Disproving the Efficient Market Theory: The Value Line Method

Abstract

As a new employee of the Value Line Investment Survey, I have come to realize that our subscribers pay our significant annual fee not only for the basic financial data, but for a "Timeliness Ranking" with which I have very little say in administering. This rating uses backward-looking information in order to predict an issue's potential, relying little on the analyst's ''view of the future ." It therefore became of interest, when I was proudly informed that I worked for a firm that has beaten the market consistently for the past 25 years, using this "Timeliness Ranking." As a student of economics for four years, I have read and been taught that it was next to impossible to find a consistently inefficient market with which to invest. As an employee of a firm that has beaten the market, and has the printed proof, I was fascinated to learn the secret of its success. Efficient market theorists claim that if an active market is truly efficient, then investors should not be able to systematically outperform the indexes. The reason being that, since a stock's price incorporates all of the company's information already, competition among well informed investors prevent the price from straying too far away from its intrinsic value. Therefore, the price of the issue is the true worth of ' the stock and, logically, no one is going to pay more for something than it is worth. Luckily, Value Line developed a ranking system, whereby they rate the 1700 companies they cover into five categories, according to how they are expected to perform, with respect to each other, over the next 12 months. The system uses five elements in order to derive each stock's rating, including historical earnings and price growth in relation to previous years, price-earnings ratio (P/E), price momentum, and an earnings surprise factor. Each of these have been proven to stand on its own, to a varying degree, and as a unit have beaten the market consistently since 1965. What I have found is that even the most die-hard efficient market followers are willing to concede to Value Line's performance. Therefore, the question is not whether or not the ranking has beaten the indexes, and, in effect, the efficient market hypothesis, but how it accomplishes this feat.