Risk Management


Mr. Market Versus Efficient Market

The margin of safety investing approach represents one perspective in a “great debate” about investing. The alternative view, and the majority view, is one often called the Efficient Market Theory or EMT. In many ways, the debate turns on how risk is best understood and how it is best managed. Palmerston Group’s services to its clients reflect the conviction that margin of safety proponents make the more persuasive case. Please contact Palmerston.

Mr. Market

Benjamin Graham, the founder of margin of safety analysis, likened the market to a moody gentleman he called Mr. Market. As recounted by Warren Buffett:

A remarkably accommodating fellow named Mr. Market … 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.”

According to margin of safety thinking, stocks can be priced fairly or they can be absurdly expensive or absurdly cheap. The opportunities arise when valuations are unduly low.

Efficient Market Theory and The Fish

In contrast, Efficient Market Theory posits that at any point in time, the market’s pricing of any security fully incorporates and reflects all available information. Hence, if markets are always efficient, trying to outperform the market is pointless. No fundamental analysis can discover discounts to true value. Since the market presumably appropriates even the discovery of a discount immediately, market prices adjust quickly to reflect that true value. Active investment management, as opposed to passive instruments like index funds are perceived as futile.

Where Graham offers the story of Mr. Market, Robert C. Higgins, in Analysis for Financial Management, offers the metaphor of efficient market as piranha:

Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are—plausibly enough—the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence.

The most important clash of the two approaches occurs over the definition of investment risk and, by implication, the possibilities of reward. More specifically, the battle centers on how risk is measured. For margin of safety, risk means the danger of permanently losing capital. The value of a company is the present value of all future earnings. Risk comes from an uncountable number of factors that could impair or destroy the ability to generate profits. Measuring risk is focused on the company itself. Those factors include new competitors with better mousetraps and lower prices; overseas firms with lower labor costs; inflation eroding the net present value of future earnings; thieving company managers who defraud shareholders; unanticipated future tax or regulatory burdens; or technological innovation that overthrows entire industries (the impact of personal computers on typewriters for example). Risk, in other words, is highly varied and difficult to quantify.

Efficient market advocates look to measure risk not through the fundamental analysis of companies, but rather through the market’s pricing and re-pricing of shares. Because share prices are assumed always to incorporate the total existing information about a company, the price is always right. Therefore if a share price changes significantly, the change reflects a correspondingly significant change in that company’s outlook. Price volatility is a reflection of risk; the greater the historic volatility, the higher the risk. The only reason an investor would buy a highly volatile stock is the expectation of an above average return. And an investor accepts a lower return in a stock with below average volatility in return for greater safety. When one hears an investment advisor speaking about “risk-adjusted” returns, it usually refers to adjusting portfolio performance using tools based on the historical volatility of the stocks in the portfolio.

This very tight definition of risk poses a problem for EMT. No one has ever produced a study conclusively correlating historical price volatility with future returns (whether a beta-centered definition of risk seeking to determine the systemic risk relative to the market, or standard deviation version of periodic (e.g. daily, weekly, etc.) returns). Hence there is no research to show that lower volatility means greater future safety or higher volatility correlates to higher risk and reward. Historical volatility is not predictive of future performance. In other words, the EMT’s measurement of risk does not measure risk. Economics, like all the social sciences can illuminate many aspects of human affairs. Yet what is important is not always easy to measure, and social science runs into trouble when its efforts to quantify overreach and exclude important factors because they are difficult to measure. The absence of a relationship between historical volatility and future rates of return in the EMT definition of risk severely limits an already narrow concept as a usable investment tool.

Margin of safety’s risk analysis has the benefit of acknowledging the fact that there are many influences that can color human behavior. It knows that it operates in a world of intangibles, and above all, educated guesses. Investing is as much the province of the inexact, imperfect, and human art of judgment as it is a hard science of crunching numbers—though it includes the latter as well. It is an analysis that expects markets to sometimes reflect the foibles of its users. Problems with a single company sometimes unreasonably depress the prices of other companies in the same sector. Institutional investors occasionally do create buying opportunities when they all simultaneously dump the stock they received for a newly spun-off company. Margin of safety investors may be subjective and imprecise, but they compensate by seeking out investment situations where there are big gaps between the appraisal of value and the share price. Those big discounts can offset a multitude of valuation errors that investors might make. Investors utilize the substantial discount to obtain the safety that they would never expect their valuation alone to provide.

Benjamin Graham summed up this debate in The Intelligent Investor:

If a group of well-selected common-stock investments shows a satisfactory overall return through a fair number of years, then this group investment has proved to be “safe.” During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer’s cost. If that fact makes the investment “risky,” it would have to be called both risky and safe at the same time. This confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position—or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.

(In a related footnote, Graham described a volatility-focused definition of risk as “more harmful than useful for sound investment decisions.”)