3 ways to exploit market inefficiency and earn market-beating returns
The markets are generally efficient at pricing securities. So, in that way, I do agree with the general notion of the efficient market theory. What we exploit, and how we invest is to find pockets of market inefficiency, and to exploit the differences between price and intrinsic value.
1. Imperfect information
The more coverage a stock receives, the harder it is to find divergences in intrinsic value based on traditional forms of valuation. They exist sporadically and infrequently.
One must remember to take stock of their own abilities as an investor. People who work in the financial industry are generally smart and highly motivated. It is extremely hard to possess an informational edge on companies that are widely covered since so many people are working on the same problem as you are. Is it possible to generate superior insight by the careful study of annual reports and financial data? Yes, but the task inevitably becomes much harder, and the payoff far less rewarding with high profile names as such inefficiencies are inevitably arbitraged away as information about the business becomes commonplace.
Following that train of thought, it is logical to deduce that gaining an informational edge is much easier by looking where NO one else is. Take, for example, the Singapore Exchange. While there are about 700 companies listed, only about 50 companies receive widespread institutional coverage. Gaining an investment edge through rigorous analysis of the remaining 600 over companies thus offers a much higher probability of success since there is little competition. Valuations that typically exist during recession-like conditions in more developed financial markets like the United States & the United Kingdom are commonplace in Singapore.
Inevitably as the markets develop in Asia, such opportunities will cease to exist. But such developments do not happen instantaneously. The evolution of the financial industry in Wall Street took decades to play out. If history is of any relevance to us, I daresay that the development of the industry in Asia will take a similar path, and it will be many years before such opportunities cease to be.
As such, the well-worn path is one that we must avoid if your goal is superior market returns. There is nothing inherently wrong with investing in a benchmark index. However, if one aspires to do better than the market, it is inherently illogical that you can achieve that goal by investing like everyone else is. Markets such as Singapore and Japan provide fertile ground for the enterprising and hardworking investor, and as markets continue to open up in Asia – notably China, Thailand & Myanmar among many others – there will be ample opportunities to exploit.
2. Prices do not always reflect intrinsic value
The underlying assumption behind all fundamental analysis is that the markets will eventually recognize the underlying value of the security. If you are long a stock, you believe that there’s a divergence between price and value — and that the markets are incorrectly pricing it below what it’s actually worth. If you are short a stock, you believe that the market is placing a far greater value than whatever the business is actually worth.
In truth, learning how to value a business is the easiest part of investing. Through careful study and due diligence, it is not hard to arrive at an estimate of what a business is worth. The difficulty comes in waiting for the market to recognize what we believe to be true.
The traditional bread and butter approach of a value investor is to find companies trading at a discount to intrinsic value, and then waiting for the markets to revalue them to what they are really worth.
Let me present to you a variation of this, one still anchored from the foundations of a focus on intrinsic value, but borne out of my own experiences from how financial markets work. For us to do that, we need to establish the premise behind exploiting this “market inefficiency”.
Humans are rationally irrational. Even after thousands of years, all of us, regardless of our origins, are governed by the same fundamental emotions of greed and fear. Investment opportunities that are widely purported to make money (whether they do so is another question) are often exploited by other people. Witness the junk bond mania of the 1980s, the dot-com frenzy of the 1990s, and the sub-prime crisis of the 2000s.
Thus, while we invest on the premise that the price of an underlying security and its intrinsic value will eventually converge, the truth is that for the most part, they don’t. Believing that markets operate rationally is the surest way to folly as they reflect so little of what reality is. In the short run, the stock market is like a voting machine. It’s driven by a herd-like mentality and emotions.
Consider this, while value investors like to talk about investing for the “long-run”, the truth is no one knows just when this revaluation will take place, if it ever does (if you know someone who claims to know, my advice is to run for the hills). It could be weeks, months or years. The whole point of speaking in broad specifics is that it affords us the margin of error seeing that we have no clue when it would happen. We have our rough ideas and our expectations, but they are rarely right. If there existed an exact science of forecasting, investors would have no need of portfolio diversification.
In the real world, prices for most transactions are governed by the fundamental laws of demand and supply. When the number of buyers exceeds the number of sellers, prices rise, and when the reverse happens, prices fall. The deeper the market, the greater the liquidity, the smaller the mispricing between the prices of what buyers and sellers demand.
The real investment opportunity comes when the normal state of the markets is thrown into turmoil without warning. Consider, for example, panic selling in the wake of market-wide declines. The number of sellers who want to get out of their positions far outweighs those who are trying to get into the market. They are highly motivated to get out and sometimes not because they want to, but because they are forced to due to margin calls, excessive leverage etc. You are essentially playing the role of a trader, exploiting the differences in positioning that both parties have.
And that’s why, sometimes, intrinsic value doesn’t matter at all. If you are a large institutional firm taking a huge short position, and word gets around that you need to get out for your position, you’re screwed. The market is going to make use of your need to cover your shorts to extract the highest possible price because you have no say in the matter. It doesn’t matter whether your thesis is right or wrong. Let’s say your house is being foreclosed and being auctioned off. Now, the value of your property conservatively valued might be $500,000. But more often than not, you won’t get anywhere close to that sum. You aren’t in a position to bargain. Intrinsic value doesn’t matter.
One of the reasons why distressed debt investing is so profitable isn’t that the underlying businesses are great; they aren’t. Rather investors can pay such depressed prices for their debt that it far compensates them for any risk that they are required to assume. They are placed in a superior bargaining position to demand lucrative prices. If you pay 20 cents for a bond with a par value of $1, a lot can go wrong AND you can still make a lot of money!
If I could sum this “market inefficiency” in one sentence, it’s that investors should be waiting for situations where the number of sellers far exceeds the number of buyers. This is different from the traditionally associated form of value investing because it requires you to be highly tuned to the market. You take on the mind of a trader, keeping up with the latest developments, waiting for situations to unfold. These investment opportunities normally only exist for short spans of time.
Closer to home, let’s take the situation of the locally listed company: Olam.
When word that Muddy Waters had taken a short position in Olam, market value of its listed debt and equity declined considerably in value. Investors were highly motivated to get out of their positions. Like every other time, it was a case of “Do first, think later”. Now, depending on what you though Olam was actually worth, there was a significant chance to buy the same company at a significant discount to what it was trading just a couple of days earlier – literally a contrarian trade with a short time horizon and not one where the holding period was years.
3. Don’t do anything — when there’s nothing to do
More than anything else, this is the biggest advantage that individual investors have over institutions. Institutions thrive on activity, and they need to be doing something or anything to justify their fees. Funds have to be fully invested, opinions have to be given even when no intelligent conclusions can be formed, and institutions in general, tend to crowd into the same trades.
Individual investors face none of that burden, and it’s the most powerful advantage you have. You can wait for indefinite periods of time for the right pitch to surface before moving, and you should exploit this advantage to the fullest.
Let me walk through how advantageous by highlighting an example: Let’s say that property prices are rising fast, the general sentiment of the average investor is extremely bullish, and people are rushing to buy property for ‘fear of missing out’. However, an investment idea which combines high levels of debt, and the assumption that interests rates continue to remain depressed indefinitely and that prices of houses continue to rise (or remain level at least) is one that is, in my view, doomed to end badly (this is what the sub-prime crisis in essence was).
But this is where the individual investor has a huge advantage. If I do not want to invest in property, I don’t have to! Sure, the average person might feel the compelling need to since all his friends are getting rich doing so, but that is different from an obligation to do so.
Now, consider this, if you were running an institutional fund and property stocks or REITs just had a terrific run, you certainly might have reached the same conclusion as me that they were overvalued. But, calls from your clients would soon come in, asking why you weren’t loaded up with property stocks when rival fund manager XYZ who had done much better than you, was. Clients would soon start leaving you, feeling you out of touched with the “new-age” of investing, and soon your livelihood – directly correlated to the amount of assets you managed would be threatened. You would be compelled to start making investments in these assets despite your own personal beliefs – not because you wanted to but because you had to.
Sound farfetched? It isn’t.
What I’ve described has repeated itself countless times throughout history. It’s the same reason why funds are normally crowded into the same trades all at the same time. It’s far better (and easier) to fail conventionally, together, than it is to succeed unconventionally, alone.
In my view, this is really the biggest advantage that individual investors have. The ability to do nothing when there’s nothing intelligent to do, and to swing for the fences when the right pitch comes is fundamental to generating market-beating returns. The only way to achieve superior results is to do what no one else is doing.