Friday, May 28, 2004

Efficient Market Theory and Corporate Governance

Golbitz and I have debated privately about the efficient market hypothesis -- that stocks at any given time are mostly fairly priced, given the amount of information available, and that, as an investor, it's practically impossible to exploit gaps or dislocations between price and intrinsic value. Golbitz usually takes a harder line in favor of efficient market theory than I do.

I came across an article on about a conference that took place in New York a few weeks ago in honor of Benjamin Graham, the father of securities analysis and Warren Buffett's teacher at Columbia Business School. Many big "value investors" were there. I found a description of one of the talks about corporate governance interesting because it intimated that the efficient market hypothesis can make one lazy about corporate governance. If you're just tracking the market, you're less likely to care about this or that management's actions; they just don't mean that much to you. Also, if you're not quite an index investor, but extremely diversified, you can just "vote with your feet" by getting out of the stock. One position in your portfolio doesn't mean that much to you. Pressuring the management is just too much trouble.

Now it's true that Jack Bogle, founder of Vanguard and staunch defender of indexing, has been rather outspoken about corporate governance. But he's not one for taking a big position in a company and trying to rattle management. We shouldn't confuse Jack Bogle with, say, Michael Price. And Bogle has ultimately been more interested in corporate behavior in his own industry -- mutual funds -- than in other industries.

Academic theories can be right or wrong (or somewhere in between), but they almost always have behavioral or "political" (if you will) consequences. One wonders whether the stranglehold that efficient market theory has at business schools these days -- including Columbia, where the young Warren Buffett once attended Graham's riveting seminars -- has been beneficial for corporate governance. One wonders whether it has simply made investors -- especially profesional investors with top-tier MBAs like pension and mutual fund managers -- lazy. Moreover, if shareholders resisted theories that prevented them from taking their responsibilities seriously, if they thought more like owners (which is what they are), then there might not be as much of an incentive to call in the government to clean up and regulate corporate accounting, exectuve pay, etc....

Investors and owners need to recover a certain selfishness that has been drained out of them by efficient market theory. It may be that business has problems not because of selfishness, but because investors and owners, rendered prostrate and enervated by fancy academic theories, aren't selfish enough.

One last word about Graham and the possibilities of exploiting differences between price and "intrinsic value": I have only glanced at Graham's tome, Security Analysis, but I am impressed by how modest he is about the possibilities of exploiting dislocations between price and value. One would gather from reading the proponents of efficient market theory, including Burton Malkiel, that Graham argued that it was easy to value companies. Quite the opposite is true. One is struck by how difficult Graham says it is to find instances of dislocation between price and value and even to value securities simply.

It may be that the market is hard to beat not because it is efficient and easy to value stocks but because it is difficult to value stocks. And we haven't even mentioned all-too-human investor psychology represented by Graham's fictional manic-depressive "Mr. Market."


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