors with the prospect of a stream of dividends that will provide inflation adjusted returns of 3 to 4%. A 1960’s era study by GE called “Profit Impact of Marketing Strategy” or “PIMS” found that a 15% after tax return on equity comprising a 5% net income to sales ratio and three investment turns was typical of industrial companies. GE used those ratios as benchmarks in deciding what businesses to retain and which to divest under Jack Welch.

The average annual return for the Standard and Poor’s 500 since 1957 amounted to 10.26%. During the same period, average annual return on equity for the underlying corporations was higher - about 15% - but varied each year with the ebbs and flows of the economy. For example, for 2023, the average return on equity for the S&P 500 was 16.59%.¹ Investors received lower returns than the returns the companies they owned earned - an anomaly arising from market over-valuation of equities in part and from the costs of trading intermediaries (brokers, agents, fund managers, analysts, etc.) in part as well.

One way to avoid suffering returns less than those earned by the entities in which you hold an interest is to buy them when their shares trading at or close to “book value” either at the time of their public issue or subsequently and hold them for long term wealth accumulation through streams of dividends. Buy and hold is the only investment strategy capable of wealth accumulation for investors as a group, with every other strategy implicitly requiring a successful investor to benefit from the losses of a “greater fool”.

Think about it next time you make an investment or cheer a “buyback”.

1. Return on Equity (nyu.edu) <https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html>