Princeton economics professor Burton Malkiel is famous for being the author of Random Walk Down Wall Street, the investment bible for efficient market theorists. The book has sold more than 1.5 million copies since first being published in 1973 and the latest 10th edition was released in January 2011. Believers in the “efficient market” argue that the prices of publicly-traded securities already reflect all available information so analytical effort spent on trying to find undervalued or overvalued securities is a waste of time. Page 187 of Random Walk’s 10th edition gives a good description of this view:
If intelligent people are constantly shopping around for good value, selling those stocks they think will turn out to be overvalued and buying those they expect are now undervalued, the result of this action by intelligent investors will be to have existing stock prices already have discounted in them an allowance for their future prospects.
Hence, to the passive investor, who does not himself search out undervalued and overvalued situations, there will be presented a pattern of stock prices that makes one stock about as good or bad a buy as another. To that passive investor, chance alone would be as good a method of selection as anything else.
Warren Buffett has shown public scorn for the market-efficiency point of view, perhaps most famously in his 1984 speech at Columbia Business School, which commemorated the 50th anniversary of the publication of Ben Graham’s and David Dodd’s book Security Analysis, the investment bible for value investors. There have only been six editions of Security Analysis, the latest in 2008 edited by Seth Klarman with a forward by Warren Buffett, and only one million copies sold, which suggests that the “battle of investment bibles” may have been won by Malkiel’s passive indexing philosophy in the mind of the public.
Indexing is Easy and For Some Probably the Best Option
This fact doesn’t surprise me, since buying an index fund is a lot easier than undergoing painstaking fundamental analysis; the public always chooses “the easy button” when it has the chance. And, truth be told, for most do-it-yourself investors index funds probably are best because fundamental analysis is hard and requires some financial accounting knowledge that most don’t have. Even most so-called investment “professionals” have difficulty beating the stock market with an active portfolio management approach. A just-released report from Standard and Poor’s found that 84% of mutual funds failed to beat their benchmark index in 2011 and the numbers for three-year (57%) and five-year (62%) underperformance are slightly “better” but still awful.
Investment Outperformance is Often Pure Luck
Equally disheartening is the low percentage of outperforming investors who can repeat their outperformance in subsequent periods. Of those mutual fund managers that were in the top 25% of investment performance in the five-year period between 2001 and 2006, the percentage that was able to repeat their outperformance in the five-year period between 2006 and 2011 was amazingly small:
Most Outperforming Mutual Fund Managers are Lucky
Based on statistical theory, 25% of each group should have been able to repeat outperformance, so the fact that these professionals couldn’t even match random statistics is evidence that mutual fund management fees are making matters worse – investors are paying investment managers for the right to underperform. Ugh.
Warren Buffett: Value Investing’s Long-Term Outperformance is Not Based on Luck
In his 1984 speech, Warren Buffett conceded that investment outperformance — by itself — does not prove investment talent. He provides the example of 225 million people (the population of the U.S. at the time) calling the flip of a coin 20 times. Based on random statistics alone, 215 people should correctly call their coin flip all 20 times. Obviously, none of these 215 people has any extraordinary prescience in calling coin flips, yet some will point to their track record and claim that they do.
But Buffett goes on to argue that – in the investing realm – you can distinguish the lucky coin flippers from the talented coin flippers by analyzing their investment philosophy. A large percentage of those people who outperform do not come from a random, cross-section of society. If you analyze the winners, you find that a vastly disproportionate number share the value-investing philosophy (i.e., are from “Graham-and-Doddsville”). He presented nine outperforming investing track records of value investors he had known for years, concluding:
So these are nine records of “coin-flippers” from Graham-and-Doddsville. I haven’t selected them with hindsight from among thousands. It’s not like I am reciting to you the names of a bunch of lottery winners — people I had never heard of before they won the lottery. I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament.
While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. Their attitude is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.
I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.
Bottom line: investors should not chase a money manager’s outperformance without understanding the manager’s investment philosophy and determining whether it makes logical sense. Simply “jumping on board” a good investment track record without any analysis is hazardous to your wealth; you may be placing your money with a temporarily-lucky coin flipper who will likely underperform in the future.
Burton Malkiel Switches to Value Investing?
But let’s get back to Mr. Malkiel. Given that his “claim to fame” is the efficient market hypothesis and his rejection of value investing, I was surprised to read his recent op-ed in the Wall Street Journal. In it, Malkiel ranks three assets classes from “worst to best:”
- 10-Year U.S. Treasury bonds and high-quality corporate bonds (worst)
- Stocks, especially those in emerging markets (better)
- Residential housing (best)
Wait a minute: if securities are efficiently priced, how can some be “better” than others? With regard to 10-year U.S. Treasuries, Malkiel says that inflation is “likely” to rise over the next decade which will make the current 2.25% yield on 10-years an “extremely poor” investment. I agree, but I believe in value investing whereas Malkiel allegedly doesn’t. Take, for example, another advocate of efficient markets: John Bogle, founder of the Vanguard mutual funds. In a recent interview, he was also asked about low-yielding U.S. Treasuries. Bogle’s answer is what I would expect from an efficient market theorist:
In the bond market, today’s yield is the best predictor we have for the returns over the next 10 years. Certainly the 10-year Treasury doesn’t look like a very good deal—and yet it seems to do better and better every time there’s an international crisis.
I don’t agree with Bogle’s neutral view on bonds, but I admire his philosophical consistency.
With regard to emerging-market stocks, Malkiel says they are a good buy right now:
Emerging market equities are particularly attractive. The price-earnings multiples for emerging markets have traditionally been about 20% higher than for U.S. stocks. Today they are 20% lower.
Over the long run, emerging markets have better demography (younger populations) and better fiscal balances than the developed markets. And they are likely to continue to grow at a far more rapid rate than the developed world.
Again, I agree with this sentiment, but Malkiel is making a valuation argument! He is saying that emerging market stocks will outperform because they are cheap relative to their prospective growth rates. Doesn’t sound like an efficient-market theorist to me.
Bottom line: one cannot read Malkiel’s recent Wall Street Journal op-ed without concluding that he has switched over to the value-investing camp. Perhaps Malkiel’s investment philosophy has been corrupted by financial considerations (he wouldn’t be the first academic corrupted by money – just watch The Inside Job to learn more about that). Malkiel is co-founder and Chief Investment Strategist of Baochuan Capital Management, a money-management firm focused on Chinese stocks. Do you think his involvement in Baochuan has any bearing on his conclusion that emerging-market stocks are undervalued rather than efficiently-priced?
Warren Buffett must feel somewhat vindicated by Malkiel’s about-face on value investing. But, then again, Buffett doesn’t need vindication from a Princeton academic to know he’s been right all along.