December 2006

Science Trumps Fad

by: Stephen Lowrie

Over the last couple of years I have talked about a new model of investing. A model that is not based on speculation, but on the science of capital markets. The science is based on decades of research. Research done in the academic community, where there are no hidden biases or products to sell.

One of the core philosophies of this model is that capital markets are efficient. While this sounds straightforward, what exactly does that mean and more importantly what implications does it have for investors?

In a recent article I wrote about Modern Portfolio Theory (PB Financial Newsletter – Summer 2006) I described efficient markets as follows:

Efficient markets is a theory based on the idea that stocks are always correctly priced since everything that is publicly known about the stock is reflected in its current market price. Some people mistakenly extrapolate this theory to suggest that every stock is perfectly priced at all times. This is obviously not the case.

A more believable premise is a toned down view that the markets are in equilibrium. This equilibrium view suggests that while inefficiencies do exist, they are virtually impossible to profit from on a regular or long term systematic basis.

Most studies support this equilibrium view. In fact, advancing information technology and increased sophistication on the part of investors are causing the markets to become even more efficient.

Let’s look at this in a practical sense. Suppose you had read an article about the tremendous opportunities in the Alberta Tar Sands. I am sure you have heard all of this before, the tar sands contain more oil than Saudi Arabia, China’s insatiable appetite for oil, increasing demand from other countries in the developing world, total supply has peaked or is about to peak (peak oil theory) etc. With current oil prices at $70, how could you possibly lose?

So, you decide to invest by buying shares in two companies that are pure plays in the Alberta tar sands, Suncor and Canadian Oil Sands trust. Seems reasonable enough. Or does it?

Let’s turn this around. Who would you buy these shares from? You don’t buy shares from the company; you buy shares on the stock market from another investor. Wouldn’t that seller know the same information as you? Wouldn’t they know about the oil reserves of the tar sands, the demand from China, peak oil theory, Hubbert’s curve etc. etc. If so why would they ever want to sell their shares? Maybe, all of this future potential is already built into the current stock price and that is why this other investor is selling.

If the information is publicly known, then you have to assume it is already built into stock prices.

So, what does this all mean? Investors would be much better served to assume that markets are efficient or at least in equilibrium. In other words, it is highly improbable that anyone (individual investors or professional managers alike) would be able to consistently out-perform the collective wisdom of everyone else.

As an investor, you either:
1) Believe markets are efficient or you don’t.
2) Believe that you (or a professional money manager) can pick superior stocks or you don’t.
3) Believe that you (or a professional money manager) can time markets or you don’t.

Remember that there is ample academic research to suggest that these active strategies are not effective and nothing more than a waste of time and money. Once again, investors would be much better served assuming that markets are efficient.

So, the next time you hear about some sort of investment opportunity, whether it be the economic potential of China, India, Brazil or Russia; the opportunities in commodities such as oil and gas stocks, gold stocks or base metal stocks; large cap stocks or small cap stocks; concept stocks such as alternative energy or biotechnology; Royal Bank, BCE or Moose Pasture Mines; as an investor, you have to ask yourself whether the future potential is already built into the current stock price. Investors will receive a much better investment experience assuming it is!

In conclusion, remember that investors serve a purpose. That is to provide capital and participate in the productive effort of every member of a thriving global economy. Capital markets throughout the world have an incredible history of rewarding investors for the capital they supply.

Capital markets work. Capital markets build wealth. Rather than trying to outguess the market, simply buy the market and let market efficiency work to your advantage!