Sunday, January 4, 2009

Efficient Market Or Fearful Market?

The Efficient Market Hypothesis (EMH) asserts that stock prices appropriately incorporate relevant information. As such, it isn't possible to generate market beating returns because the current price reflects available information. While it's not possible to completely disprove this theory (EMH theorists attribute the success of Warren Buffett and other value investors we've looked at here to random chance), there are examples which make this very difficult to believe. Consider CVS Caremark (CVS), a provider of pharmaceutical services.

Despite economic hardships, most people will not go without their required medication. As such, one would expect this business to be stable even at the worst of times. A look at the operating margins for CVS over the last business cycle reveals this line of thought to be correct:

We can see from the chart above that CVS has maintained margins through downturns, as one would expect considering its industry. The stock price, however, tells a different tale. The stock has dropped 30% in just the last few months, despite very little change in the earnings or earnings outlook for this business.

If the market was right when the price was $43 then how can it be correct now at $27, when little has changed. Examples like this certainly offer doubt as to whether the market always appropriately values stocks. While this doesn't neccessarily mean CVS is undervalued now (as perhaps it was just overvalued before), it does suggest there are profit opportunities for those who are able to take advantage of Mr. Market's mood swings.

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