The details of my Big Bet against Krispy Kreme

[hawk59]

"More specifically, what does the EMT say about the ability of a particular investor - no matter how smart he is - to more accurately forecast the movements of a particular stock, than all the other investors in the market, combined?"

It's not about your ability to forecast the movements of a stock, it's about your ability to act on it. Because it's usually a fairly simple manner to come up with a ballpark range for what a predictable business is worth.

You can have Jesus come on CNBC and tell everyone that GE is trading for 20% of it's intrinsic value, but if the market is in the crapper and inflation is high, and there isn't any liquidity in the system, and etc etc etc then people won't buy it because they are afraid it might drop to 5% of its intrinsic value before it goes up. But there are other times when you can be positive that it is trading for 150% of its intrinsic value but people will buy it because they are hoping for it to get to 300% before it goes down. It all depends on what mood everyone is in. Everyone has been happy the past for years. Maybe we are seeing people start to get sad now.

[Sniper]

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It's not about your ability to forecast the movements of a stock, it's about your ability to act on it. Because it's usually a fairly simple manner to come up with a ballpark range for what a predictable business is worth.

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You are making an incorrect assumption, if you presume that the majority of trades in the stock market are based in any way on what a business is worth.

[LinusKS]

I read Random Walk years ago - and it's on its way from Amazon. So I'll get a chance to read it again. Perhaps I'll take a page from your book, and try to start a discussion on it. I was obsessed with markets for a while, and I'd like to get back into it.

From Wikipedia:
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Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market hypothesis, so long as this irrational behavior is not predictable or exploitable.

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Which sort of brings me back to the question - what does EM mean? If it doesn't mean markets are rational, or that prices are related to fundamental value, what does it mean?

And if stocks can depart from fundamental value, shouldn't they - eventually - return to it again? And if they do, that would make the market predictable.

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I think the track records of Warren Buffett and some others clearly demonstrate skill.

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Buffet talks about a hypothetical, where everybody in the country flips a coin, and bets $1 on the result. The losers drop out, and the winners go on to the next round. After enough trials, there's only a handful left. Each of them have guessed twenty or more times in a row, and all of them millionaires. The odds against any one person doing this - considered individually - are astronomical.

Buffet, of course, doesn't think he's just lucky. But it is interesting to think about.

[LinusKS]

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You can have Jesus come on CNBC and tell everyone that GE is trading for 20% of it's intrinsic value, but if the market is in the crapper and inflation is high, and there isn't any liquidity in the system, and etc etc etc then people won't buy it because they are afraid it might drop to 5% of its intrinsic value before it goes up. But there are other times when you can be positive that it is trading for 150% of its intrinsic value but people will buy it because they are hoping for it to get to 300% before it goes down. It all depends on what mood everyone is in. Everyone has been happy the past for years. Maybe we are seeing people start to get sad now.

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I think what value investors would say is that it doesn't really matter how irrational people are in the short run.

Fundamentally, what a value investor is doing is not so much betting on the price of the share, but on the amount of money the company will be putting in the investor's pocket.

Theoretically, even if the market never comes to its senses, a value investor is fine with that, as long as the company continues to put money into its shareholders' pockets.

Practically speaking though, it's unlikely, since somewhere down the line someone will say, "Hey, this company's making tons of money for its owners. I need to get me a piece of that."

[BDaws]

[ QUOTE ]
I read Random Walk years ago - and it's on its way from Amazon. So I'll get a chance to read it again. Perhaps I'll take a page from your book, and try to start a discussion on it. I was obsessed with markets for a while, and I'd like to get back into it.

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Just finished reading Random Walk. It makes a very, very convincing case for the EMT and is a great read.

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Which sort of brings me back to the question - what does EM mean? If it doesn't mean markets are rational, or that prices are related to fundamental value, what does it mean?

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I believe it means that the market is very good at adjusting to new information. So good, that the inefficiencies in the market are not predictable nor are they exploitable for any amount of money above what a traditional buy and hold strategy would yield in the long run.

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Buffet talks about a hypothetical, where everybody in the country flips a coin, and bets $1 on the result. The losers drop out, and the winners go on to the next round. After enough trials, there's only a handful left. Each of them have guessed twenty or more times in a row, and all of them millionaires. The odds against any one person doing this - considered individually - are astronomical.

[/ QUOTE ] Burton Malkiel, author of Random Walk, uses this very example to demonstrate that mutual funds can’t beat market in the long run. Some do for a short while, and those are the ones flipping heads 5 times in a row.

[buffett]

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You are making an incorrect assumption, if you presume that the majority of trades in the stock market are based in any way on what a business is worth.

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I think his "Jesus" paragraph clearly shows that he agrees with you.

[DesertCat]

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Buffet talks about a hypothetical, where everybody in the country flips a coin, and bets $1 on the result. The losers drop out, and the winners go on to the next round. After enough trials, there's only a handful left. Each of them have guessed twenty or more times in a row, and all of them millionaires. The odds against any one person doing this - considered individually - are astronomical.

[/ QUOTE ] Burton Malkiel, author of Random Walk, uses this very example to demonstrate that mutual funds can’t beat market in the long run. Some do for a short while, and those are the ones flipping heads 5 times in a row.

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Buffett's examples is actually a counter example to Malkiels. The RMers (random-walkers) came up with this example to show why people like Buffett are just lucky, enought coin-flippers and you have to have a few Buffetts, right?

Buffett said, yes that's true. But what if a large number of lucky coinflippers all came from the same philosophical background, i.e. they either worked for Ben Graham, studied under him, or adopted his philosophy? Buffett provided a decent sized list of managers from that group that beat the market soundly over long periods of time. which defied the odds of statistical likelyhood and demonstrated skill at work, not luck.

And this debate was originally began in the 70s. At the time it was almost reasonable to think Buffett had just been lucky for 20 years, that is, if you knew who he was at the time. Most academics probably didn't, as he didn't run a mutual fund or a large corporation and didn't have a big public presence.

But now Buffett has beaten the market something like 48 out of 52 years. The odds of doing that through coinflipping, well, are practically impossible. The leading EM proponents, including Fama, admit that Buffett is far too successful to be lucky.

Interestingly, even Malkiel after all his discussion in "Random walk" about the market being impossible to beat, devotes a partial chapter to his techniques on beating the market. You can't beat the market, but he believes he can!

To summarize my understanding of EM theory. Thousands of academic studies have looked for predictable patterns of price movements, and couldn't find any that lasted. This establishes that prices are a random walk, and can't be predicted. I tend to believe this.

Sniper doesn't, but he spends his time predicting movements and has his own track record of success. Perhaps he's been lucky, perhaps not, I don't care because it doesn't affect how I do my job. One counter example to support Sniper, is John Henry's fund, which has a 25 year track record that's hard to attribute to pure luck, and appears to have been based totally on price movement prediction.

Anyways, assume the random walk theory is true. Next academics studied mutual funds, and found the vast majority trail the market. So, if you can't predict price movements, they theorized you couldn't beat the market, and the mutual fund studies "proved" it.

None of that makes sense. First, you don't have to predict "short term" price movements to beat the market, Buffett has established that. Secondly, there are a ton of reasons why actively managed mutual funds trail the market that have nothing to do with market efficiency. Mutual funds are inefficient by design, have high fees, investment restrictions, are short term focused, have been market timed, lost best managers to hedge funds, etc, etc.

Let me give you a thought experiment to show why EM theory is wrong-headed with it's focus on price as everything. You buy a bunch of down trodden stocks at what you feel are good values with very high dividend yields. Your stocks yield 10% while the market is only yielding 5%. Afterwards the market has a bad year and goes down 10%. Your portfolio does worse, it goes down 20%. Did you fail to beat the market? According to EM proponents you did, because they are all "price biased".

But in reality your portfolio yielded 10%, in cash. You have sold nothing, so you have lost nothing. You know eventually prices will be restored to fair value, in the mean-time you'll make 10% per year. And if the market continues to plunge, and your shares continue to do worse than the market, would you be upset or happy?

You would be happy. You can buy more shares with your dividends at a 12% yield, then a 14%, then a 16% yield, etc, etc. The cheaper your stocks get, the higher your yield on new purchasers, and the bigger your profit when markets return to sanity. But EM proponents would say you are trailing the market, that your "beta" (a meaningless number they like pretend measures risk) was worse than the markets, that it was a disaster in the making.

The 70s were much like this for Buffett. I think he made comments about selling stocks at an 8 PE to buy stocks at a 5 PE, and about feeling like the only man in a harem. Buffett made a lot of money in the 70s.

Once again I'll quote Buffett on the essential differences between EM theory and value investing.

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Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a
private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in
that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will
unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If
you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

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[LinusKS]

If someone told me he'd won $10K playing slots, I'd tell him he'd been lucky. If he said he'd won it playing poker, I'd tell him he might be good, or he might be lucky - but I'd need to see him play.

So I guess what you think about Mr. Buffet, depends on whether you think the market is more like slots, or more like poker. I'm not sure he proves it, one way or the other.


(Fwiw, my wife is convinced she's great at 3-card poker. And if all I knew about the game was her record of success, I'd tend to agree with her. [img]/images/graemlins/smile.gif[/img])

[BDaws]

DC,
Good post. Thanks.

[buffett]

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what you think about Mr. Buffet, depends on whether you think the market is more like slots, or more like poker. I'm not sure he proves it, one way or the other.

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You should read The Superinvestors of Graham and Doddsville.