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Dear Fellow Investors:
At Smead Capital Management, we have our own Efficient Market Theory. Ben Graham observed and Warren Buffett repeated, "The stock market has a very efficient way of transferring wealth from the impatient to the patient." We would add that over ten to twenty years the stock market moves money "efficiently from the those who over-think the stock market to those who don't." In this missive we will explain why we believe the patient benefit at the expense of the impatient and why those who over-think the stock market are incredibly inefficient and move their money to those with less complicated views on finance.
Last week we shared some thoughts on the lessons of Warren Buffett and Charlie Munger from the Berkshire Hathaway annual meeting. The week of the meeting, Samuel Lee wrote a column at Morningstar.com called the "A Come-to-Buffett Moment." It was a lengthy discussion of the changes that Professors Fama and French have made to their "three-factor pricing model" based on additional research and evidence. They have now added two factors which appear to be more important and explain the other three. Here is how Samuel Lee explains the new work from Fama and French:
After more than 20 years, Fama and French have embraced the notion that size and value may not be the best factors to explain stock returns. Their new paper, the first draft of which was released in June 2013, finds that two additional factors--profitability and investment--make redundant the value factor. In other words, value stocks--defined as those with low price/book—only beat growth stocks because they historically tended to be more profitable and less voracious users of capital.
For Efficient Market Theorists and those who have created a massive cottage industry in money management based on the theory (passive funds and ETFs), we believe it is effectively a “shot heard around the world." Further on in his piece, Lee suggests that the mathematically inclined efficient market theorists are having a “come to Jesus" moment, thus agreeing with our belief that money moves efficiently to the patient when you don’t over-think the market.
Fama and French said that their three-factor theory of markets, market-cap size and valuation cheapness were true in "back testing," but weren't valid as academic theory. As a 34-year veteran of the investment business, you have no idea how many great ideas I've looked at which relied on "back-testing" and proved to be relatively useless going forward.
In his Columbia Business School letter in 1984 called, "The Super Investors of Graham and Doddsville," Buffett did his own "back-testing" attempting to prove that the Efficient Market Theory was hogwash. He showed that all of his friends who practiced long-duration and high margin-of-safety stock picking disciplines had significantly outperformed the stock market over a 15-year time period. The key to us was that these were real market participants and that it was a long duration view. These wise and patient investors were the recipients of the money left in the stock market by the impatient. Now Samuel Lee is telling us exactly what Buffett told us 30 years ago and he is paid to report on an industry which has relied heavily on the Fama-French back testing!
The two factors which Fama and French added are companies with strong free-cash-flow and what the two professors called "low investment intensity." Our translation: Investors who bought common stock in publicly-traded businesses which generate high levels of free-cash-flow and have low-capex needs were dramatically better investments over long durations. Another look from Samuel Lee's article:
The value factor has held up a lot better. While the value factor has been found almost everywhere, it's largely been driven by small stocks. While that would seem to support value as a risk factor, it's difficult to actually tie value to some measure of risk. Distressed stocks actually have bad returns.
Fama and French add to the puzzle by finding that the value premium can be explained away as a combination of profitability and investment intensity. An efficient-market theorist would argue that profitable firms and firms with low capital intensity must therefore be riskier in unique ways in order to have commanded return premiums.
Accordingly, Warren Buffett, who famously favors profitable firms with low capital requirements, must then have exploited the special kinds of risks these firms have. And someone who invested in firms with low profitability and huge ongoing investments must have earned lower returns because of such stocks' lower risks. This story defies common sense. I think Buffett's explanation for his success is better: investors are not perfectly rational and tend to undervalue wonderful firms. By the gold standard of science--the ability to predict patterns in data yet unseen--Buffett's framework passes with flying colors, even if it was never published in a prestigious academic journal.
Let us provide you our interpretation: highly-educated finance people have just taken thirty years to explain something that any small business owner can explain in five minutes. The best businesses generate a great deal of free-cash-flow and don't require much capital to perpetuate future success. We contend that future success creates ever higher levels of profitability. To enjoy this you have to use long durations of ten years or more. The patient owners of above-average businesses make more money because the stock market is actually very inefficient. Here is how Warren Buffett enlightened us at the annual meeting about his own "come to Jesus" moment on the subject of qualitative analysis over quantitative analysis of individual common stocks: "Fisher was qualitative in analyzing stocks, Graham was quantitative and Charlie [Munger] convinced me that Fisher is correct."
Earlier during the meeting, Munger observed: "See's Candy taught Warren and me about brands and led to the purchase of Coke in 1988. In effect, it "removed some of our ignorance" associated with brands.
Lastly, we will leave you with one more quote from Charlie Munger which is one of our favorites on the conclusion that Fama and French came to:
"We’re partial to putting out large amounts of money where we won’t have to make another decision. If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But, if you can buy a few great companies, then you can sit on your bottom. That’s a good thing."
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.