Monday, February 27, 2023

No Matter What Anybody Says, the Markets Aren't Truly Efficient... And More on Buybacks

By Herb Greenberg (View Archive)

The market has seemingly become so efficient, with so much information flowing so quickly in so many places, that it's as inefficient as it has ever been...

Here's what I mean...

The efficient-market hypothesis, as it's called, claims that stock prices reflect all available information.

Economists have been squabbling over it for decades, often using overly complicated algebraic formulas to prove their points. But like anything else, it shouldn't be that complicated... and it isn't.

After all, the whole concept is little more than a theory, not fact...

And even if the "markets" are efficient – which they're not – stocks certainly aren't.

That's the nature of investing and why there are bulls and bears...

Some stocks are overpriced and some are underpriced... but either way, they're mispriced.

Warren Buffett said as much in the Berkshire Hathaway (BRK-B) annual letter to shareholders over the weekend, writing...

"Efficient" markets exist only in textbooks. In truth, marketable stocks and bonds are baffling, their behavior usually understandable only in retrospect.

This isn't the first time Buffett has said something similar. And he's not alone, because it's simple common sense...

As famed value investor Seth Klarman of Baupost wrote nearly 20 years ago...

To my way of thinking, the reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital.

The Internet will not make the market efficient, even though it makes far more information available at everyone's fingertips, faster than ever before. Markets are inefficient because of human nature – innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions – they simply cannot help it.

Look no further than discount retailer Walmart (WMT), which lost roughly 20% of its value overnight in May last year on disappointing earnings, only to gain it all back, and then some, the following quarter...

And last week, when most retailers were reeling on earnings reports, Walmart actually rose...

Or as my friend, the retail stocks maven Jeff Macke, tweeted the morning of its earnings, "WMT goes green on strong results, great team, bright future." He added...

Other retailers getting killed on everything else Walmart said.

As I responded...

What, one or two quarters ago everybody was claiming they were dopes?

That prompted another friend, Matt Malgari at Kailash Concepts, to write, "Almost like Herb is suggesting markets are inefficient."

"Not almost like!" I shot back.

Source: Twitter/@KcrEquity

Here's where it gets tangled...

An efficient-market theorist might point to Walmart's slide in May 2022 and say that the stock tumbled because all investors had the same information at the same time. As a result, they all dumped the stock. Realistically, the selling was more likely the result of computer algorithms, or artificial intelligence, rather than human brains.

That created an enormous inefficiency...

The computers and/or emotional investors were selling on the headlines, not fundamentals – or what was really going on inside Walmart.

For that very reason, the model portfolio for my Quant-X System newsletter – a year old next month – hasn't been beating the market with non-speculative longs because the markets are efficient (creating great so-called "alpha" performance in the process)...

It's because the model portfolio is filled with real companies with real products and services that generate real profits and real free cash flow that had fallen through the cracks of coverage or interest during one of the most speculative markets known to mankind. The reason? They were too boring because they were too busy making money, not headlines.

Here we had a market pretty much correlated to itself as investors flocked into the same big-cap tech stocks that dominate the indices...

That left everything else – thousands of other stocks – relegated to the junk heap when in reality there were (and are) plenty of jewels just waiting to be found...

One example is Dole (DOLE), the fruit and vegetable grower and marketer, which might represent one of the great inefficiencies out there.

Most people still think it's the old Dole, which was controlled by financier David Murdock. Most people have no idea that the company merged with its largest counterpart in Europe and is now run out of Ireland.

Or Hillenbrand (HI)... Mention it to almost anybody and they're likely to say, "That company makes caskets."

No, Hillenbrand used to make caskets. That business has been spun off so the company can focus on being a pure play on the industrial machinery business it has been building while nobody was looking.

Meanwhile, as investors have embraced index investing via exchange-traded funds ('ETFs'), everybody crowds into the same stocks at the same time...

And if those ETFs are market-cap weighted, those investors really piled into just a few stocks.

As my friends at Kailash Concepts put it back in 2021...

Low-cost index funds are the herd today. Despite overwhelming evidence of inefficient markets, the crowd has embraced the efficient market hypothesis like never before.

Except, rather than being efficient, the herd really does little more than create a self-fulfilling prophecy in the form of a market correlated to itself... until it's not.

Ask any value investor... or short seller, for that matter. During manias, they're usually the laughingstock. But thanks to very inefficient markets, they're the ones who usually wind up having the last laugh.

Do you agree or disagree? I'd love to hear from you – send me an e-mail by clicking here.

Meanwhile, stock buybacks are likely to be back in the news, now that Buffett offered up a good defense of them in Berkshire's annual letter...

Among his comments, he said...

When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).

If you missed it, I wrote a defense of buybacks right here two weeks ago. Headlined, "Why Buybacks Are Just Another Form of Investing," I said...

In other words, buybacks are really another way to return cash to shareholders. It really shouldn't be any more complicated than that – politicians be damned.

Glad to see I'm in good company.

Not everybody agrees, of course...

As one reader writes...

"Hi Herb, I don't like to read that buybacks are 'giving money back to shareholders'. That doesn't really make sense as to what buybacks are. Existing shareholders don't get any money from buybacks. They end up owning a bigger chunk of the company than they would have absent the buyback; but they didn't get any money from a buyback. If the shareholder wanted money from owning shares in the company then they can easily sell some of their shares, in the open market, in exchange for dollars.

"I mostly agree with your article on this topic. Company share buybacks are good when the shares are undervalued by Mr. Market. Also, when the company has extra cash laying around that they don't have a better use for. Also, when management buys at a low price of shares. All of these conditions don't come around very often. Often the management buys when share prices are high. Human nature.

"So, it's rare that a long-term buyback program is actually one of the best uses of a company's cash. Largely because CEOs often aren't really good at stock buying. Even if they are savvy about knowing when their company's share price is undervalued, then they are unlikely to pull the trigger and buy shares when the market has tanked. They're too afraid that the economy is in a recession, afraid for their job security, etc.

"Apple, Inc. has been a rare exception. Same for Berkshire Hathaway.

"If I were running a company board, I would ensure that the company had a huge stock authorization, so that it could take advantage of rare situations when the stock price tanks. Look at Meta Platforms in November. The stock inexplicably tanked to $86 per share. The company should have backed up the truck at that point, especially considering they had the power and discretion to unilaterally cut the [tens] of billions of dumb expenses on the metaverse.

"I could go on ranting regarding the buybacks topic.

"But, thanks for your analysis and commentary. Cogent, as per usual." – David C.

Herb comment: Thanks, David – not only for your observations and opinion (which is as valid as any on this topic), but also for keeping it civil!

Regards,

Herb Greenberg
February 27, 2023