Why It Is Possible to Make Above Average Returns – Even in Efficient Markets

There is a well-known hypothesis in financial economics, called the Efficient Market Hypothesis (EMH), that spawns a lot of debate. The EMH states that financial markets are ‘informationally efficient’. In other words: a financial asset’s market price always incorporates and reflects all available relevant information. Hence no investor can consistently use such information to find stocks that earn him above average returns. After all: such information is already reflected in the asset’s price; so if there is a lot of ‘positive’ information about the company, the stock’s market price will have increased, and if there’s a lot of ‘negative’ information, the price will have decreased.

I want to make an argument why, even if the EMH holds, it might still be possible to consistently earn above average returns on investments. The argument is basically very simple. Let’s first recall the EMH. We know that an efficient market is a market in which the price of a financial asset (let’s say a stock) always incorporates and reflects all available information. Hence, you cannot benefit from the set of available information in such a way that you can consistently earn above average returns on investing in the asset – or any asset for that matter. But does it follow from this that you cannot consistently achieve above average returns? I don’t think so.

Because what if you are consistently better than other investors in anticipating future information? Then, even though the stock’s market price reflects all available information, you can utilize this anticipated future information to decide whether to buy or sell a stock. And if you can anticipate future information (which is information not yet incorporated and reflected in the stock’s price) better than the average investor, then you can earn above average returns, time after time.

This all sounds pretty abstract. So let’s look an example. Suppose there is a stock of a company that produces wind turbines – call it ‘stock A’. Furthermore, let’s suppose that at this point in time investors are on average not confident about wind energy’s potential. They might think that the cost of producing wind energy is too high, its profits depend solely on the current regulation, or that it will still take a long time before our fossil fuels are depleted, making the switch to wind energy not urgent yet. Given these considerations the stock trades at a price of – let’s say – 10. Let’s assume that this price indeed incorporates and reflects all available information – such as information contained in annual reports, expert analyses etc. Hence it seems reasonable to say that you cannot consistently earn above average returns on this stock by utilizing only this pool of existing information.

But what if you believe that, given the ever increasing energy consumption and ever decreasing level of fossil fuels, society has in the middle-long term no choice but to turn to alternative forms of energy – forms such as wind energy? If you think this is true, then you can anticipate that any future information about the wind-turbine producer will be positive – at least more positive than today’s information is. You can anticipate that the future information will show an increase in the firm’s revenues, or – for example, in case the firm is close to bankruptcy but you know that its managers don’t profit from a bankruptcy – a decrease in costs. Given that the market is efficient, you know that at the time this information will become public, the market price of the stock will increase to reflect this information, to a price of let’s say 20. If you can anticipate such future information consistently, then you can anticipate the future stock price consistently, allowing you to consistently earn above average returns – despite the perfectly efficient market.

An equivalent way to look at this matter is to say that you take into account more information than the average investor in calculating the stock’s fair value. Let’s say that you are doing a net present value calculation, and you have estimated the firm’s future cash flows. In case of stock A, investors used estimated cash flows that lead them to a fair value of 10. However, given your anticipation of future information, you estimate these cash flows to be higher – leading you to a higher valuation of the stock. Again: if you can consistently anticipate future information better than the average investor, you can consistently earn above average returns – even in an efficient market.

Commercials: Not All Publicity is Good Publicity

Commercials: you’re likely to absorb hundreds of them per day, via media such as the TV, radio and internet. As I have written about in a previous article, the average person spends 1/24 of his life watching commercials on television. That’s a quite a lot, isn’t it? But I don’t want to focus on this act of wasting our lives by consuming useless material. I want to take a look at the effect of commercials, and of marketing in general, on the perception of a company’s brand. Most companies seem to believe that any publicity is good publicity. They seem to think that – no matter how bad a commercial might be – it’s always better to have a commercial than to have no commercial at all. But the question is: is this true?

When you’re watching television, and you see a commercial of a brand you’ve never heard of before, what will be the effect of this commercial on your perception of the brand? Marketers seem to think that they’ve increased your ‘awareness‘ of their brand, in the sense that – consciously or not – you now know about the brand‘s existence. And this might very well be true. But then the question would be: is all awareness good awareness? Or can awareness – as created by commercials – lead to a (more) negative (instead of positive) perception of the brand by the customer?

I believe it can. I believe that whenever people see terribly non-funny commercials (as there are plenty of) on television, they associate the brand promoted in the commercial with negative values such neediness, pity and lameness. I believe that the next time these people are in front of, for example, a supermarket they’ve just seen in an utterly non-funny (but intended to be funny) commercial, they will think to themselves: ‘Come on, I’m not going to support such a quasi-funny company’, and they’ll decide to skip the store. Even though these people might have entered the store if they hadn’t watched the commercial, or if the company wouldn’t have produced the commercial in the first place. But now they’ve got all kinds of negative associations with the brand, they decide to skip the store and go to another store – which might have less awareness but still more positive awareness than the supermarket of the commercial. And this goes not only for the supermarket-market, but for any other kind of market as well.

Customers usually don’t care about whether a brand is well-known – note that this doesn’t hold for clothing brands and other products that depend for their value to a large extent on marketing. We just want to buy a particular good or a particular service. And the only thing guiding us to a particular store is our perception of this brand/store. And if this perception is negative – which it very likely might be as a result of a bad commercial – you’d consciously avoid this store, and move to a next one. Even though the particular brand might have put a lot of money into its marketing efforts, they’re worse off than they would have been if they hadn’t launched the commercial.

Of course, marketing – including commercials on television and radio – can have a positive effect on a company’s brand and consequently on the sales of the company’s goods/services. But only if the company markets the relevant aspects of its brand, and not just launches a commercial for the sake of showing how ‘funny’ it is as a supermarket. Most people won’t appreciate that: the intelligent people might feel like they’re being treated like babies, and will therefore consciously avoid the brand, and the less intelligent people might not respond at all to this irrelevant kind of commercials.

If want to get people to your store (or make use of your service), you have to stay close to the product your selling, because that’s where customers are coming for or not coming for. Emphasize your low prices, your current actions/sales or your great service, and skip the bullshit. Then, and only then, can marketing attract – instead of scare away – customers.

But what do you think?