Exploiting the Market's Inefficiencies


Eugene Fama is often called "The Father of Finance."  He won the 2013 Nobel Prize in Economics, he's a professor at the University of Chicago Booth School of Business, and he has written many important finance books.  Please don't doubt my sincere respect for this man, but I must say one thing:  He's got it all wrong.

Eugene Fama is most famous for his work in developing the efficient-market hypothesis, which simply states the following: at any point in time, a current stock price accurately represents a company's intrinsic value.  

All bits of information, including the market's collective dreams and doubts about a company's future, are represented by that stock price.  You can't out-smart the market.  It's efficient.  Dumb luck is the only way you'll win.  Fama even famously said, "I'd compare stock pickers to astrologers, but I don't want to bad mouth astrologers."  Ouch.

Needless to say, I disagree.  But before I do, I must say, there is some truth here for short-term investors.  The market is incredibly reactive to the news, politics, unexpected earnings, and even the weather.  It's impossible for anyone to know when news will break and the market will move.  You'll need a lot of dumb luck to win in the short-term.

But in the long-term, anyone can build a market-beating portfolio.  

Here are my personal requirements for the 3-5 cornerstone stocks that anchor my portfolio:

  1. Innovation: Find a few companies with a history of innovation.  Not just one innovation, and not just one disruptive entrance into an industry.  Look for the companies with a consistent record of impacting the future of at least two industries.
  2. Visionary Leader: Chances are, those innovative companies are led by visionary, often iconic, leaders.  
  3. Failure:  Not only is failure inevitable, it's a key step in developing the next big innovation.  Look for companies that have failed and then followed-up with an innovative product or service.
  4. Remain Invested:  Add to the winners.  Don't sell the losers unless there has been a drastic change in leadership or in the industry.


That's the easiest and most conservative way to identify future innovators; look for companies who already know how to innovate.  People love to say, "Buy Low, Sell High" ... as if you should cut ties with a company after a great innovation sparks growth.  But the best way to predict growth is to pick the companies with a history of creating new business models and disrupting or creating industries while they grow.  

For example:

  • Nvidia (NVDA) was famous as the best computer graphics card manufacturer for years.  Now they're establishing themselves as a leader in brand new industries like autonomous cars and virtual reality.  (10 year return vs. S&P 500:  +349%)
  • Netflix (NFLX) first succeeded by inventing a new subscription business model for borrowing DVD's through the mail, but then created an entirely new on-demand delivery system for its content. Today, Netflix is a leading content creator and is disrupting Hollywood.  (10 year return vs. S&P 500:  +6,998%)
  • Amazon's (AMZN) original motto was "Earth's Biggest Bookstore," but now it's hard to name anything they don't sell.  Who know's what's coming next after the acquisition of Whole Foods Market.  Not to mention the incredible dominance of Amazon Web Services.  (10 year return vs. S&P 500:  +915%)
  • Apple (AAPL) was originally named "Apple Computer."  Then, the iPod and iTunes transformed the music industry.  Next, the iPhone created an entirely new smartphone industry.  Now, millions of app developers around the world earn their living by creating smartphone and tablet applications.  (10 year return vs. S&P 500:  +597%)
  • Google (GOOGL) found initial success as a search engine, then established itself as the leader in internet advertising. Next, Google built the most widely used email system, successfully grew the Android operating system, and created Chrome OS for Chromebooks. Now called Alphabet, this company continues to expand its dominance in numerous industries today.  (10 year return vs. S&P 500:  +144%)

Just look at the outperformance of these wildly innovative companies over the past ten years.  The so-called "efficient market" could not predict these rerurns, but I am willing to bet there are plenty of investors who held most of these stocks for years, allowing these returns to dominate their portfolio.  

For serial innovators, disruptive products and services are essentially guaranteed, but the magnitude of their impact is unpredictable.  That's inefficiency, and anyone can exploit it.



Disclosure: This blog represents my personal opinions.  I am not a financial advisor.  Do not buy or sell securities based solely on what you read on this website.  Seek opinions from a qualified financial professional before making any financial decisions.  See the Terms of Service for more details.

As of the time of this writing, Michael Neal owns shares of AAPL, AMZN, GOOG, NFLX, and NVDA.