Value Investing in the context of the Efficient Market Hypothesis

1. Value Investing in the context of the Efficient Market Hypothesis What is the relationship and how to optimize returns? By Nawar Alsaadi

2. How can they be reconciled? • As value investors we are naturally skeptical of EMH. • Without EMH we can not realize the value inherit in a value investment. So how to reconcile them? • EMH is ultimately true long term, but is flawed short term • “In the short run, the market is a voting machine but in the long run it is a weighing machine.” Benjamin Graham

3. Why is the EMH flawed in the short term? • EMH is based on the premise that a security price is reflective of all available information at any moment in time, and thus miss pricing can not occur. • The performance of successful value investors indicate the contrary. (Warren Buffett, Seth Klarman, Martin J. Whitman) • What is behind such flaws?

4. Three Underlying flaw drivers • Not all investors reach the same conclusion based on the same information at the same time. • Not all investors are in a position to act on a given piece of information. • Not all information is disseminated at the same speed to all investors, and most importantly not all information reaches the investors who can and want to act at the same time. (especially for information dealing with small cap stocks and less widely followed securities)

5. Company X just released positive financial information. Information Processing: • Investor A: believes that information enhances the value of the company. • Investor B: is undecided, maybe waiting for more evidence. • Investor C: is not yet aware of the information. • Investor D: believes the information is negative to the future of the company. Acting: • Investor A: would like to act, but he has no funds to do so. • Investor B: can act but is not yet willing to do so. • Investor C: is able to act but he is not aware of the information. • Investor D: has acted on the information.

6. Are company X shares correctly priced? The actions of A, B , C and D are repeated thousands of times, thus creating a market, but not necessarily an efficient market. An efficient market is when: • Investor A and D act. • Investor B takes a decision. • Investor C receives the information and acts. At some point this would happen, however as new information is released this cycle will re-start, and will lead us to :

7. Cyclical Efficient Market Hypothesis Is the point where the intrinsic value of a security converges temporarily with the security’s market price.

8. Cyclical EMH in Action • Consider at which point in the cycle you are buying?. • Constantly analyze the movement of the intrinsic value and the market price

9. Real Example • Between September 2004 and December 2009 the divergence in Pine tree stock (TSX: PNP) ranged from a 53% discount on the low end to 241% premium, keeping track of the relation between net asset value and price is essential in choosing an entry point and an exit point out of the stock.

10. Conclusion Optimum Value investing can be simplified to: • Buying at the biggest divergence point (discount) between the company’s intrinsic value and the company’s market value, and selling at the point of convergence (CEMH) or overpricing of the company, depending on the investor strategy of either buying long term and riding the cycles, or exploiting temporary price inefficiencies.