There is a great deal of academic research around what is known as the Efficient Market Hypothesis. The original research was done by US academic Eugene Fama of the University of Chicago back in the 1960s. His hypothesis is straightforward enough - that it is not possible to consistently outperform markets - adjusted for risk - by acting on the information that the market already knows except for luck or inside information. The logical extension of the efficient market theory is that because the share market is efficient it is almost impossible to outperform the market rate of return over time. Recent events on the Australian sharemarket paradoxically may appear to the ordinary investor to both support and challenge the notion of an efficient market. Cast your mind back to the day the prospect of a private equity bid buyout of Coles Myer hit the news - the company's share price reacted dramatically just as it did when the Coles Myer management subsequently rejected the overtures. The pricing mechanism was certainly efficient at factoring the new information into the company's price. Then we have had the Telstra T3 float followed by the extraordinary takeover speculation sparked by the changes to media ownership laws. With Telstra the market sentiment and discussion about the company moved from almost war-zone coverage of the arguments between Telstra management, board and federal government coupled with a languishing share price and a seemingly endless list of issues that threatened the long-term profits of Australia's largest telco. This week we have been reading articles about how much demand there is for T3 stock - suddenly it seems the market has been undervaluing Telstra all along. The rollout of a new generation wireless network obviously helps but the question has to be asked: has a massive enterprise the size of Telstra suddenly been transformed or rather is it a case of a super sales effort from the investment bankers and brokers and a cleverly packaged offer based on its dividend yield? The media ownership changes tell us something different about how efficient markets can be. Clearly this represents structural change within the media industry at a time when new technology is already forcing major media companies to rethink their business models. The pre-emptive moves by Jamie Packer's PBL to restructure its operation to position itself for those changes was received, analysed and very quickly factored into the share price - just as the prices of other media companies like Fairfax and West Australian Newspapers were adjusted accordingly.
Fairfax is a great case in point. Its share price has risen 22% since early August. Has its business changed? Has anything fundamentally happened to improve its cashflow or earnings as a business? No. This could lead you to conclude that the market pricing mechanism is indeed efficient at pricing in new information - even if it is simply speculative. Investors need to be cautious at times like these because just as the market efficiently prices in the speculative appeal of potential takeovers, mergers or company breakups it is ruthless in discounting prices once the dust has settled and the various players have returned to their corners to get on with running their businesses. The madness of crowds - remember tech stocks in 2000 - can be highly destructive of personal wealth if you are caught on the wrong side of the market's pricing efficiency. It is perhaps a good time to remember there is a fundamental difference between investing and speculating and having a written financial plan is a great tool to separate the two. Another of the great thinkers on investment and company analysis - Benjamin Graham the author of The Intelligent Investor and one of Warren Buffet's inspirations perhaps described the market's pricing ability best of all. He said: In the short run the stockmarket is a voting machine; in the long-run it is a weighing machine." At times of great market excitement it helps to understand which category your investment decision falls into and that pricing efficiency does not always equal value. Smart Investing
By Robin Bowerman
8 September 2006
Principal & Head of Retail, Vanguard Investments Australia
www.vanguard.com.au
23rd-November-2006 | 
