There has been a lot written on what market efficiency is, but much less on why it is important – probably because everybody knows the market is efficient. My view comes from my background in financial markets: Market efficiency is important because it affects the flow of capital in the economy. Ideally, we want capital (money) to go where it gets the best risk-adjusted return. If the market isn’t efficient, it doesn’t go there – and the economy doesn’t perform as well as it could.
Over- And Under-Priced Companies
In my Why The Stock Market Is Inefficient post I wrote about why I think the market is inefficient. Here I’ll show why that is important to investors and management.
Over- And Under-Priced Companies In An Inefficient Market
Investors do not look for mis-priced stocks, so stocks are not priced efficiently. Investors have poor outcomes and managements have good outcomes.
- Under-priced company
- Investors can purchase the stock – but the price doesn’t change and they make no profit because nobody else knows it’s under-priced.
- Management can buy back stock – this seems to work and arbitragers are probably watching for it.
- Over-priced company
- Investors can sell the stock, maybe even a short sale – but the price doesn’t change and they make no profit because nobody else knows it’s over-priced.
- Management can sell stock – they get more funds than they should; allowing them to hoard cash.
The Result
So what’s left? Randomness and fads! Some companies are considered “good”, and may become over-priced; and others are considered “bad”, and may become under-priced. William Fruhan’s Financial Strategy book1 shows both a tool for assessing stock value and – unfortunately old – examples of management actions when their companies are mis-priced. If it were written today there would be different examples – Apple and Tesla perhaps – but the conclusions would be the same.
Consider the broader effects: When someone is considering starting a company what companies do they emulate? The “good”. When someone is considering investing in an IPO which do they prefer? Again, companies like the “good”. So no capital flows to the “bad” companies; existing ones languish and new ones are neither started nor funded. Too much capital flows to the “good” companies and they don’t know what to do with it – so they hoard cash.
Remember, these “bad” companies are not bad necessarily, they are just not “good”, according to current thinking. But they have fewer opportunities to increase production or introduce new products – and the economy doesn’t have the products that it should have had.
April 5, 2020
Footnotes
1 Fruhan, William E. Jr. (1979). Financial Strategy: Studies in the Creation, Transfer and Destruction of Shareholder Value. Homewood, Illinois: R. D. Irwin. OCLC878176877.