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Fool On The Hill

Wednesday, November 25, 1998

An Investment Opinion
by Louis Corrigan

Thanks for Inefficient Markets

'Tis the season to take stock of all that we are thankful for. Family, friends, good health and gainful employment probably top your lists. It's my sincere wish that they do. Yet as investors, we also must make room for some special thanksgivings.

For starters, we should probably thank Federal Reserve Chairman Alan Greenspan for having the good sense to know how to manage financial markets so that the bleak days of early fall now seem like a mere bad dream from which we have been pleasantly awakened. We all tried hard not to lose our heads when professional investors were throwing themselves on the guillotines and the media was encouraging us to do the same, but it's nice to have our Dr. G in the house in times of panic. It's easier on the collar.

As we gather around a financial column posted to a vibrant online community with hundreds of thousands of participants, we must also thank the various wizards who have conjured the Internet into existence, the Brothers Gardner who have fostered its use in the name of financial freedom, and perhaps most of all, each other.

Make no mistake, all of us revolutionary do-it-yourselfers who are teaching each other the stuff we never learned in school are like pilgrims settling in a new world that's still as ripe with promise as America's supposedly virgin land was 378 years ago. As Fools, we even have our own funny hats. The truth is that we individual investors have simply never before had access to such astonishing resources for managing our own money. And one of our best resources is each other. As you send greetings to those who have not yet made the perilous journey to our new world, note that the threats of sea monsters and unfriendly natives so often sensationalized in the press are unimportant compared to the community that awaits them.

Thank yourself for having the smarts and the gumption to turn away from the multimillion dollar ad campaigns designed to convince you that financial ignorance is bliss and that the ability to underperform the S&P 500 index fund is a marketable skill for which you should pay top dollar. Congratulate yourself for venturing into the land of Emersonian self-reliance where you have the opportunity and the power to shape your own destiny and remake the world according to your most Divine sense of justice.

When I survey everything for which I'm thankful, though, I find I must return to what I wrote in this space a year ago. As an investor, I'm most thankful for market inefficiency and for every instance that reminds me that at every hour of every day there's an opportunity available to the patient and sensible investor willing and able to seek it out.

The academic research tells us that markets are efficient, that stock prices always rapidly adjust to the latest incremental piece of news that could affect a company's business. The assumption is that stock prices are set on the margin by the most knowledgeable investors so that the current price is always the fair price. The logical conclusion is that one cannot beat the market by picking individual stocks because one is never in a position to know what other investors do not. So the best plan is to aim to match the market by buying into an index fund. Clearly, that's not a bad plan when faced with mutual fund managers who do their best to prove the theory accurate.

But in the real world, markets are often inefficient, highly so when it comes to smaller, less followed companies. That's because fund managers get graded on their quarterly and annual performance numbers rather than on their long-term results. So they're more prone to suffer from shifts of psychology (and fears of redemptions) than is the average individual investing for the long term. That's one reason why a giant blue chip technology stock like Cisco (Nasdaq: CSCO) can be valued at $68 on July 20, $44 on October 7, and then at $77 1/16 today. There's nothing efficient about that.

On the other end of the spectrum are day-trading types who to some degree could care less what a business is actually worth. They work from the "greater fool" (small f) theory, buying stocks with little care for the price as long as they think they can sell them at a higher price to someone else, possibly later the same day. Many of the Internet stocks work as such simple trading vehicles. There's no way anyone can offer you a reasonable argument to justify their valuations because reasonable arguments don't figure into the decision-making process of the buyers.

That's why I'm thankful today for Books-A-Million (Nasdaq: BAMM), the nation's third largest store-based bookseller with 172 bookstores in 17 states. The stock traded around $3, near its all-time low, for most of the last few months due to deteriorating year-over-year results. Today it soared $8 9/16 (196%) to $12 15/16 after trading as high as $16 1/4.

The big news? The retailer has beefed up its website (! It hopes to expand its customer base by offering members of its Millionaire's Club super discounts of up to 46% off bestsellers, 37% off all other in-stock hardcovers, and 28% off all in-stock paperbacks. Books-A-Million was surely wildly undervalued when it dipped to just 0.38 times book value earlier this fall. Now at 2.2 times book value, the price seems off-the-map excessive.

But there's nothing that unusual about this. What we've seen over and over again during the last three months is that markets are never as efficient as the academics think. In fact, they're sometimes insanely inefficient. For individual investors willing to do their own research and exercise their own judgment, that's definitely something to be thankful for because it means there's always a new opportunity. Thank goodness.

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