Monday, April 20, 2009

Best Buy And The Efficient Market

In an "efficient market", all stocks are fairly priced by the market. If the US stock markets are efficient, and many finance industry professionals believe this to be the case, one cannot generate index-beating returns except through luck. However, if we were in an efficient market, it seems hard to believe that stock prices for even the most stable of companies should fluctuate so drastically from year to year and even from week to week. Yet that is exactly what happens. 

Consider Best Buy (BBY), a US-based multi-national electronics retailer. It has generated consistent returns year after year, and has a low debt to equity ratio resulting in minimal financial risk. Yet it's stock price has fluctuated dramatically, offering astute investors the opportunity to achieve enormous returns.

Below is a chart depicting Best Buy's annual return on invested capital (ROIC) contrasted with its stock price:

While ROIC has been predictable and consistently range bound for the last several years, the stock price has been anything but. It seems hard to believe that the market is efficiently pricing this security when its price can fluctuate wildly in relatively short periods of time while the company itself generates predictable earnings on capital. For example, if the company is worth X amount in early 2000, how does it become worth just one quarter of this amount 3 months later, and then three times this amount six months after that?

More recently, three months ago the market valued Best Buy at $7 billion, but now values it at $16 billion! Investors who recognized the mispricing have seen returns of over 100% in a 3 month period!

We've also seen other examples of this phenomenon: we've looked at graphs illustrating wild fluctuations in the historical P/E ratios of Coke and Walgreen, for example, which have allowed value investors to buy in at tremendous discounts.

Value investors willing to put psychological bias aside and instead invest at the height of the market's fear can indeed achieve above average returns.

Disclosure: Author owns a long position in shares of BBY

1 comment:

PlanMaestro said...

Very good post Barel. BobShiller made his name with a paper making the same point: how can a market be called efficient when it fluctuates an order of magnitude more than earnings.

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