TMIT Chapter 2: “Understanding Market Efficiency (and Its Limitations)”

“deliberate engaged reading”

The idea is to take the book " The most important thing illustrated" ( it’s Howard Mark’s most recent book with useful comments from great investors and teachers)
We cover one chapter at a time. We try and answer in our own words

  1. What were the key messages?
  2. Where have I seen this in real life? ( kind of applied learning)
  3. What questions come up as I reflect? What would I like to know more?

The outcome

  1. We are reading very deliberately and tuning ourselves to the 19-20 risks Mr.Marks would like us to understand.
  2. We have internalised the learnings as we are going to write each chapter’s key learnings, interpretation and questions that pop up.
  3. In a few weeks we have all “very” well read the book and created a repository to further investment learning
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What are the key messages?


Comment added

The second chapter introduces us to the theories behind finance and investing, a body of thought known as the “Chicago School” because of its origins at the University of Chicago.

“The theory included concepts that went on to become important elements in investment dialogue: risk aversion, volatility as the definition of risk, risk-adjusted returns, systematic and nonsystematic risk, alpha, beta, the random walk hypothesis and the efficient market hypothesis. The last one being specially important because of its influence.

“The efficient market hypothesis states that:

There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.

Because of the collective efforts of these participants, information “is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.

Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.

Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.”

#Howard Marks offers a more practical take on this theory…

“I also use the word efficient, but I mean it in the sense of “speedy, quick to incorporate information,” not “right”…because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. I do not, however, believe the consensus view is necessarily correct”

In January 2000, Yahoo sold at $237. In April 2001 it was at $11. Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.”

#Howard Mark makes an important distinction, where information may be quickly assimilated but the consensus views that develop may not always be correct. Thereby creating market inefficiencies.

“If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or non consensus, view.”

#Howard Mark again asks us to incorporate second level thinking to take advantage of market inefficiencies.

“it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences—to consistently hold views that are different from the consensus and closer to being correct.”

“Seth Klarman: Psychological influences are a dominating factor governing investor behavior. They matter as much as—and at times more than—underlying value in determining securities prices.”

“One of the greatest ramifications of the Chicago theory has been the development of passive investment vehicles known as index funds.”

“The most important upshot from the efficient market hypothesis is its conclusion that “you can’t beat the market.”

“Because theory says in an efficient market there’s no such thing as investing skill (commonly referred to today as alpha) that would enable someone to beat the market, all the difference in return between one investment and another—or between one person’s portfolio and another’s—is attributable to differences in risk.”

“we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise. Those halcyon periods lull people into believing that to get higher returns, all they have to do “is make riskier investments.”

#HM does not think this is true and investors are often given a rude lesson when riskier assets cause permanent losses.

“In fact, some asset classes are quite efficient. In most of these:

-the asset class is widely known and has a broad following;

-the class is socially acceptable, not controversial or taboo;

-the merits of the class are clear and comprehensible, at least on the surface; and

-information about the class and its components is distributed widely and evenly.”

“If these conditions are met, there’s no reason why the asset class should systematically be overlooked, misunderstood or underrated.”

“Paul Johnson: Inverting these conditions yields a test of market inefficiency. For instance, in the first case, if an asset is not widely known and broadly followed, it might be inefficiently priced; in the second case, if an asset is controversial, taboo, or socially unacceptable, it might be inefficiently priced; and so on for each of the other two cases.”

Howard Mark introduces us to some conditions under which inefficiencies may get reflected.

“With millions of people doing similar analysis on the basis of similar information, how often will stocks become mispriced, and how regularly can any one person detect those mispricings?

Answer: Not often, and not dependably. But that is the essence of second-level thinking.”

“Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception”

In making an investment thesis he urges to ask “And who doesn’t know that?"

This is the essential message, second level thinking requires informational edge or analytical edge or both. Implied also is the “behavioural edge”.

He also urges us to create a variant view that might help build a non consensus thesis.

“A market characterized by mistakes and mispricings can be beaten by people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.”

“Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material—mispricings—that can allow some people to win and others to lose on the basis of differential skill.”

“In the great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree.”

“I believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there”

“Paul JohnsonMarks’s observation is that investors should look for markets or assets that are not fully efficiently priced rather than chase after the false god of completely inefficient markets.”

“Bottom line: Inefficiency is a necessary condition for superior investing. Attempting to outperform in a perfectly efficient market is like flipping a fair coin: the best you can hope for is fifty-fifty. For investors to get an edge, there have to be inefficiencies in the underlying process—imperfections, mispricings—to take advantage of.

“…let’s say there are. That alone is not a sufficient condition for outperformance. All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter. Many of “the best bargains at any point in time are found among the things other investors can’t or won’t do.”

“Joel Greenblatt: This is very important and helps explain why most professionals have a hard time beating the market. Investments that are out of favor, that don’t look so attractive in the near term, are avoided by most professionals, who feel they need to add performance right now.”

“The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.”

Howard Mark urges us to look for pockets of inefficient markets where an investor can create an edge.

“theory should inform our decisions but not dominate them. If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets. But swallowing theory whole can make us give up on finding bargains, turn the process over to a computer and miss out on the contribution skillful individuals can make.”


Q Where have I seen this in real life? ( kind of applied learning)

The learning from this chapter is very broad and can be seen everywhere in the public markets.

Information is quickly assimilated, a consensus about a sector or company develops and everyone jumps on the bandwagon.

In the last few years, most people had a negative view on the “oil marketing companies” and the companies were selling for very low multiples. Investors who could build a non consensus thesis have been rewarded handsomely.

The present negative perception on the pharmaceutical sector may offer a discerning second level thinking investor the raw material of market inefficiencies to develop an variant view on a particular company and potentially be rewarded for his efforts.

The high multiples presently being attributed to the small companies (in general) reflects a building underlying consensus of high risk and high reward. This trend has the potential to revert and may teach investors some tough lessons.


Q. What questions come up as I reflect? What would I like to know more?

Can a investor actually develop the psychological make up to act out of consensus or is this an attribute one is born with?

Inspite of loads of investors looking at the big companies - where there should be less inefficiencies- one can see very big price movements in any given year. (Even amongst the blue chips.). What may explain this phenomenon? Does this suggest that pockets of inefficiencies are everywhere?

How big is the influence of psychology on the market prices versus market efficiencies attributable to information assimilation and sound decision making?


The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences— to consistently hold views that are different from the consensus and closer to being correct. That’s what makes the mainstream markets awfully hard to beat— even if they aren’t always right.

HM shows, that being contrarian and ALSO being right is not easy, even if the market is making a mistake. However, the efficient market hypothesis is centered around relative performance…i.e. investor bench-marking his/her return with that of the market. However, the point to ponder for me- someone who strongly believes in “absolute return” school of thought where I measure my success/failure with respect to the absolute risk adjusted return that I am able to generate over time - why should I worry about whether the market is efficient or not? Doesn’t it de-focuses one from the primary objective of generating X% risk adjusted return over Y years? If I remember correctly, Seth Klarman has succinctly it, it is terrible way to think that one is better off if market is down my 50% and one’s portfolio is only down by 40%!

Okay then, what about the celebrated investors we hear so much about? First, one or two good years prove nothing; chance alone can produce just about any result. Second, statisticians insist nothing can be proved with statistical significance until you have enough years of data; I remember a figure of sixty- four years, and almost no one manages money that long. Finally,the emergence of one or two great investors doesn’t disprove the theory.The fact that the Warren Buffetts of this world attract as much attention as they do is an indication that consistent outperformers are exceptional.

Another interesting take by HM which is quite rational…unlike many other value investors who wholesomely rejects efficient market hypothesis. The key point here that he is making…the base rate of success is so low in terms of outperforming the market that siting an example of successful investors beating market proves the counter point!:slight_smile:

Then HM defines characteristics that may represent efficient market

In fact, some asset classes are quite effi cient. In most of these:
• the asset class is widely known and has a broad following;
• the class is socially acceptable, not controversial or taboo;
• the merits of the class are clear and comprehensible, at least on the surface;
• information about the class and its components is distributed widely and evenly.

So implication for us as an equity market investor…invert and find the asset classes/investment ideas where these characteristics are not present. In other words

  • Not widely known and under the radar ( meaning low institutional participation…largely undiscovered businesses)
  • Controversial and/or low social acceptance or a well accepted myth ( one example- bottom of the pyramid group is the least credit worthy and risk is highest- non-salaried/lower middle class/self employed financing which was under served by banks- which gave an opportunity to NBFC/HFC/MFI)
  • The merits of the class is not clear and comprehensible on surface (great businesses in distress with uncertainty around them)
  • Very limited information availability (Companies who don’t do con calls/don’t do management meet but gives succinct information at AGM/in AR)

For me this is the essence and most important takeaway. And I can’t marvel at our beginners luck in 2009-2010, when most of us at VP started off as active investors. Call it beginners Luck - We started off with relatively the most inefficient market segment - Micro and Small size businesses - in Indian Markets.

In the Indian Market Context - obviously Top 200, Top 500 Businesses are were the markets are more efficient - at least in information/analysis. Information was much more readily available about these well-discovered businesses; 1000s of analysts are following them; the businesses themselves followed certain standards for information dissemination through websites, annual reports, investor presentations and conference calls.

Beginners Luck came from having folks like Ayush and Hitesh who had familiarity (family/peers) with the inordinate pay-offs from a non-consensus call in small.micro caps should the call prove right. Those were real bear markets - they had dozens of ideas - which you couldn’t shake off - 30%+ growers, 25-30% RoC, available 5-6 PE - screaming bargains even novices like us could make out.

_No one wanted to invest then - so that itself was a non-consensus call_ :slight_smile: And then came the important part - since no one was buying - some of us passionate deep-divers - had time sometimes like 6 months to research a business - to separate the wheat from the chaff - why invest here and not there. The hard work scuttlebutt in businesses like Mayur, Astral started, collecting lot of data and meeting Management - again using some skill in business analysis.

I still remember for 6 months I would go around meeting any Fund Manager/Analyst - just to know where we are going wrong - challenging anyone “show me another small business with similar potential, world-class customers, growing at similar rates, with these kind of returns” - and no one would bat an eyelid. The best response I would get is - "Donald, we can’t really look/invest meaningfully in a business till it is at least 500 Cr Sales, or 50 Crs in Profits!! By then Mayur in 2011 had in 3 years grown from ~100 CR Sales, 6 Cr Profits in 2009 to ~250 Cr Sales 25 Cr Profits - the business transition was visible.

But folks like us who had gone in 2009/10 and spent 6-7 hours in the factory, met Management, interacted with workers, talked to distributors like Stanley - clearly had that Information and Analysis edge - by dint of hard work and skill.

We were quite alive to a few edges that we had bumbled along towards, naturally (courtesy generous mentor @janak Janak Merchant) - as we found us saying boss, there is a method to this madness perhaps - and captured that essence in this write-up of Sep 12 The 3 Investor Edges

Today the scenario is probably that small and micro caps segment has a much wider following/bevy of investors. Information dissemination is also much better and more efficient - reaches many more folks far more efficiently - why we at VP also play a role in more efficient info dissemination :wink: for micro and small businesses.

So I like to hazard that Information Edge is available only to the hardest slogger today. And that’s not really a sustainable edge - unless backed up by high skill. How much harder can you keep slogging - you are bound to lose a fighting battle against information efficiency!

The rest like you and me - who have now access to information at say more or less the same time - have to rely more on building our Skill Edge - which I again hazard to say will endure - only if we can remain Continuous Learners. Skill in learning to ask the right questions, progressively every year (for a business we are familiar with) - skill in absorbing and extracting pertinent industry/competitive positioning/strategy (key for Valuations) - over 2-3 years these become like domain skills. And then Refinement for Assessing superior Business Quality, Superior Management Quality - one can keep wondering and keep learning - and keep getting more skilled. As more folks get more skilled here - we are needing to build in more refined skills in Understanding Markets/Investor Behaviour.

HM reflects it’s not easy for any one person to consistently hold views that are different from the consensus and closer to being correct** - That is my second biggest takeaway!!

Since everyone can’t get equally skilled in everything, it pays off hugely to have folks around us who are diversely-skilled. Again at VP we had Beginners Luck in attracting that set of multi-talented, diversely-skilled folks that know and play their different roles, energetically. Again, luckily we were aware/acknowledged that - some method in the madness - that seemed to be working for us. Assorted-Skills Team. Needless to say (with @Sanjay_Bakshi Prof Bakshi’s nudging/generosity) - we did get to capture this again in this Why Team VP Works presentation at FLAME in 2015.

The beauty is - the more skilled Team VP becomes, the more varied specialist skills Team VP starts attracting!!


Given that accent on “No one Individual”, it would be interesting to know how HM thinks about

  1. A Team of People working closely together in the endeavour to outperform the market more consistently
  2. What kind of skill-diversity would be a necessary, but not sufficient, pre-requisite for that endeavour?
  3. How to foster a strong culture and shared values that might create a self-reinforcing loop for such a Team?