BENJAMIN GRAHAM was Warren Buffett’s teacher and mentor. He also ran an investment fund that specialized in uncovering demonstrably undervalued stocks.
One day in 1926, Graham was at his desk, reading through a government report on railroads, when he noticed a potentially important footnote. It referenced assets held by a number of oil pipeline companies. But there wasn’t a lot of detail, so Graham boarded a train to Washington and found his way to the Interstate Commerce Commission (ICC), where he thought he might get more information.
What Graham uncovered in the ICC’s dusty offices confirmed what the footnote had suggested—that many pipeline companies, due to a quirk of history, held assets that were worth far more than the companies themselves. Northern Pipe Line’s shares, for example, were trading at $65, but the company held bonds worth $95 per share. It was about as obvious an investment opportunity as ever existed. Graham began purchasing Northern shares and, after discussions with the company’s management, eventually unlocked $110 per share for investors. This investment was an almost no-lose situation, but it was one that other investors hadn’t noticed because the information was so inaccessible.
Today, the world is different. The sort of data that Graham had to look for in a government filing cabinet are now readily available online. Rarely, if ever, is there public information that isn’t in digital form. It’s for that reason that the market is regarded as more efficient today. Stock prices are seen as being more accurate because the relevant data have been factored in.
This development is generally seen as positive. Greater access to information allows investors to make more fully informed decisions. You may recall Enron, for example, where an accounting fraud brought down the company. What caused the fraud to unravel? A reporter named Bethany McLean took a close look at the company’s annual report online and concluded that the numbers didn’t add up.
She published her initial findings in the March 2001 issue of Fortune, and by December the company had filed for bankruptcy. It was a stunning fall, all prompted by the research of a single reporter working from her desk. Looking at examples like this, today’s market seems far more efficient than it was in Graham’s time, when Enron might have been able to continue its fraud undetected for far longer.
In a recent paper, though, Clifford Asness, an investment researcher and fund manager, suggests that conventional wisdom might be wrong—that the market might be less efficient today than it was in the past, despite the improved access to data. To support his claim, Asness looks at market valuation as a proxy for market efficiency. Specifically, he looked at the valuation gap between the most expensive and least expensive stocks, and examined how that gap has changed over time. What he found is that this ratio has been rising steadily for years and, through a number of lenses, it has become more extreme. You can see an illustration of this in his paper.
This valuation trend is evidence of inefficiency, Asness argues, for the simple reason that it’s irrational for investors to overpay for stocks. It’s a pillar of market efficiency, in fact, that prices should reflect all available data. Asness reasons that if investors were reading the data rationally, they’d be making different decisions, and that would cause the valuation gap to close. But that’s not what’s happening.
If investors have more information today, why would they be making decisions that seem contrary to the data? Asness explores a variety of possible explanations. In the end, he concludes, ironically, that it’s the internet itself that’s made the market less efficient.
On the one hand, the web can be a source of reliable information—as it was for Bethany McLean. But on balance, Asness calls it a “fever swamp” of misinformation. In the past, there was the notion of the wisdom of crowds, which posited that groups of people together make better decisions. But Asness feels that today’s social media has produced the opposite result, turning large groups of people into “a coordinated clueless and even dangerous mob.”
We saw this sort of un-wise mob dynamic with the meme stock craze in 2021, when groups of investors bid up the shares of bankrupt and nearly bankrupt companies. Their leader: a YouTube personality who called himself Roaring Kitty. That year also saw a boom in special purpose acquisition companies (SPACs) and other questionable investments.
While that period was perhaps extreme, the valuation data Asness presents suggest that the market is still less efficient than it used to be. The gap, in other words, between the most highly valued growth stocks and the most depressed value stocks doesn’t have a rational basis. If investors were looking more carefully at valuations, this argument goes, some of the most expensive growth stocks would see their valuations moderate, and some of the more depressed value stocks would see their price rise.
What’s the antidote? Asness believes that eventually reason will prevail. “Assuming a valuation change will continue to go on forever is obvious folly.” But he also knows that the current situation may not correct any time soon: “[D]epressingly, I’m saying you can do the right thing and still be wrong for about 30 years.” In other words, the market looks like it’s being irrational, but it might stay that way, perhaps for a while.
Where does this leave investors? In building a portfolio, I’d avoid making any big bets. If you start with a fund that tracks an index like the S&P 500—which includes both growth and value stocks—you’ll benefit regardless of which way things turn out. But recognizing that the market today is more heavily weighted toward growth stocks, you might incorporate a modest position in a fund that tilts toward value. That way, the bulk of your portfolio will be diversified, but you’ll have a thumb on the scale toward the stocks which, according to the data, are undervalued. If they eventually come back to life, you’ll benefit. If they don’t, you won’t have given up too much.
Most important, I’d avoid going to any one extreme. On the one hand, I’d stay away from riskier, growth-oriented funds like Invesco QQQ ETF. To be sure, their performance has been head and shoulders above the rest, but past performance doesn’t guarantee future results. And according to the data, these are the stocks that are most overpriced.
At the same time, as Asness says, the market isn’t always rational. I wouldn’t interpret the data he presents as reason to go in the other direction, to become overly conservative. When it comes to the stock market, as I’ve suggested before, try to take a balanced, center lane approach.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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Back in the early 2000s I was the IT director for a large organization. I invested in mutual funds but decided to invest in a few IT stocks. One of these was 3Com. 3Com provide a network adapter for PCs and we used a lot of that product.
It did ok but one day it dropped 25% without any warning. I checked online and 23 of 24 analysts who followed this stock rated it a buy. There was no information online explaining the drop. I asked my network manager if he had any idea for the drop. He said it might be because Intel has announced that they put that adapter on their next chip which will eliminate about 25% of 3Com sales. I asked him when he learned about that, and he said a few weeks ago.
I lost a lot of faith in Wall Street that day. It reminds me of the old quote about Wall Street, “Nobody knows nothing”.
My wife is adamant about choosing those funds with the lowest costs.
She says … “Costs are forever … Alpha is fleeting.” Not sure where she got that from.
Maybe one of her Finance professors?
She knows way more about finance – and likely everything else too … except for computers – than I do.
The conventional wisdom about Enron and Arthur Anderson is deeply flawed. In fact, business school students who examined the company well in advance of their implosion concluded it was not a good investment based on the public numbers. In fact people who actually looked at the numbers would know. Famously, Fayez Sarofim wouldn’t buy Enron because he couldn’t make sense of the balance sheet. No one could. People bought it on faith that it would keep going up.
Moreover, you cannot trust Investopedia to have good history on such things. It is false that “Arthur Andersen legal counsel tells auditors to destroy all Enron files, except Enron’s most basic documents.” Completely false. Which is why SCOTUS flatly threw out the AA conviction. But it was too late, and the company was destroyed. Who was behind the prosecution of the case?
Robert Mueller – FBI director
Andrew Weismann – Enron task force
Michael Chertoff – Enron task force
Do you recognize those names? The same idiots who spent millions of public dollars fanning the flames of the Russiagate scandal, which turned up nothing. The modus operandi was the same. Try people in the court of public opinion, bag some heads, and damn the legal issues or consequences.
Look, it is sad that so many people lost their savings. But to go from that to the idea that someone must pay for people buying what they didn’t understand set a dangerous precedent.
Anderson was exonerated by SCOTUS because they did NOT order the destruction of documents. ALL companies –all companies– have document destruction polices, and must and should. You can’t keep them forever. These polices can be overridden by court order for the purpose of discovery. If it is the policy to destroy documents at 1 year, and a lawsuit happens a court may say no documents may be destroyed until the case is resolved. But what Mueller and Weisman did was come in and claim the standard document destruction policy was an attempt to fool the court and the FBI loudly told the public that is was illegal and malicious. That was NOT true, and that is why SCOTUS threw the case out. AA did not violate the law on document destruction. Not in any way.
But Mueller and Weisman got their narrative met, and it still lives on in the naive to this day.
Maybe Humble dollar can do better than to repeat falsehoods, no matter how entrenched they may be in the public mind?
Nonsense. Enron was hardly the only fraud that AA was involved in. The SCOTUS ruling involved lack of clarity regarding jury instructions. To say also that the so called ” Russiagate” investigation turned up nothing is equally ludicrous.
Yeah they were vague, and in legal terms that means highly novel and expansive. The idea that is no big deal is ludicrous. As many and the Chamber of Commerce noted in “friend of the court” briefs said on if this novel “vague” basis stood, routine business policies on discarding documents would be seen as criminal.
The Washington Legal Foundation called the Supreme Court decision “a stinging rebuke to the DOJ for its abusive prosecutorial conduct.” A stinging rebuke to the Enron Task Force.
Standard document retention policies as regards shredding were adhered to until Enron was served with subpoena, and then all document destruction stopped. Document destruction is normal policy and is approved by a firms legal team in any business.
In fact, the jury was close to a deadlock when a holdout was persuaded that an AA lawyer’s memo amounted to obstruction of justice. So yeah, being “vague” with the law is an egregious breach of trust in this case.
At issue was the very same thing that the DOJ now engages in, and has been struck down by SCOTUS again. Namely, that “impeding” an official proceeding, even innocently and unknowingly, under this vague guidance, could constitute obstruction of justice. Hit a pole outside a courthouse with your car and kill the power? Yep, you’ve just obstructed justice. It’s absurd. The DOJ is weaponized against whomever it doesn’t like for any reason.
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the jury was told that, “even if [petitioner] honestly and sincerely believed that its conduct was lawful, you may find [petitioner] guilty.” App. JA—213. The instructions also diluted the meaning of “corruptly” so that it covered innocent conduct. Id., at JA—212.
…
These changes were significant. No longer was any type of “dishonest[y]” necessary to a finding of guilt, and it was enough for petitioner to have simply “impede[d]” the Government’s factfinding ability. As the Government conceded at oral argument, “ ‘impede’ ” has broader connotations than “ ‘subvert’ ” or even “ ‘undermine,’ ” see Tr. of Oral Arg. 38, and many of these connotations do not incorporate any “corrupt[ness]” at all.
The instructions also were infirm for another reason. They led the jury to believe that it did not have to find any nexus between the “persua[sion]” to destroy documents and any particular proceeding.10 In resisting any type of nexus element, the Government relies heavily on §1512(e)(1), which states that an official proceeding “need not be pending or about to be instituted at the time of the offense.” It is, however, one thing to say that a proceeding “need not be pending or about to be instituted at the time of the offense,” and quite another to say a proceeding need not even be foreseen.
https://www.law.cornell.edu/supct/html/04-368.ZO.html
“markets can remain irrational a lot longer than you and I can remain solvent”, said A. Gary Shilling in 1986.
As Adam skillfully points out, this is precisely why we index. Trying to ascertain whether the market is “overvalued” or “undervalued” at any given time is generally a fool’s errand, and why achieving “average” results while investing is actually stellar performance. Thanks for the helpful reminders!
Adam, I look forward to your articles each week as I’m always learning something new and interesting from you. Thank you!
Regarding Enron and the like that seemingly managed to manipulate company financial information for years before getting caught, I’m curious what the SEC, IRS and other entities have done to use technology to flag such malfeasance faster for investigation. While I have no doubt that there are many ways for such companies to “cook the books” on an ongoing basis, one diligent person was able to do so in the case of Enron. I’d enjoy your perspective on the matter of technology being used to do such on a comprehensive scale.
Don’t buy the naive view on Enron and Arthur Anderson as presented by Grossman. Many diligent people could see that all was not well with Enron as an investment. The non-diligent investing on faith lost their money. Go figure. He’s just repeating a conventional wisdom that is deeply flawed. See my earlier comments. Better yet, read a more full account in the book “Three Felonies a Day.”
Adam, I very much agree (and have seen) that the market can seem irrational and can remain that way for long periods of time. Also, irrationality is certainly in the eye of the beholder. As you point out, this is a good reminder of why the SPY or better yet the total market index fund approach has been so successful since inception. No one knows whether growth will continue to outperform value for 10 more years or 10 more days. The same goes for large cap vs small cap stocks and for one market sector vs another.