Should I Buy Efficient Markets or Cheap Stocks?

We refer often, and usually with a whiff of disdain, to a controversial (at least we think so) financial theory called the efficient market hypothesis (EMH). The inevitable implication of the theory; as investors we are solely at the mercy of the markets and no amount of work or research will allow us to “outperform”. Proponents of the theory will point to the track records of great investors like Warren Buffet and Bill Miller and claim that they are purely the bi-product of statistical chance. In any large random sample of investors there will be a few that widely under-perform, a few that widely outperform and a great majority in the middle that do about average. Great investors, say the efficient market crowd, are just the few who happened to be lucky enough to out-perform.

If you believe that analysis and careful selection are irrelevant then you would just have to hope that the market goes up enough over time to make you richer. Unfortunately for some investors there have been long periods of time when the “market” has made little or no progress. Take for example, the mother of all calamities, the 1929 stock market crash and the Great Depression that followed. The Dow did not reach its 1929 September high of 381 again until 1954! This kind of bear market may never happen again, but are you willing to bet your retirement on it? During the same period educated, unemotional bargain hunters were able to make money while the efficient market crowd was drifting with the tide...

All about EMH in Less Than a Minute

Like most of the great contributions from the world of academia the EMH is not as simple as it might appear at first glance. For starters, it comes in three varieties. The “weak” variety assumes all market information (historical prices, volume data, rates of return, etc...) is reflected in a given stock’s price.

The “semi-strong” variety assumes that stock prices adjust rapidly to the release of all public information. We are less inclined to agree with this variety of EMH. Watching shares of your favorite stock “gap down” 10% in one day after a lower than expected earnings announcement might give you the perception that this is an efficient market rationally adjusting to new information. Note that we chose to italicize the word rationally. The “semi-strong” variety implies that market participants are rational and profit maximizing decision makers. This isn’t always the reality as emotions like fear (also called career risk for those of us that do this for a living) and greed can effect the decision making process of many market participants.

We won’t spend much time on the “strong” variety only to say that it proposes that stock prices reflect all information from public and private sources. The extended assumption here is that all information is “cost free” and available to everyone at the same time. Sometimes we wonder what planet these efficient market folk are living on.

Back to Warren & Bill....

By this point you have probably guessed that we don’t subscribe to the belief that Warren Buffet and Bill Miller are just statistically lucky. So rather than focus on cutting edge research about EMH, we have made the focus of this letter on finding cheap stocks. This school of investing, called value or “Graham & Dodd” (an homage to the Grandfathers of security analysis Benjamin Graham and David Dodd), focuses on buying companies that are fundamentally cheap and holding them until the market recognizes their value. This price-value convergence is the great source of returns for value investors.

About American Money Management, LLC

American Money Management, LLC, an SEC Registered Investment Adviser, manages accounts for individuals, companies, trusts and retirement plans. Minimum account size is $100,000 but investors are invited to try a managed account with as little as $25,000 (AMM reserves the right to withdraw this option at any time). For more information on our managed accounts program, please call us at 888-999-1395 or visit us on the web at www.amminvest.com.

Subscribe to The Fallen Angels Report

Every two weeks, subscribers receive the Fallen Angels Focus List designed to help you find potential bargains that are cheap and timely. The Focus List is updated and sent out bi-weekly. The editors define Fallen Angels as quality businesses whose value is not currently recognized in the company's stock price.

3 Months Subscription - Only $18
1 Year Subscription - Only $55 (That's less than $5 per month)
2 Years Subscription - Only $80 (That's about $3 per month)

Disclaimer
The opinions expressed are those of Gabriel Wisdom and Michael Moore and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor. Clients of AMM, Mr. Wisdom, Mr. Moore and employees of AMM may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything.