We are active investors, which means we choose where and when and to deploy our capital to achieve superior capital returns. All active investors striving for adding value over time are assuming that capital markets aren’t fully efficient – if they were, the opportunity cost of an index approach would be too lucrative to give up for active money management. However, unlike companies which spend considerable resources to study their competitive environment and adopt strategies to cope with competition, active money managers often “just assume” that they should beat the market, quite like most people “just assume” that they are above-average car drivers. We take a different approach, and feel obliged to immediately and explicitly justify our existence, despite our track record.

Market efficiency is one of the most debated issues in finance. One reason it is so controversial is that people seem to argue over it without even agreeing on its definition. As no-nonsense practitioners, we are merely interested in examining whether market prices are always a correct reflection of the intrinsic value of the underlying businesses. If this is not the case, there’s conceptually room for at least some investment strategies, as oppose than pure luck, to beat the averages over time. Here are some observations:

1. From a purely logical standpoint, markets can neither be fully efficient nor completely inefficient, as each would create its own destruction: markets can only be efficient if enough people believe that markets aren’t efficient, and therefore through constant effort try to outperform it and by their collective efforts arbitrage away any source of excess returns. Similarly, markets will be inefficient only if enough people believe that markets are efficient and therefore give up on trying outperforming it. This paradox illustrates that capital markets are neither inherently efficient nor inefficient but, if anything, behavioral. Thus, from a logical standpoint, people erroneously believing in market inefficiency are a prerequisite for a de facto efficient market and vice versa. However, this line of reasoning makes it very unlikely that markets are fully efficient everywhere at all times.

2. Proponents of market efficiency spend almost all of their time discussing information efficiency, i.e. that the market is not systematically discriminating in discounting incremental information available to market participants. However, this tunnel vision entirely misses the simple fact that a successful - or flawed - investment thesis is a function of both the information available and the analysis of that information and other factors, such as temperament etc. These other and crucial elements are totally ignored by academic research, implicitly assuming that every market participant is more or less equally adept to analyze the information available to him. In reality although no one is perfect, it is safe to assume that not everybody are equally likely to misjudge the information available.

3. Furthermore, Fisher Black, one the most famous proponents of market efficiency, once said that he considered markets efficient if stock prices were between 50% and 200% of the companies’ intrinsic value. Coming from the horse’s mouth, this illustrates that the debate about market efficiency was probably never aimed at how well stock prices predict the future, but rather something completely else (e.g. winning that Nobel Prize). Either way, the important takeaway is that even market efficiency advocates seem to acknowledge that there are pockets of opportunity out there for those who can spot and exploit them.

4. One last observation on market efficiency is the volatility of stock prices. Within any 12-month time-frame shares of even large and well-known companies swing very widely. As it is very unlikely that the prospects of the underlying operations change dramatically each and every single year, the more plausible explanation is that stock prices are much more volatile than the underlying business developments, and that the market therefore is not reflecting the intrinsic value of the companies at all times.

Despite all the evidence that markets aren’t efficient, we haven’t here presented any evidence that markets are fully inefficient simply because they are not. As a practical matter, we approach each security with the assumption that the market is pricing it correctly enough, and simply move on to the next case if we can’t clearly say that it the market pricing is wrong. Our existence as an active money manager does not require all securities to be mis-priced all the time to do well, only some of them some of the time. However, when mis-pricings are discovered, it is our job to investigate them.