A Case Study in Market Inefficiency

"I'd be a bum on the street with a tin cup if the markets were always efficient"

- Warren Buffett (BRK.B)

For anybody who has had the joy of learning about finance at a university in the past forty years, you are likely all too familiar with the efficient market hypothesis (EMH). As summarized by Investopedia, EMH is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information (just to be clear, financial theory as taught at colleges around the world is still based on this idea). According to this theory, anybody reading this article or anything else written on GuruFocus is simply wasting their time; as such, I like to take the time every once in a while to show the utter ridiculousness of this theory – this article is a case study into the recent price movement of J.C. Penney's (JCP) stock.

In October 2010, Bill Ackman of Pershing Square filed a 13D with the SEC indicating that his firm had taken a 16.8% stake in Penney's, causing the stock to move up nearly 5% and to a price nearly 60% higher than where it had traded just a month earlier. After that time, the stock was relatively range bound, and traded at a price between $30 and $40 per share until mid-2011.

On June 14th, the retail world was enamored with the announcement of former Apple (AAPL) retail head Ron Johnson as Penney's new CEO, with the stock shooting up nearly 20% in the trading session. Yet for some reason (there was no material news announced), the obsession with Mr. Johnson faded and the fear of a euro crisis continued to circle the market (where Penney's doesn't have a single store), resulting in a share price declined of one-third in the next sixty days.

As Mr. Johnson began building a management team with former Target co-workers (namely Michael Francis) and speculation began to swirl about his transformation plans, the market got interested in JCP aga! in, with the stock working its way back to $35 by late January.

On the 25th of that month, JCP's management team hosted an event to outline the company's transformation plans; looking at how the stock reacted, you would of thought that Mr. Johnson announced that Penney's had attained exclusive rights to distribute Apple products – the stock shot up nearly 20% again, the second time in less than six months that a press release had caused the company to add more than $1 billion in "value".

The stock peaked around $43 over the next two weeks, and has been on the decline ever since; today, it sits at a shade under $35, nearly identical to the price that the stock had hit upon the announcement of Mr. Johnson's hiring.

In the past ten months, very little has changed at J.C. Penney's; the company is in the early stages of a transformation that will take years to complete. While the market likely reflects all "relevant information", as termed by the efficient market hypothesis, there are two real issues with this idea.

First, human beings are not machines, and 99.99% don't use Markowitz Optimization when building their portfolio (Harry Markowitz, after which the practice is named, noted that even he didn't use this methodology when constructing his personal portfolio); secondly, and most importantly, all "relevant information" doesn't mean much of anything when it comes to future events that will determine cash flows in perpetuity, a necessary component for determining the "right" price.

And you know what I have to say about that? FANTASTIC! The intelligent investor can use what they know with certainty (namely historical information in the form of financials) to make intelligent and conservative estimates about what they can't and don't know; while I can't tell you exactly what J.C. Penney's is worth, I know with a fair amount of certainty that it falls into a determinable range – and with the stock moving between $23 and $43 ove! r the cou! rse of just a year, that means with a bit of patience that I can be relatively sure that I'm making an intelligent allocation of capital.

Luckily, the world is full of people that fall onto the opposite ends of the spectrum: those who think that trying is a waste of time (EMH proponents), and those that think every single data point (the OBSESSION with monthly sales data is the clearest example of this) is a reason to buy or sell. For the intelligent investor, the sweet spot is a balance between the two: focusing on the essential information (like sustainable competitive advantages) and acting in size periodically when the manic depressive Mr. Market thinks the sky is falling.

The longer I invest, the clearer it becomes: a clear understanding of business, competitive advantages and valuation, mixed with a heavy dose of patience, is a sure fire way to attain long term success; let the continued volatility work to your advantage by standing apart from the herd and developing the necessary toolkit to capitalize upon the market's bouts of inefficiency.