"For example, what risk is a residential REIT taking, especially one whose properties are all insured? By contrast, you can look at a business like a casino (or a catastrophe reinsurer), where it is legitimately the case that operating income is predominantly the result of risk-taking."

If you actually believe that a residential REIT is zero-risk and a casino is high-risk but they have the same ROIC, you should buy REITs and short casinos and you can make a big profit. That illustrates why there's probably a flaw in your understanding (though not necessarily! you might be able to make a big profit!). The market should have the same logic, and if this is actually true, REITs will be bid up and casinos bid down until the ROIC on casinos is higher than on REITs, appropriately compensating investors.

FWIW, REITs face a lot of significant risks, eg. a regional downturn could lead to all the workers becoming unemployed and vacating or not paying rent, or a rise in interest rates could increase financing costs, or rent control might be enacted and prevent the property management from raising rents as much as financial models predict. And casinos are actually much less risky than assumed: most gambling games have statistical models for how much they pay out, and with millions of games played reality tends to approximate the models very closely (due to the central limit theorem), and they tend to take out insurance on extreme black swan events anyway. I don't know the ROICs on either of these industries in detail, but I suspect that if it's similar, it's because the actual risks to them are similar.

> If you actually believe that a residential REIT is zero-risk and a casino is high-risk but they have the same ROIC, you should buy REITs and short casinos and you can make a big profit. That illustrates why there's probably a flaw in your understanding (though not necessarily! you might be able to make a big profit!). The market should have the same logic, and if this is actually true, REITs will be bid up and casinos bid down until the ROIC on casinos is higher than on REITs, appropriately compensating investors.

No, the return on an investment security (in this case, a share of publicly traded stock) is different from the return on a dollar actually invested in the underlying business (i.e., ROIC). This has a lot to do with the price action that you outline.

The rest of your comment deals with why these are bad toy examples, which is fine but not really all that interesting in context.

The security reflects how investors expect the ROIC of the underlying business to change over time, hence the "risk" aspect. They're forward looking over the life of the security's cash flows, while the company's financials now are a snapshot in time.

You're still confused. The EMH is understood to imply that securities prices are the NPV of future cash flows (or more specifically their best estimate, using all public information), but that has nothing to do with ROIC.

(As an aside, the EMH is obviously false and you don't need to look any further than meme stocks for evidence, but anyway)

For example, suppose you have two businesses, both of them have a future cash flow NPV of $1 billion. However, one of them was started in a garage with $1 million of angel money. The other one is a "fallen unicorn" that got $500 million of VC money before it finally IPOed.

The ROIC of the first company is obviously going to be something like 500x the second, but this is irrelevant to their market caps, which should be the same in textbook-EMH-land, ceteris paribus.

"Does a bread factory that hedges its future wheat purchases with wheat futures have a lower expectation profit than one which does not?"

To the extent that it hedges them rationally, they have exactly the same expectation profit. But the bread factory that hedges its future wheat purchases has a lower real profit than the one that does not, assuming the price of wheat doesn't go up, because buying those futures contracts costs money. That's what it means to turn risk into money: if you are willing to bear the costs of things turning out poorly, you can avoid the costs of avoiding the chance of things going poorly, and increase your profit by the same amount.

I think in general the transaction costs associated with hedging wheat price risk are so small via futures (0.05% or less) that it proves the larger point that profits cannot possibly be due principally to assumption of risk.

Your question about what futures is weird. Yes? It does have a lower expected profit? But a mitigation of downside risk. You seem to think the answer is "no."

That's because the answer is 'no', unless there's an underlying reason to expect that the expectation price of wheat will be less in the future. The only impact to profits is the actual transaction cost of the wheat futures, which is de minimis.

Since this is what you think, you should definitely go into some kind of real inventory heavy business and use futures to hedge against all your inputs going up in price. It'll be a real competitive advantage for you, since you seem to think it's all upside.

A lot of businesses actually do hedge their inputs, this is not a crazy idea I've just come up with. For some industries it's de rigeur (jewelers typically hedge even the value of their inventory and WIP), in others it seems to be a matter of preference (jet fuel for airlines). That's perhaps the single biggest justifying reason for the existence of commodity futures in the first place -- because producers and consumers want to reduce price risk. Agreeing on a fixed future price achieves that goal for both parties. Why would either the producer or the consumer need to pay anything to reach such an agreement? Why would it reduce expectation profits for either party? The futures markets simply provide a low-friction venue.

I agree that lots of businesses do hedge their inputs! Just as lots of people buy insurance. Reducing catastrophic downside risk of something is indeed worth a loss of expected value. But insurance has negative expected value, just like hedging their inputs. If you believe that it's costless or near-costless to hedge your inputs, you should do it literally everywhere to everything that you possibly can, and anyone who doesn't is just leaving money on the ground for you to pick up.

And while lots of businesses do hedge their inputs to some degree, it is not the case that everyone does it to the maximal possible extent.

> If you believe that it's costless or near-costless to hedge your inputs, you should do it literally everywhere to everything that you possibly can

... no? Just because you've eliminated price risk doesn't mean you've eliminated holistic market risk. For example, suppose you're an airline: if fuel prices go up, and your competitors are not hedged, it's no big deal if you're not hedged, because everyone just increases ticket prices. But suppose you ARE hedged, and your competitors aren't, and fuel prices go down, and your competition cuts ticket prices, and... uh, you're screwed, because 1) you have a bunch of fuel locked in at the higher price, and 2) nobody wants to buy your tickets with the old fuel surcharges. So you're forced to take a loss, and the hedge hasn't actually reduced business risk in this scenario. It tends to depend on the game-theoretic context whether hedging commodity inputs actually reduces systematic risk.

Seriously, hedging price risk in commodities is nearly costless, decisions not to hedge almost never have to do with the actual cost of the hedge. In the real world where things are much more complicated than a toy example, many airlines do some hedging, with the aim of reducing sensitivity of profits to short-run volatility in oil, rather than trying to truly eliminate exposure to fuel prices. But that does come as a "free lunch".