A non-academic take on markets for my professors and Nobel Prize winners Fama and Thaler

I did an MBA at Chicago Booth in 2006-08 and was lucky enough to attend the classes of three professors who later won the Nobel Prize in Economic Science: Eugene Fama (2013), Richard Thaler (2017) and Douglas Diamond (2022).

Interestingly, Fama and Thaler both won the award, but with contrasting theories. Fama won the award for his efficient market hypothesis, which suggests that stock prices reflect all available information, making it difficult to consistently outperform the market. Thaler won his award for his work in behavioural economics, showing how investors’ rationality is limited and influenced by psychological factors.

I’m a corporate credit analyst at M&G, and after a number of years as a market participant, I can offer my non-academic perspective on this debate.

Who is right? Fama with his efficient market hypothesis, or Thaler with his limited rationality? Given that Thaler gave me a B in his course, I’m inclined to think that Fama has got it right, although markets in practice function a bit differently from textbooks.

First of all, I have learnt that there is no such a thing as one market. There are different markets, which process information differently. The equity and the credit market could look at the same company and reach very different conclusions. While the equity market is mainly focused on EPS (Earnings Per Share), the credit market is mainly focused on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation), and this different focus might lead to very different conclusions. A low-levered company (on an EBITDA basis), for example, might look healthy to the credit market, but have a very low market capitalisation if its EPS is low or negative, creating a short circuit between the two markets. Businesses with high capital intensity, for example, might have a healthy EBITDA and a skinny EPS at the same time.

Which metric is best to use: EBITDA or EPS? Any metric has a vantage point and a blind spot at the same time. EBITDA is a proxy for the operating cash generated by the business, but it does not account for its capital intensity. EPS is a non-cash metric and, as such, is more susceptible to accounting management. In my view, analysts shouldn’t focus on one metric, but select a range of metrics that give maximum visibility on the business. There is information value in both EBITDA and EPS and a number of other metrics. I have my favourite credit metric, but it is a non-standard one and I would lose half of the audience by delving into it.

When two markets can reach different conclusions on the same company, it is hard to claim that they can both be efficient. However, it is fair to say that each market participant is doing their best to process the information available within their own constraints in terms of time, resources and analytical skills.

So who wins the argument from the non-academic perspective of a market participant? My conclusions is this: markets do try to be as efficient as they can, but this attempt is subject to a number of constraints and there is a significant degree of dispersion within markets of analytical processing capacity. Such constraints might lead to “irrational” outcomes, although in my experience, they are more the exception than the rule. The size and experience of the analyst team could be seen as a good proxy of the information processing capacity of an institutional investor and this factor has a significant degree of dispersion across market participants. This is why investors reach different conclusions.

At the end of the day, for each trade there must be a buyer and a seller at the same price. Markets are a collective best-effort attempt to process the information available as best as possible, subject to a series of constraints which have a significant degree of dispersion across market participants, and which could drive very different performance outcomes. Both Fama’s and Thalers’ theories have a vantage point and a blind spot, complementing each other. I guess that over time I have forgiven Thaler for giving me a B.