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Management in Practice

Are markets always efficient?

Legendary investor Martin Whitman describes the factors that push markets toward efficiency — and how inefficiency presents opportunities for investors.

Modern Capital Theory (MCT) was born in the 1960s as a description of how markets operate. MCT has been widely accepted as a general law by most financial economists. The basic tenets of MCT revolve around the Efficient Market Hypotheses (EMH) and Efficient Portfolio Theory (EPT).

Professor Martin Shubik to his everlasting credit has consistently stated that MCT, EMH, and EPT are not a general law, but really relatively narrow special cases. He has time and again postulated a general law describing
markets. I picked up on Shubik's pioneering views about markets when, in a January 31, 2005, letter to the shareholders of Third Avenue Value Fund, I wrote a piece, "The General Theory of Market Efficiency." Professor Shubik has long been and remains a director of Third Avenue. This essay represents what I've learned from Shubik's views about markets. I, for one, believe that this General Theory makes a most important contribution to economic theory and economic practice!


Before delving into the subject of market efficiency, it is important to define what a market is: A market is any financial or commercial arena where participants reach agreement as to price, and other terms, which each participant believes is the best reasonably achievable under the circumstances.

Myriad markets exist and include the following:

  • Outside Passive Minority Investor (OPMI) markets including the New York Stock Exchange, NASDAQ, and the various commodity and option exchanges. For most academics, this seems to be the only market that exists.
  • Markets for control of companies.
  • Markets for Consensual Reorganization Plans in Chapter 11.
  • Institutional creditor markets.
  • Markets for executive compensation.

For the past 40 years, financial academics have operated mostly on the assumption that financial markets are highly efficient. In a highly efficient market, the price of a common stock multiplied by the amount of shares outstanding reflects the underlying equity value of the company issuing that common stock. This is embodied in the Efficient Market Hypothesis. Recently, behaviorists have challenged EMH based on the theory that investors sometimes make emotional, irrational, and stupid decisions. But even behaviorists seem to concede that if investors were rational, financial markets would be highly efficient. I disagree. Certain markets always will be inefficient versus EMH standards of efficiency. The raison d'etre of the Third Avenue Value Fund is to take advantage of the absence of instantaneous efficiencies in the majority of markets in existence.

A basic problem faced by financial academics — whether efficient market theorists or behaviorists — is that they are strictly top-down analysts who study economies, markets, and prices, and not the underlying fundamentals that really determine what a business might be worth and what the characteristics are of the securities issued by that business. Put simply, the academics are best described as chartist-technicians with PhDs. Few, if any, qualify as value investors. Insofar as academics try to be value investors, they seem to believe that value is measured only by future predictions of Discounted Cash Flow (DCF). They don't grasp the fact that most firms and market participants have an overriding interest in wealth creation, not DCF, and DCF is only one of several paths usable to create wealth.

In bottom-up analysis, conclusions are drawn based on detailed analyses of individual situations — securities, commodities, companies — to ascertain whether or not gross mispricings exist, or persist. As a general rule, such mispricings can arise out of one or more wealth-creation factors that are sometimes interrelated:

  1. DCF.
  2. Earnings. Earnings are defined as creating wealth while consuming cash. For most firms (and governments), earnings can have long-term value only insofar as they are combined with reasonable access to capital markets.
  3. Asset and/or liability redeployments via mergers and acquisitions, contests for control, asset redeployments, refinancings, capital restructurings, spin-offs, liquidations.
  4. Access to capital markets on a super-attractive basis such as selling common stock issues into a super-heated IPO market or having access to long-term, non-recourse debt financing at ultra-low interest rates.

The general theory of market efficiency

Markets run an efficiency gamut. Some markets tend toward instantaneous efficiency, thereby comporting with the standards that are the essence of the EMH. Some markets tend toward a long-term efficiency but many never actually reach EMH efficiency. As a subset of this, it should be noted that price efficiency in one market, say the OPMI market, is usually, per se, price inefficiency in another market, say the takeover market.

Some markets are inherently inefficient. Or to put it in another context, an "efficient" market in these situations means that certain market participants are virtually assured of earning very substantial excess returns on a relatively continual basis.

Four characteristics will determine whether a market tends toward an EMH-like instantaneous efficiency on the one hand; whether a market will tend to be inherently inefficient by EMH standards on the other hand; or something in between.

Characteristic I:

Who is the market participant? Insofar as the market participant is unsophisticated about value analysis, financed with borrowed money, noncontrol, and lacks inside information, that participant will face a market tending strongly to instantaneous, EMH-like efficiency. Insofar as an investor is well trained, well informed, and not influenced by day-to-day or short-run price fluctuations, that investor avoids being influenced by an EMH-like efficiency.

Characteristic II:

How complex or simple is the security, or other asset, which is the object of the market participant's interest? Insofar as the security is simple, i.e., can be analyzed by reference to a very few computer programmable variables, the asset's pricing will reflect a strong tendency toward instantaneous, EMH-like efficiency. Insofar as securities are concerned, three types of issues tend to be characterized by instantaneous, EMH-like efficiencies:

  • Credit instruments without credit risk, e.g., U.S. Treasuries.
  • Derivatives, including options, warrants, and convertibles.
  • Risk arbitrage, i.e., situations where there are relatively determinate workouts in relatively determinate periods of time, as, for example, tends to exist after merger transactions are announced publicly.

Insofar as the analysis of the security entails complexity, EMH-type efficiencies tend to become unimportant.

Characteristic III:

What are the time horizons of the participants? If the participant is an OPMI involved in day-to-day trading, that participant will, in all probability, be faced with EMH-like instantaneous efficiencies. If, on the other hand, the participant is a manager of a well-financed company, and the manager has a five-year time horizon during which time the company might choose to access capital markets, either credit markets or equity markets, that participant will be involved in a market which is inherently inefficient by EMH standards. The manager who can control the timing of when to access capital markets over a five-year period knows that there will be times when credit markets are unattractive for his company and times when credit markets are very attractive for his company, e.g., interest rates are ultra low; there will be times when it will be impossible, or nearly impossible, to raise equity capital and there will be times when it will be relatively easy and ultra attractive to issue new equity in public offerings and/or mergers, e.g., an IPO boom.

Characteristic IV:

How powerful are the external forces seeking to impose disciplines on the market participants and the companies which are issuers of securities? Insofar as the external forces are very powerful, prices will tend toward EMH-like instantaneous efficiencies. Competition among market participants, such as exists on the floor of the New York Stock Exchange (NYSE), or on NASDAQ, is one powerful external force imposing restraints on OPMI traders so that their returns will likely reflect EMH-like efficiencies. For a financial market such as the NYSE and NASDAQ to approach instantaneous efficiency, however, two external forces seem necessary if there are to exist EMH-type efficiencies. The first is competition, and the second (to the surprise of many) is strict regulation. Such strict regulation comes from varied sources including the government, e.g., the Securities and Exchange Commission; self-regulatory organizations, e.g., the NYSE; auditors; and the plaintiffs' bar. Insofar as the external forces are weak, markets will be inherently inefficient by EMH standards. Boards of directors are an external force imposing discipline on the compensation of top management executives. Boards tend to be weak, and thus top corporate executives tend to earn excess returns consistently. Indeed, where external forces are weak, certain market participants (not only corporate executives) will earn excess returns consistently. This is part and parcel of the definition of a market where each participant strives to achieve the best returns reasonably achievable under the circumstances.

The external forces influencing markets explained

Markets, and market participants, are very much influenced by external forces, of which the principal ones include the following:

External Forces Imposing Disciplines on Stockholders,
Companies, and Management

Competitive Markets
Regulatory Agencies

  • Government
  • Self Regulatory Organizations

Tax System
Control Stockholders

Additional External Forces Imposing Disciplines on
Companies and Management

Board of Directors
Rating Agencies
Labor Unions
Plaintiffs' Bar
Passive Stockholders

When external forces impose very strict disciplines, e.g., government regulators, senior creditors, credit rating agencies, and the plaintiffs' bar, such strict regulations or control tends to stifle innovation and productivity. It is important to note that the government does not have a monopoly on actions which stifle innovation and productivity. The same disease exists in the private sector, where, say, financial institutions follow overly strict lending practices. However, it is Professor Shubik's observations that no financial markets of any sort, whether banking, insurance, finance, or passive investing, can approach instantaneous efficiency unless they are strictly regulated both by government and private sector forces.

When external forces impose little or no discipline, e.g., boards of directors rubber stamping top management compensation and entrenchment packages, or passive shareholders' proxy votes, an environment is created which will be characterized by corporate inefficiency, frauds, and a gross misallocation of resources.

Again, my kudos to Professor Martin Shubik.