The Efficient Market Hypothesis, or EMH for short, is a theory that argues it is impossible to do well in the stock market because all information is already reflected in market prices.
There are three different versions of EMH, known as the weak, semi-strong, and strong forms.
- Weak EMH: Quoted asset prices reflect all forms of publicly available information.
- Semi-strong EMH: Quoted asset prices change instantly to reflect new public information.
- Strong EMH: Quoted asset prices change instantly to reflect inside information (not just public).
EMH is popular in academia as a way to roughly explain how markets work. But as a theory, EMH has major flaws. Here are three of the biggest problems:
- Markets are mostly efficient for much of the time, but not perfectly efficient and not all of the time.
- Public information is available to all, but investor talent varies in the ability to use that information.
- Markets are driven by human behavior and human rules, which can sometimes be irrational.
The most important thing to understand, and the biggest reason why EMH is wrong, is because some investors have more skill at analyzing public information than others, and that skill results in an ability to beat the market longer term.
This is why we track a roster of legendary billionaire investors in our various software products. They are the equivalent of world-class athletes in this space — athletes who get even better with age.
To understand how flawed the whole EMH concept is, it helps to realize just how inefficient, or even wildly inefficient, markets can sometimes be. We’ll cover three recent examples that highlight this.
Our first example is Zoom Video Communications Inc., a company that went public on April 18, 2019.
Zoom Video Communications is that rare beast, a highly profitable unicorn. Shares rocketed higher on the first day of trading, and as of this writing, the company has a market cap above $18 billion.
The funny part has to do with the ticker. The best ticker for a company named Zoom Video Communications would obviously be ZOOM. But that ticker was already taken by Zoom Technologies Inc., based in Beijing, China. So, Zoom Video went with ZM instead.
Zoom Technologies (ZOOM) has nothing to do with Zoom Video Communications (ZM). In fact, Zoom Technologies does not do much of anything at all. Its description on Yahoo Finance begins by stating: “Zoom Technologies, Inc. does not have significant operations.”
At one point in the 1990s, ZOOM traded above $1,000 per share. But then the stock crashed and burned. In 2015, the company delisted and now trades on the pink sheets. In February 2019, ZOOM shares were trading for a fraction of a penny and saw less than 5,000 shares change hands for the entire month.
But then, investors who were excited about the Zoom Video Communications IPO, got their tickers mixed up and started buying ZOOM by accident.
This caused the price of ZOOM shares to rise more than 70,000 percent at one point.
As a dead company, ZOOM went from a market cap of $12,000 to a market cap of over $8 million in a matter of weeks, purely because investors got their tickers confused. (As of this writing, ZOOM is still showing a $5 million market cap. It is still a dead company.)
The price of ZOOM shares did not, well, “zoom” higher purely because investors made a mistake. There are also algorithms in the market that look for exactly this type of error, anticipating a price rise in nano-cap ticker symbols that could be confused for the ticker of some hot new offering.
There were no doubt also professional buyers of ZOOM, who absolutely knew it was the wrong ticker and not the IPO ticker, but were cynically “playing the players” in anticipation of the mix-up. So, the run-up in ZOOM shares became a kind of self-fulfilling prophecy.
Is this what you would call an “efficient market”? Hardly.
Our second example of non-efficient markets is Blackstone Group, the private equity giant that trades under the symbol BX on the New York Stock Exchange.
On April 18, Blackstone announced it was changing its structure from a publicly traded partnership to a corporation. You can see the presentation deck here.
Here is what’s curious about the Blackstone deal. In changing from a publicly traded partnership to a corporation, Blackstone will be paying more in taxes. Not a lot more in taxes, relative to its size as a $45 billion company, but more than before. This means Blackstone will be a little bit less profitable.
And yet, investors cheered the news of the Blackstone conversion. Shares in BX immediately jumped higher on the news that Blackstone would convert, even though it means paying more in taxes, which means slightly lower profits for the business. Why, then, did shares jump?
The answer has to do with a weird quirk of market structure.
Due to rules in the fine print, many institutional money managers are not allowed to buy shares in a partnership. They can only buy shares in publicly traded corporations. The same holds true of various market indexes. A number of indexes are allowed to hold publicly traded corporations but not partnerships. This meant that, as a publicly traded partnership, Blackstone was off limits to institutional money managers and excluded from some market indexes.
But now, as a publicly traded corporation — and a leading $45 billion market cap private equity firm — Blackstone can presumably be added to more stock indexes, which means more passive indexing dollars can flow into Blackstone’s shares, which should push up the valuation.
So, the shares in BX jumped higher because, due to a weird quirk in the fine print, Blackstone was off limits to various buyers but has now become available to them. That means a bigger pool of potential demand, which should mean a higher share price — even though Blackstone’s profits will now be a little bit lower.
Our final example has to do with Disney, the entertainment giant.
On Friday April 12, Disney shares (symbol DIS on the NYSE) jumped 12%, adding more than $20 billion to Disney’s market cap. The price surge set a new intraday record for Disney shares.
Disney shares jumped because investors were excited and enthusiastic about Disney’s presentation explaining their new streaming content service, which is seen as Disney’s answer to Netflix.
The new service, called Disney+, will launch in November 2019. It will be $6.99 a month and ad-free. It will contain thousands of TV episodes, hundreds of movies new and old, and 25 pieces of original content rolled out in the first year. Disney will spend billions on the effort and expects to have 60 million to 90 million subscribers within five years.
We use Disney as an example because, though the shares jumped sharply on April 12, smart investors were already long Disney shares based on common sense analysis of the power of the streaming service.
This is an example of using public information in a smart way, to be long Disney prior to the announcement, on a rational analysis that the streaming service would be well-received.
Investors who were already long understood that Disney has the most lucrative roster of intellectual property and content in the world, and that the streaming Disney+ service would act as a flywheel that drives self-reinforcing profit all across the Disney kingdom — including Disneyland, toys and merchandise, music, feature films, books and games, and so on.
A few weeks ago — well prior to the Disney streaming announcement that sent the stock to an all-time high — the TradeSmith research team released a “Billionaire Ideas” Special Report highlighting three top picks from our billionaire’s club.
Disney was one of those picks. These were the opening and closing lines of the Disney section:
“Disney (DIS:NYSE) has a market cap of roughly $161 billion and a dividend yield of 1.62%. It is favored by multiple billionaires including George Soros, John Paulson and Seth Klarman…
…Disney has significant opportunity to expand globally — for example via Star India, a dominant player in the India television market — and also with its upcoming streaming service. Disney’s intellectual property is so strong (think Star Wars, Marvel and more) their streaming offering will be a strong competitor to Netflix, in an era where digital entertainment assets and monthly subscription revenue is highly valued.”
If you had bought DIS based on that report, you would have done quite well. The point here is it was possible to understand Disney’s strengths and weaknesses — and the power of the upcoming streaming service offering — before Disney made the announcement.
And that highlights what is, again, probably the biggest way in which markets are not at all efficient: Some investors — like the billionaires we follow — can make much better use of public information than others.
You can benefit from those information streams, too, by following along with the billionaires — and using our software to maximize their investment picks — via TradeStops and Ideas by TradeSmith.
Richard Smith, PhD
CEO & Founder, TradeSmith