Buffett debunked the Efficient Market Hypothesis: The Superinvestors of Graham-and-Doddsville

Paul the octopus proves Buffett was right
GREG HOFFMAN
July 14, 2010 - 12:08PM

The unlikely hero of the recent World Cup of football? Paul the octopus, a common cephalopod living in a tank at a Sea Life Centre in Oberhausen, Germany.

In case you missed Paul’s highly-publicised predictions, he correctly forecast the winner of all seven of Germany’s World Cup games and the winner of the final. Paul became a media sensation, although he wasn't much use in interviews.

The idea that an octopus would even know of the World Cup, let alone be able to forecast its outcome, is of course ridiculous. Paul can tell us nothing useful about football. But our collective fascination with a Nostradamus octopus is reminiscent of a parable told by the world’s greatest investor more than 25 years ago.

In 1984 Warren Buffett penned an article titled The Superinvestors of Graham-and-Doddsville, based on a speech he had given on the occasion of the 50th anniversary of his mentor Ben Graham’s legendary textbook, Security Analysis.

In it, Buffett rejected the then growing (and now entrenched) view in academia that markets are ''efficient'' because ''stock prices reflect everything that is known about a company’s prospects and about the state of the economy.''

Many academics conclude that anyone who beats the market (like Buffett) is simply lucky; an argument to which Buffett presents a devastating rebuttal.

He asks the reader to ''imagine a national coin-flipping contest'' where 225 million Americans wager a dollar and flip a coin each morning. Each makes their call before flipping and the winners double their stake by taking the money from the losers (who drop out).

''After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000.''

After 20 days, 215 people would have successfully called their coin flips 20 times in a row and each be sitting on $1m in winnings. He suggests that such people would, by this stage, probably start writing books about their success and ''and tackling skeptical professors with, ‘If it can’t be done, why are there 215 of us?’'' Some might even crawl into a fish tank and start predicting the outcomes of sporting contests.

But, as Buffett points out, exactly the same result would be achieved if 225 million orangutans (or octopi) had engaged in the same activity.

Having set the stage for scepticism with his coin-flipping parable, Buffett makes a pre-emptive strike against it; ''I would argue that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something.''

Buffett says that if you find an unusual concentration of abnormal results in some kind of geographic area (be it successful coin-flipping orangutans or the incidence of cancer, for instance), it calls for further investigation.

''In addition to geographical origins,'' writes Buffett, ''there can be what I call an intellectual origin.'' He then puts his view that an unusually high number of successful ''coin flippers'' in the investment world employ a similar philosophy; value investing.

After cataloguing the track records of various successful investors who he had pre-identified, Buffett sums up there approach thusly; ''...these investors are, mentally, always buying the business, not buying the stock ... all exploit the difference between the market price of a business and its intrinsic value.''

It’s astounding to me that this approach isn’t more widely followed. Think of the five most respected names in the Australian funds management industry (as opposed to the biggest names). I bet that of the names that spring to mind for most people, at least two would have a strong value investing flavour to their approach.

Those names might include Platinum Asset Management, Perpetual, Maple-Brown Abbott and Argo Investments. Other approaches are likely to be top of the pops in any single year but, over the full sharemarket cycle, you’re likely to find a cluster of value investors near the top of the long term performance league table.

It doesn’t take the predictive powers of a German octopus to conclude that the same will prove true by the time we’re through with this current cycle.

Conventional economic theory tells us that people like Kerr Neilson and Warren Buffett are statistical flukes. But, unlike Paul the octopus, their stock selections are based on a pre-defined philosophy. That should tell us something about the efficient market hypothesis (it's flawed) and the type of approach—the intellectual origin—these successful investors employ (it's successful).

This article contains general investment advice only (under AFSL 282288).

Greg Hoffman is research director of The Intelligent Investor. BusinessDay readers can enjoy a free trial offer at The Intelligent Investor website. For more Intelligent Investor articles click here..