Watch stocks you care about
The single, easiest way to keep track of all the stocks that matter...
Your own personalized stock watchlist!
It's a 100% FREE Motley Fool service...
Eugene Fama's shared economics Nobel Prize last week surprised no one except, oh, the few who know the reality of his life's work. The Nobel Committee cited what we know as his and Kenneth French's "efficient-market hypothesis" in rewarding Fama one-third of the prize pie. Efficient-market theory, or EMT, is used everywhere today, but Fama and French's own research later made it all but moot. The real contribution is the "Fama and French three-factor model." Thanks to Stockholm, Fama will be remembered for EMT forever, and the three-factor model will rarely be cited. Such is life -- but investors can do better by Fama.
Fama, a University of Chicago Booth Business School professor, became the father of EMT beginning with his 1965 paper Random Walks Down Wall Street. It fell to another famed economist, Burton Malkiel, to use the title for his megaseller, A Random Walk Down Wall Street, and spread the word (and reap megaroyalties). EMT states that past stock prices don't predict future movements, because stock prices quickly reflect all publicly available information. Thus markets are "efficient," according to this theory, so investors might as well throw darts -- they can't beat the market.
That was certainly the shot heard 'round the world, though it was a slow-moving bullet. Over time, the finance industry created index funds in respect of, and to profit from, Fama's findings. Most notorious was the poster child S&P index fund. Once that fund came along, nothing else would do. The S&P 500 has become the be-all and end-all of investing benchmarks. Index investing through the S&P 500 can be a good idea, but it has become something people take on faith, rather than questioning.
Another group, the "modern portfolio theory" adherents, simply incorporated index funds selling MPT's asset allocation to investor portfolios. If the practical import was to protect individual nonprofessional investors from the world by keeping a hand on their checkbooks, the financial world did just fine. Let 1,000 index funds blossom! Their low costs? Just add a fee to them so you can make your nut putting your clients in Vanguard funds with 0.20% expense ratios, give or take. Worse, the exalted talisman of the S&P 500 index fund is a flawed idea to start (see "Kill the S&P 500").
The three-factor model
Many Nobel economics winners made their reputations on the work that won them the prize. They are understandably unwilling to give up the academic cred that came with their work, and they fight anything that dings their reputations. But Fama and French actually had the curiosity and open-mindedness to mine more data and accept new conclusions. Twenty-seven years after the 1965 paper, they began publishing the results of work on expected stock returns. A result was their three-factor model.
They found a first factor: that small-cap stocks and those with a high book-to-market ratio (now expressed more simply as a low price-to-book-value ratio) tend to outperform the market as a whole. Then, the authors produced two more factors -- woe to the math-impaired -- to adjust for the higher risk premium of lower price-to-book-value small caps. The result was a strong case that 90% of diversified portfolio returns were due to small-cap value stocks, compared with the then-popular capital asset pricing model's 70%.
Tell us something we didn't already know
Fama and French's new model took a different path, but it was the academy's acknowledgement of what Buffett and his teacher, Benjamin Graham, had known and practiced since the 1940s and '30s, respectively: Mr. Market is emotional and inefficient. Past performance can predict future results when you buy what has been discarded by emotional investors, is cheap, and offers a margin of safety. Conversely, you can lose money buying what they find popular. Readers of Buffett's 1984 Columbia Business School presentation, The Superinvestors of Graham and Doddsville, already knew these points -- but, hey, academics sniff until the soup has proven ingredients.
Most investors can't analyze stocks for low price to book, but they don't have to. They can choose small-cap value mutual funds -- some mutual funds actually outperform, you know, including quiet, non-self-promotional Dimensional Fund Advisors (DFA) and many others. The greatest irony for the University of Chicago EMT adherents, and the Nobel committee, is that Fama helped found, and continues to advise, DFA.
Index investing still rules, unfortunately
Eugene Fama harmed no indexes in the creation of EMT, but the worship of index investing obscured his greater contribution of thrusting the knife deep into the theory behind it. This kept investors from the truth: Markets are inefficient, stock prices often do not contain all available information, and small-cap value accounts the returns of a diversified portfolio 90% of the time. Perhaps things will change. Even Malkiel, in his book's 2003 revised edition, allowed, "Don't ignore small cap companies: smaller firms tend to have higher rates of return." Throwing a bone is better than nothing in a book that, year after year, remains an investing best seller, confusing investor after investor that EMT is still the only rule.
Meanwhile, Davids fight Goliath. The unjustly obscure but superior What Works in Investing, by investment firm Tweedy Browne, also buries EMT in contrary data -- there's no false advertising in its tag line, "Studies of Investment Characteristics Associated with Exceptional Returns." It's an exhaustive study that shows small-cap value investing to provide the best returns over time. And Harvard Business Review editor Justin Fox's masterful and novel-like The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street brings the research and history to us, and it deserves a wider audience than Malkiel's work, which is now less helpful than it once was
But then, what sells is rarely what's best for people. If investors read Fox, they will outfox EMT.
The real winners are...
Thank you, Fama and French, for work that went part of the way to proving what an intrepid few already knew. Thank you, Justin Fox, for a gripping book that takes the reader through the evolution, like a great detective novel. Perhaps Fama's Nobel Prize will lead a merry few to go beneath the surface of Fama to learn about, and profit from, small-cap value.
The stock Buffett wishes he could buy
Take the small-cap value proof to your portfolio. It's often assumed that small investors are at a great disadvantage relative to hedge fund managers and other institutional investors. But that's not always true. Bound by multibillion-dollar portfolios and strict bylaws that govern what they can and can't invest in, these giants are often prohibited from tapping the market's greatest stocks until it's too late -- that is, after the stocks have already shot into large-cap status. In this free report, our analysts identify one such stock that Warren Buffett himself wishes he could buy but is effectively restricted from doing so because of its size. To discover the identity of this stock instantly (and for free!), simply click here now.