The amazing success of investors like Mr. Buffet is the primary ammunition for those attaching the efficient market hypothesis. My belief is that these unicorns of the investment world manage to beat the market for two reasons: 1. The EMH is only partially true. 2. Unicorns pick their game in ways that retail investors cannot. The EMH and its associated random walks do not tell the whole story. There is a simple, rational, linear relationship between economic growth and the growth of various markets, but that elegant regression line is hidden beneath vast amounts of noise. That noise is dictated by a very complex and multivariate human psychology.
To complicate matters further, the contribution of each part to the whole of stock price movements is a function of time. My thesis is that as conditions change such that when investors are either more optimistic or more pessimistic than usual, the beta weight of the irrational component increases while the beta for the rational component decreases. This high degree of noise suggests that prices will regress to the long-term regression line, but it may take decades to do so. The takeaway for retail investors is to design a portfolio that is calculated to produce maximal returns for a given level of risk, reallocate yearly to keep the target balance and ignore the vicissitudes of daily price action. Markets will move up, but we can’t fight the randomness that hides that truth.
One secret of the Titans, then, is that they have tools that we do not to make investment decisions at a blistering speed that lets them capitalize to some small degree on the momentum of price movements of they invest for periods that the normal person cannot risk. Most sane retail investors will start to de-risk their portfolio as retirement approaches, but investors like Mr. Buffett have no such limitations. When Mr. Buffett moves on and hands the reigns of Berkshire over to a new breed of investor, the capital will carry on.
The EMH says that trying to beat the house is impossible. It is for those of us that play bout the house rules. As long as we are playing roulette, the house has a 5% edge, and we will always lose over time. What we often find is that when the titans of trade sit down to play, they are counting cards. Of course, they aren’t literally playing blackjack. The idea of “counting cards” is an analogy for purposely investing in inefficient markets. If we want to invest in real estate, we usually will buy REIT shares on the open market. Those markets are brutally efficient, and luck and time are our only friends. When you can write checks in the multi-million dollar range (or even into the billions), you can largely dictate the terms of the trade.
Arbitrage opportunities are very hard to find within efficient markets, and they are quickly closed once word gets out. Direct business dealings work differently; REIT shares may be efficiently priced, but buying 100,000 acres of standing timber from a distressed paper company that is on the verge of bankruptcy is decidedly not being priced in an efficient market. Venture capitalists can largely set their own terms. You may get a P/E in the teens from a Wall Street IPO, but if you are trying to get a million dollar direct investment from Kevin O’Leary, you had better reign in your expectations. There are some factors that the Titans do frequently take advantage of that we will discuss in the final chapter. They mostly revolve around assuming additional risks beyond what others think of as “the market,” and using the only free lunch on Wall Street to keep the harm caused by that risk to a minimum: Diversification.