The efficient market hypothesis (EMH) states that it is impossible to outperform or beat the market because stocks and bonds are always priced at fair value. Fair value is determined by the market incorporating all publicly available about a company into it’s stock price. As an investor, you should determine whether or not you believe the efficient market hypothesis to be true. Your decision regarding the efficient market hypothesis will drastically affect how you should approach investing. In this post, I present you with a case study comparing Amazon and Berkshire Hathaway. My goal is to allow you to make your own decision concerning the efficiency of the market.
Efficient Market Hypothesis Assumptions
The efficient market hypothesis makes multiple assumptions that affect it’s usefulness:
- Investors act in their rational best interest.
- This means that investors seek to maximize their risk-adjusted returns when investing. For this assumption to hold true, investors must always make their investment decisions based upon logic or data to determine what each individual company is worth. Rational investors do not allow emotions, such as fear or greed, to sway their investing decisions.
- On average, the total investing population is correct in it’s valuation of a companies. (Based upon Market Capitalization)
- In this case, even if every single person is individually wrong in their valuation of what a company is worth, the final market price is the correct value for the company because it averages out the mistakes of individuals.
- The current value of stock prices incorporates all known public information about a company.
- The additional assumptions created by this statement are that most, if not all, investors have access to this public information, know how to access it, and does so prior to investing.
- Stock prices will quickly, or immediately, update any new information released publicly about a company.
- The market must incorporate new information in order to ensure that it remains efficient. If the market does not incorporate new information then it will lose it’s efficiency simply whenever new information is released. The efficient market hypothesis does allow for the fact that temporary changes will occur as the stock price adjusts to the new proper valuation due to news releases.
Amazon vs Berkshire Hathaway Comparison
As of Monday, July 11th, Amazon has surpassed Berkshire Hathaway in market value to become the 5th largest U.S. listed company. Amazon now has a market cap of approximately $356 billion while Berkshire Hathaway has a market value of $355 billion. For our purposes, we can say that the market has determined Amazon and Berkshire Hathaway to be essentially equivalent in value with Amazon having a slight edge. Let us compare these two companies in more detail.
Market Cap: $356 billion
Annual Profit: $0.59 billion (2015), Loss of $0.24 billion (2014), $274 billion (2013), Loss of $0.03 billion (2012), $0.63 billion (2011)
Price to Earnings Ratio: 306
Consensus Earnings Growth Rate (5 years): 49.4% per year
Trailing 5 years Earnings Growth Rate: -13.15% per year
Market Cap: $355 billion
Annual Profit: $24.08 billion (2015), $19.87 billion (2014), $19.47 billion (2013), $14.82 billion (2012), $10.25 billion (2011)
Price to Earnings Ratio: 14.5
Consensus Earnings Growth Rate (5 years): Not available
Trailing 5 years Earnings Growth Rate: 13.1%
Current Profits Comparison
Berkshire Hathaway’s profits are in the billions while Amazon’s profits were consistently less than $1 billion. Amazon also posted losses in two of the past five years, while Berkshire Hathaway has posted steadily rising profits each of the last 5 years. For illustration purposes, I have created a chart of the profit and loss figures for the two companies.
Future Profits Comparison
Remember, the market is saying that these two companies are worth approximately the same amount right now. The market value of a company is based upon future performance, not what it has done in the past. If the efficient market hypothesis is true, there should be no difference in the performance of an investor who invests $10,000 in Amazon vs someone who invests $10,000 in Berkshire Hathaway. Let’s assume that the profit estimates for Amazon come true for the next 5 years. Meanwhile, Berkshire Hathaway merely matches it’s previous 5 years of growth. The result is shown below.
Amazon ends with $4.4 billion in annual profit in 2020,while Berkshire Hathaway ends up with $44.5 billion in annual profit. Let us assume both companies end the period valued at fair value. We’ll state that a P/E ratio of 15 is fair value in this example.
Amazon’s value in 2020 = $66 billion
Berkshire Hathaway’s value in 2020 = $667.5 billion
Based upon these numbers, if investor A put $10,000 into Amazon today, while investor B put $10,000 into Berkshire Hathaway, a large difference would result. Investor A would have $1,853.93, while investor B would have $18,287.67. This leaves investor B with almost ten times as much money as investor A. The efficient market hypothesis would suggest that this outcome is not possible.
There are a few possible conclusions. The first and simplest solution is that the efficient market hypothesis is wrong. It is possible to outperform the market by proper selection of stocks via fundamental analysis. I believe this to be the most credible answer.
A different conclusion could be that Amazon will maintain a growth rate much larger than Berkshire Hathaway for longer than 5 years. If we were to accept the 49.4% growth rate and let Amazon’s earnings continue to grow at that rate, they would eventually surpass Berkshire Hathaway’s earnings. This is a possible outcome. If this were to happen, then the market could be efficiently valuing Amazon and Berkshire Hathaway. It’s up to you to determine whether you think that is the likely outcome.
Implications of the Efficient Market Hypothesis for Investors
If you believe the efficient market hypothesis to be true, then your best action as an investor is to invest solely in index funds that match the market. Under the efficient market hypothesis, it is impossible to outperform the market, so you will achieve maximum risk-adjusted returns by simply owning the entire market. You can use index funds or index ETFs to achieve this goal.
If you believe the efficient market hypothesis is not true, then your best action is less clear. It can still be rational to invest in index funds. Even if the market is not efficient, you could still capture average market returns without much effort. This can be a very positive outcome. However, if you wanted to outperform the market, then you could follow a number of value-based strategies to increase your odds of success. I will cover these strategies in depth. I believe it is possible for an individual to either beat the market or match the market with less risk than the market as a whole.
Do you think the market is efficient? Share your thoughts below in the comments.
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