This
is a small case study with data from 2015. This demonstrates the failure of
efficient market hypothesis in the light of behavioral finance. EMH focuses on the
rational best interests of an investor and that the current valuation of the
company is incorporated in the public information available. It also states
that any new information which is public will be immediately incorporated in
the stock prices of the company. In the light of such theories I choose Amazon
and Berkshire Hathaway to compare the efficient market hypothesis with
behavioral finance theories.

Amazon vs Berkshire Hathaway Comparison

Amazon had surpassed Berkshire Hathaway in market value in around July
2016 to become the largest U.S listed company. Amazon had a market cap of $356
billion while Berkshire stood at $355 billion. The market has now determined
that Amazon with a slighter edge is now nearly equivalent to Berkshire. A small
comparative analysis is shown as follows:

Name of Company

Amazon

Berkshire Hathaway

Market Cap:

$356 billion

$355 billion

 Annual Profit:

 $0.59 billion (2015), Loss of $0.24 billion (2014), $274
billion (2013), Loss of $0.03 billion (2012), $0.63 billion (2011)

$24.08 billion (2015), $19.87 billion (2014), $19.47 billion (2013),
$14.82 billion (2012), $10.25 billion (2011)

  Price to Earnings Ratio:

306

14.5

Consensus Earnings Growth Rate (5 years):

49.4% per year

Not available

Trailing 5 years Earnings Growth Rate: –

13.15% per year

 

Analysis:

A quick
analysis reveals that Berkshire which a company based on strong fundamentals
have profits in billions of dollars whereas Amazon, the e-commerce giant has
consistently lower profits and has losses that are far more than the profit it
generated. This is a classic example where behavioral finance theory comes into
play. Amazon’s huge market capitalization has been built on the positive
acceptance of ecommerce by the people thus leading to huge positive sentiments
that leads to asset over valuation. Since market prices fully incorporate all
information in the past hence it should be no different that we invest in
Amazon or Berkshire.

Assumptions:

1.     
Amazon’s growth: Estimates are assumed to be true:

2.     
Berkshire growth: The growth rate of previous 5 years

 

If we calculate
the profit for Amazon discounted to present value it turns out that it has
accrued a profit of $4.4 billion by 2020 in the meantime Berkshire Hathaway ends
with $44.5 billion profit. If we assume that both company are valued on the
basis of fundamental data and take the P/E ratio of 15, we see that Amazon
reaches a valuation of $66bn and Berkshire $667.5 billion by 2020.

Investor performance

The analysis above shows that
we would earn 10 times more if we invest in Berkshire than in Amazon. But clearly
that is not the case. Both the efficient market and behavarial hypothesis fail
in such cases. Efficient theory suggests that both the companies would have earned
nearly the same whereas behavior suggest that Amazon would have given better
return owing to huge positive sentiments.  It is conceivable to outflank the market by
legitimate choice of stocks through fundamental analysis and behavior theory.

Let’s look at the market today
to derive at better conclusions on the theories. If we see the market today,
Amazon has surpassed Berkshire by a near 100 billion dollars in market capitalization.
Let’s dig a little deeper to understand the basic theories and explain it.
Amazon has surpassed all expectations due to solid behavioral theory. Amazon
has diversified its business from only ecommerce to a portfolio of ecommerce,
hyperlocal services, video streaming services, web services , payment and
wallet services, machine learning services, etc which has led to a considerable
increase in revenue. The additional new services leading to growth can be
attributed to fundamental analysis of the stock. But this is not enough to
double the market capitalization only by increasing services you offer. The over
valuation can be attributed to behavior theory where the general goodwill of
the company has increased as people as started terming Amazon as a good company
because of its large inventory, provide jobs to a lot of people, provide
services at affordable rates(like Amazon prime) and web services at cheaper
prices to emerging small businesses. This has led to positive sentiment in the
entire community restoring faith on people’s mind that the emerging giant is
going to do a lot of business and better growth.

Implications of the Efficient Market Hypothesis
for Investors

On a concluding note, the current Market capitalization of
Amazon has hugely surpassed Berkshire. The most important reason attributed to
such an event is the market sentiment relating to Amazon. The positive vibe
about ecommerce making life simpler and the readiness of people investing in
the technology perspective has hugely helped Amazon to amass nearly double the
capitalization in just 3 years. It is quintessential to observe that the market
sentiment, investor confidence and the general goodwill of the people accepting
ecommerce technology and putting their trust in it has led to huge gains for
Amazon. This case study is a classic example of the traditional finance vs
behavioral finance anomaly.