Does price reflect value?

The answer depends on who you ask. Warren Buffett, one of the most successful investors in history, argues "no". Professor Eugene Fama, a distinguished finance academic, claims "yes".

Warren Buffett

Warren Buffet is a strong believer of value investing. Value investing is all about investing in stocks that are trading well below their intrinsic values. One of Buffett's most famous quotes goes like this: "Price is what you pay, value is what you get." However, the notion of value investing is at odds with the concept of market efficiency, which is pioneered by Eugene Fama. In an efficient market, prices should reflect intrinsic values of assets. There is no room for value investing in an efficient market. In other words, strictly speaking, Buffett and Fama can't be both right.

So, what has Warren Buffett actually said about market efficiency? During an interview with Fortune, he was quoted as saying: "I'd be a bum on the street with a tin cup if the markets were always efficient." The quote seems to suggest that Buffett believes there are windows of opportunity during which markets are inefficient.

The chairman's letter Buffett wrote in 1988 to the shareholders of Berkshire Hathaway Inc. is also insightful. He devotes a section of this letter to his views on the Efficient Market Theory (EMT). Buffett comments:

"Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.  From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT."

Although this comment seems to cement the view that Buffett is in disbelief of market efficiency, one has to be careful before drawing a definite conclusion, because the very next paragraph goes like this:

"All this said, a warning is appropriate.  Arbitrage has looked easy recently.  But this is not a form of investing that guarantees profits of 20% a year or, for that matter, profits of any kind.  As noted, the market is reasonably efficient much of the time: For every arbitrage opportunity we seized in that 63-year period, many more were foregone because they seemed properly-priced."

Professor Eugene Fama

Buffett is actually agreeing that markets are efficient much of the time. He is simply saying that they are not always efficient; arbitrage opportunities can be found if you search enough for them.

How about Eugene Fama's thoughts about outstanding investors such as Warren Buffett? Is he willing to concede that investors like Buffett are evidence against market efficiency, or does he argue that such investors  can have a place in efficient markets?

Here is what he once said in an interview about legendary investors:

"I might be willing to say that the people who get pointed at consistently, who have shown consistent performance even after they have been pointed at, really do have something."

But, Fama adds:

"These are always the same people, Warren Buffet, Peter Lynch, and then who?"

What Fama is willing to accept is that the superior investment performances of Buffett and Lynch are not purely down to luck. These guys are truly extraordinary investors. But, there are not many others who are in the same league with them. In other words, if only a couple of investors (out of millions) can beat the market, this is probably good news for EMT rather than bad!

Buffett and Fama represent different schools of thoughts. On one hand, Buffett believes an investor can find undervalued stocks if he or she looks hard enough. On the other hand, Fama argues the prices of stocks reflect their fair values. But, neither of these successful individuals is dismissing the other's views on markets entirely. Buffett recognises that markets are efficient much of the time; and Fama admits that there is something beyond luck behind Buffett's extraordinary success in his investments.

Bibliography
Buffett, Warren, 1989, Chairman's letter

Pare, Terence P., 1995, Yes, you can beat the market, Fortune 131 (6), 68-79
Tanous, Peter J., 1997, Investment gurus: a road map to wealth from the world's best money managers

Related articles: 

Market efficiency
How does arbitrage work?
Did Bill Miller beat the market?

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