Disproving the Efficient Market Hypothesis: Starting with Tickers that Begin with "A"
John is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Efficient Market Hypothesis (EMH) goes something like this: no one can consistently achieve returns that exceed average market returns, because all relevant information is seamlessly integrated into the price of any given stock, at any given moment. It’s clear (claims the EMH) that Warren Buffett is a multibillionaire solely because he’s been wildly lucky for decades on end. In American economist Robert Shiller’s 2005 book, Irrational Exuberance, Shiller examines P/E ratios as a predictor of future performance and finds a correlation between low P/E ratios and higher returns. This sort of predictability would be impossible in a truly efficient market.
If this fact alone is not convincing enough, consider the very concept of a “stock market bubble.” Let me ask you: do you think it’s possible for 30 of the largest institutions in the world to actually have been worth 22% less on the afternoon of October 19th, 1987 than they were in the morning? Because that’s what the stock market thought. Keep in mind, it’s not like these companies all disclosed shocking, materially-relevant information to investors that day, and though the fall clearly involved more global and macroeconomic concerns, the fact that there was no single, undeniable cause of the dramatic drop is revealing. It reveals the obvious: the power that emotion—in this case, the emotion of fear—plays in investing and trading. Emotions do not mix well with rationality.
All investors who believe they can beat the market or spot an undervalued stock believe in market inefficiency. Sites like the Motley Fool would not exist if at some level this implicit assumption was not made. So without further ado, allow me to identify some of the opportunities that current market inefficiencies have created. Companies that begin with the letter “A” seem like a good place to start:
- Amazon.com (NASDAQ: AMZN) is grossly overvalued. I see this as one of the most glaringly mispriced securities in the stock market universe, even after its rapid, 26% decline from its 52 week high in October. The fact that there are forty analysts (yes, that’s the number 4, followed by the number 0, with no decimal in between) covering the stock with an average rating of “overweight” and average target price of $235.60, is nothing short of obscene. Did I mention that the projected EPS for next year is barely expected to break the $2.00 mark? To the one brave analyst bold enough to have a “sell” rating on the stock, I salute you. The case for AMZN’s overvaluation can be made solely upon inspecting its absurd P/E valuation (nearly 100 times earnings), which would perhaps be defendable if its forward P/E on 2012 earnings estimates wasn’t somewhere around 90. Great-looking company. Horrible-looking investment.
- Large-cap dividend and value stocks are widely neglected, apparently because everyone and their mother bought Amazon. One victim of this neglect, Abbott Laboratories (NYSE: ABT), is a broadly-diversified healthcare company with a 3.5% dividend and exposure to emerging markets. ABT is an example of a company with financial security (it hiked its dividend 9% in February), solid growth, and increasing synergies from acquisitions. The company boasts a 5-year EPS growth rate close to 17%, and during that time its dividend growth rate has held at nearly 10%. Its acquisition of Indian pharmaceutical company Piramal in September 2010 signified its entry into emerging markets. Along with its acquisition of Solvay’s pharmaceutical unit February of the same year, management has made it clear that aggressive cost-cutting—from the elimination of duplicate divisions and a proposed 2% decrease in the sales force—will be strong contributors to bottom-line earnings growth. With an aging baby-boomer population looking to boost business for healthcare companies in the coming years, Abbott Labs looks like a steal. If analyst estimates for the 4th quarter this year are anything close to being accurate, Abbott is trading at less than 12 times this year’s projected earnings. Abbot’s P/E for the trailing twelve months is 18.
- Apple (NASDAQ: AAPL) is the Rodney Dangerfield of the stock market. It’s a household name but it gets no respect. In the same vein that I see Amazon as an unforgivably-mispriced stock that dozens of analysts are misled about, AAPL is also misunderstood by Mr. Market. It’s nothing short of astounding that as the 2nd largest company by market-cap in the world, Apple A) has been able to grow revenues and earnings at a mind-numbing clip (1-year rates of 66% and 85%, respectively), while commanding the whopping P/E multiple of 13.8. In fact, with 100% YoY Free Cash Flow (FCF) growth, from $16.6 billion to $33.3 billion, I can’t find a meaningful ratio that doesn’t just blow me away. Perhaps sentiment is tempered because in 2010 it only grew FCF at an 84% clip, or because its 2010 EPS growth rate was pathetic at 67%, while that number was 82% in 2011. Oh, wait...I’m sorry. Those unheard-of growth rates have actually been accelerating. Now, I understand that Apple has lost its visionary, and that you simply cannot replace someone like Steve Jobs, and that tastes in technology can change at the drop of a hat. But with global PC market share growth that recently outpaced the growth of the overall PC market for the 22nd straight quarter, Apple still only controls 5.3% of the global market. In other words, nothing about this stock justifies a multiple in the low teens.
Fool blogger John Divine owns shares of AAPL common stock and January 2013 in-the-money call options in ABT.