"Is the Market Efficient?", by Philip Fischer
This is a brilliant essay by Philip Fischer that I've transcribed from Common Stocks and Uncommon Profits and Other Writings, the third book, Developing and Investment Philosophy. Here it is:
By the coming of the 1970's nearly all of my investment philosophy was firmly in plce, molded by my experience of four prior decades. It is not coincidence that with only one exception all of both the wise and the foolish actions I have mentioned as examples that helped form the background of this phiosophy were incidents that occured during these four prior decades. This does not mean that I have made no mistakes in the 1970's. Unfortunately, it seems that no matter how hard I try, sometimes I must stub my toe more than once in the same way before I truly learn. However, in the examples I have used I usually took the first instance when a particular type of event happens to illustrate my point, which explains why all but one of the examples I used occured during these earlier periods.
It might be helpful to notice the striking parallels in each of these past ten-year periods. With the possible exception of the 1960's, there has not been a single decade in which there was not some period of time when the prevaling view was that external influences were so great and so much beyond the control of individual corporate managements that even the wisest common stock investments were foolhardy and perhaps not for the prudent. In the 1930s there were years when this view, influenced by the Great Depression, was at its most extreme, but perhaps not any more than the fear of what the German war machine and World War II might do in the 1940's, or the certainty that another major depression would hit in the 1950's, or fear of inflation, hostile government action, etc., in the 1970's. yet every one of these periods created investment opportunities that seemed almost incredible with all the advantages of hindsight. In each of these five decades there were not a few, but many common stock opportunities that ten years alter yielded profits running to many hundreds of percent for those who had bought and stayed with the shares. In some instances profits ran well into the thousands of percent. Again in every one of these five decades some stocks which were the speculative darlings of the moment were to prove the most dangerous kind of trap for those who blindly followed the crowd rather than those who really knew what they were doing. All of these ten-year periods essentially resembled the others in that the greatest opportunities came from finding situations that were extremely attractive but that were undervalued because at that particular moment the financial community had significantly misjudged the stiuation over this fifty-year period and at the great waves of public optimism and pessimism that succeeded each other over this time span, the old French proverb,
Plus ca change, plus c'est la meme chose (the more things change, the more they remain the same), comes to mind. I have not the slightest doubt that as we enter the emerging decade of the 1980's, with all the problems and the prospects that it now offers, the same will continue to hold true.
The Fallacy of the Efficient Market
In the last few years, too much attention has been paid to a concept that I believe is quite fallicious. I refer to the notion that the market is perfectly efficient. Like other false beliefs in other periods, a contrary view may open up opportunities for the discerning.
For those unfamiliar with "efficient" market theory, the adjective "efficient" does not refer to the obvious mechanical efficiency of the market. A potential buyer or seller can get his order to the market where a transaction can be executed very effectively within a matter of a couple of minutes. Neither does "efficiency" refer to the delicate adjustment mechanism which causes stock prices to move up or down by fractions of a point in response to modest changes in the relative pressure of buyers and sellers. Rather, this concept holds that at any one time the market "efficient" prices are assumed to reflect fully and realistically all that is known about the company. Unless someone has some significant, illicit inside information, there is no way genuine bargains can be found, since the favorable influences that make a potential buyer believe that an attractive situation exists are already reflected in the price of the stock!
If the market was as efficient as it has become fashionable to believe, and if important opportunities to buy or significant reasons to sell were not constantly occuring, stock returns should not subsequently have the huge variations that they do. By variation, I am not referring to changes in prices for the market as a whole, but rather the dispersion of realtive price changes of one stock against another. If the market is efficient in prospect, then the nexus of analysis that leads to this efficiency must be collectively poor.
Efficient market theory grew out of the academic School of Random WAlekrs. These people found that it ws difficult to identify technical trading strategies that worked well after transactions costs to provide an attractive profit relative to the risks taken. I don't disagree with this. As you have seen, I believe that it is very, very tough to make money with an out trading based on short-term market forecasts. Perhaps the market is efficient in this narrow sense of the word.
Most of us are or should be investors, not traders. We should be seeking investment opportunities with unusual prospects over the long run and avoiding investment opportunities with poorer prospects. This has always been the central tenet of my approach to investments in any case. I do not believe that prices are efficient for the diligent, knowledgeable, long-term investor.
Directly applicable to this is an experience I had in 1961. In the fall of that year, as in the spring of 1963, I undertook the stimulating duty of substituting for the regular finance professor in teaching the senior course of investments at Stanford University's Graduate School of Business. The concept of the "efficient" market was not to see the light of day for many years to come and had nothing to do with my motivation in the exercise I am about to describe. Rather, I wanted to show these students in a way they would never forget that the flucations of the market as a whole were insignificant compared to the differences between changes in price of some stocks in relation to others.
I divided the class into two groups. The first group took the alphabetical list of stocks on the New York Stock Exchange, starting with the letter A; the second group, those starting with the letter T. Every stock was included in alphabetical order (except preferreds and utilities, which I consider to be a different breed of cats). Each student was assigned four stocks. EAch student looked up the closing price as of the last day of business of 1956, adjusted for the stock dividends and stock splits (rights were ignored as not having sufficient impact to be worthy of the additional calculations), and compared this price with the price as of Friday, October 13th (if nothing else, a colorful closing date!). The percentage increase or decrease that occured in each stock over this period of almost five years was noted. The Dow Jones averages rose from 499 to 703, or by 41 percent in this period. Altogether, there were 140 stocks in this sample. The results are displayed in the following table:
|Percentage Capital Gain or Loss||No. of Stocks in Group||Percentage of Total Gropu|
|200% to 1020% gain||15 stocks||11%|
|100% to 199% gain||18 stocks||13%|
|50% to 99% gain||14 stocks||10%|
|25% to 99% gain||21 stocks||15%|
|1% to 24% gain||31 stocks||22%|
|1% to 49% loss||32 stocks||23%|
|50% to 74% loss||6 stocks||4%|
These date are quite insightful. In a period when the Dow Jones averages rose 41 percent, 38 stocks, or 27 percent of the total, showed a capital loss. Six of them, or 4 percent of the total, recorded a loss of over 50 percent in their total value. In contrast, roughly one quarter of the stocks realized capital gains that would have been considered spectacular.
To drive the point home, I noted that if a peron invested $10,000 in equal amounts in the five best stocks on this list, at the outset of this four and three-quarter year period, his capital would now be worth $70,260. On the other hand, if he had invested the $10,000 in the f ive worst stocks, his capital would have shrunk to $3,180. These extreme results were most unlikely. It would take luck, either good or bad, as well as skill, to hit either of these extremes. It would not be so implausiable for a person with real judgement to have picked five out of the ten best stocks for his $10,000 investment, in which case his net worth on Friday the 13th would have been $52,070. Similarly, some investors consistently select stocks for the wrong reason and manage to pick lemons. For them selecting five out of the ten poorest in performance is also not an entirely unrealistic expectation of results. In that case, the $10,000 investment would have shrunk to $4,270. On the basis of this comparison, there might be, in less than five years, a difference of $48,000 between a wise and an unwise investment program.
A year and a half later, when I also taught this same course, I repeated the exact same exercise, with the exception that instead of using the letters A and T, I selected two different letters in the alphabet from which to form the sample of stocks. Again, over a five-year time frame, but with a different starting and different closing date, the degree of variation was almost exactly the same.
Looking back on most markets of five-year duration, I believe that one can find stock performance results that are about as disparate. Some of this dispersion may come as the result of surprises -- important new information about a stock's prospects that could not be reasonably foreseen at the outset of the period. Most of the differences, however, can be anticipated at least roughtly both in terms of direction and general magnitude of gains and losses relative to the market.
The Raychem Corporation
In view of this kind of evidence, it is hard for me to see how anyone can consider the stock market efficient, again using the word "efficient" as it is used by the proponents of this theory. But to belabor the point further, let me take a stock market situation of just a very few years ago. In the early years of the 1970's, the shares of the Raychem Corporation had considerable prestige in the market place and were accordingly selling at a relatively high price-earnings ratio. Some of the reasons warranting this prestige may be perceived by some comments made b y the company's Executive Vice President, Robert M. Halperin. In outlinining what he called the four cardinal points to Raychem's operating philosophy, he stated:
- Raychem will not do anything technically simple (i.e., something that would be easy for potential competitors to copy).
- Raychem won't do anythign unless it can be vertically integrated; that is, Raychem must conceive the product, manufacture it, and sell it to the customer.
- Raychem won't do anything unless there is substantial opportunity for real proprietary protection, which generally means patent protection. Unless this occurs, research and development energies will not be employed on a project, even though toherwise it might fit Raychem's skills.
- Raychem will only go into new products when it believes it can become the market leader in whatever niche, sometimes smaller, sometimes larger, that product attempts to capture.
By the mid-1970's, awareness of these unusual strengths was sufficiently prevalent among those who controlled large institutional funds so that sizeable blocks of shares had been taken out of the market by people who believed that Raychem was a situation of unusual competitive strength and attractiveness. However, it was another aspect of this company that gave Raychem its greatest appeal to these holders and was probably the cause fo the high price-earnings ratio at which it was then selling. Many considered that Raychem, which was spending an above average percentage of sales on new project development, had perfected a research organization capable of producing an important enough stream of new products so that the company could be depended on to show an uninterrupted upward trend in sales and profits. These research rpoducts had quite justifiably a special appeal to the financial community because many of the newer ones only indirectly competeted with older products of other companies. Primarily, the new products enabled high-priced labor to do the same job in considerably less time than had previously been required. There were enough savings offered to the ultimate customer of these products to justify a price which should afford Raychem a pleasing profit margin. All this caused the stock twoard the end of 1975 to reach a high of over $42.5 (price adjusted for subsequent stock splits) -- a level about 25 times the estimated earnings for the fiscal year ending June 30, 1976.
Raychem, Dashed Expectations, and the Crash
Toward the close of the June 30, 1976, fiscal year, Raychem was hit by two hammer blows, which were to play havoc with the price of the stock and with the company's reputation in the financial community. The financial community had become very excited about a proprietary polymer, Stilan, which enjoyed unique advantages over other compounds used by the airplane industry for coating wire and which was then in the final research stages. Furthermore, the polymer was to be the first product in which RAychem would go basic, that is, make hte original chemicals in its own plant rather than buying raw materials from others and compounding them. Because of the appeal of the product, Raychem had allocated by a considerable margin more funds to this research product htan to any other in its history. The financial community assumed this product was already on its way to success, and after passing through the unusual "learning curvea" experienced by all new products it would become highly profitable.
Actually, quite the opposite was occuring. In the words of Raychem management, Stalin was "a scientific success but a commercial failure." Improved products of an able competitor, while technically not as desireable as Stilan, proved adequate for the job and were far cheaper. Raychem management recognized this. In the course of a relatively few weeks, management reached the painful decision to abandon the product and write off the heavy investments made in it. This resulting charge to earnings for that fiscal year was some $9.3 million. T his charge-off caused earnings, exclusive of some offsetting special gains, to drop to $0.08 a share from $7.95 the previous fiscal year.
The financial community was as much upset by the erosion of the great confidence in the company's research ability as by the precipitous drop in earnings. Largely ignored was the basic rule that some new product developments are bound to fail in all companies. This is inherent in all industrial research activity and in a well-run company is far more than offset in the long run by other successful new products. It may have been just bad luck that the particular project on which the most money had been spent had been the one to fial. At any rate, the effect on the stock price was dramatic. By the fourth quarter of 1976, the stock had dropped to al ow of approximately $14.75 (again adjusted for subsequent splits amounting to six to one) or to approximately one-third its former high. Of course, only a tiny amount of stock could be bought or sold at the low point for the year. Of greater impact, the stock was available at prices only moderately above this low level for months thereafter.
Another development also affected the profits of the compnay at this moment and contributed to Raychem's fall from favor. One of the most difficult tasks for those responsible for the success of any growing compnay is to change the management structure appropriately as the company grows to allow for the difference between what is needed for proper control of small companies and optimum control of big companies. Until the end of the 1976 fiscal year, Raychem management had been set up along the divisional lines based largely on manufacturing techniques; that is, on the basis of the products produced. This worked well when the company was smaller, but was not conducive to serving the customer most efficiently as the company was growing. Therefore, at about the end of the 1975 fiscal year, top Raychem management started working on a "big compnay" management concept. THe firm restrucured the divisions by the industry served rather than by the physical and chemical composition of the products being manufactured. The target date to make the change was at the end of the 1976 fiscal year. This was done at a time when there was not hte least thought within the management that this date would coincide with the time of the huge write-off for the abandonment of Stilan.
Everyone in Raychem knew that when the organizational change was to occur there would be at least one quarter and probably a minimum of two of subsequently reduced earnings. While making these changed caused almost no change in the individuals on the Raychem management payroll, so many people now had different superiors, different subordinates, and different co-workers with whome they had to interface their activities that a time of inefficiency and adjustment was bound to occur until Raychem employees learned how best to coordinate their work with the new faces with whome they were now dealing. Perhaps no stronger indication could have existed to justify long-range confidence in this company or to indicate that management was not concerned with short-term results than its decision to go ahead with this project as planned rather than to postpone what was bound to be a second blow to Raychem's current earnings.
Actually, this significant change worked with considerably less difficulty than had been anticipated. As expected, the first-quarter earnings of the new fiscal year were much lower than would have been the case if the change had not been made. However, the change was working so well that as the second quarter progressed, the short-term costs of what had been done had largely been eliminated. Fundamentally these developments should ahve been considered bullish by analysts. Raychem was now in a position to handle the growth properly in a way that could not have been done before. It had successfully hurdled a barrier of the type that is most apt to dull the luster of otherwise attractive growth companies. By and large, the financial community did not seem to recognize this, however, and instead the temporary further shrinkage of earnings was just one more factor holding the stock at the low levels to which it had fallen.
Making these price levels even more attractive to potential investors was another influence that I have seen happen in other companies shortly after they had abandoned a major research project that had proved unsuccessful. One financial effect of the abandonment of Stilan was that a sizeable amount of money that had heretofore been devoted to that project was now free to be allocated elsewhere. Even more important, it had similarly freed the time of key research people for other endeavors. Within a year or two much like a field of flowers starting to bloom where rain follows drought, the company began to enjoy what was possibly a greater number of attractive research projects in relation to its size than had ever before been experienced.
Raychem and the Efficient Market
Now what has Raychem's situation to do with the theory of an "efficient market" that has recently gained such a following in certain financial quarters? According to that theory, stocks automatically and instantly adjust to whatever is known about a company, so that only those who might possess illicit "inside information" that is not known to others could benefit from what might lie ahead for a particular stock. In this instance, at the drop of a hat, the Raychem management would and did explain to anyone interested all the facts I have justed cited and explained how temporary they believed was the period of poor earnings.
Actually, well after all this had happened and when profits were climbing to a new all-time high level, the Raychem management went even further. On January 26, 1978, they held a long one-day meeting at their headquarters which I had the priviledge of attending. Racyehm management invited to this meeting the representatives of all institutions, brokerage houses, and investment advisors who either had any interest in Raychem or they thought might have. At this meeting the ten most senior executives of Raychem explained with what I believe was extreme frankness and in detail, such as I have only occasionally seen at similar meetings of other companies, the prospects, the problems, and the current status of Raychem matters under their jurisdiction.
In the year or two following this meeting, Raychem's earnings growth developed exactly as might have been inferred from what was said there. During that period, the stock was to much more than double from the price of $23.25 at which it was selling that day. yet in the weeks immediately following this meeting, there was no particular effect on the stock whatsoever. Some of those present were obviously under the influence of the double shock that they had experienced a year or two before. They obviously mistrusted what was being told them. So much for the theory of an efficient market.
What kind of conclusion does the investor or the investment professional reach from experiences like Raychem? By and large, those who have accepted and been influenced by this theory of the "efficient market" fall into two groups. One is students, who have had a minimum of practical experience. The other, strangely enough, seems to be many managers of large institutional funds. The individual private investor, by and large, has paid relatively little attention to this theory.
From this experienced gained in applying my personal investment philosophy, I would conclude that in my field of technological stocks, as the decade of the 1970's comes to and end, there would therefore be more attractive opportunities among the larger companies, the market for which is dominated by the institutions, than among the small technological companies where the individual private investor plays a considerably bigger role. Just as some ten years years earlier those who recognized the folly of the then prevailing concept of the two-tier market benefited from recognizing that particular nonsense for what it was, so in each decade false ideas arise creating opportunities for those with investment discernment.