Of market (in)efficiency

CIO Insights 4Q2014

In theory, stock markets are supposed to become more efficient all the time: more and cheaper data availability, faster and better trading systems, more sophisticated and flexible financial instruments. However, we believe there are some powerful forces at work which may lead to less rather than more efficient equities markets. Indeed, being immersed into the plentiful variety of available equity investments on an everyday basis, we run across as many pockets of inefficiency as ever before. We would like to mention just four typical pricing aberrations which we have recently encountered: an announced takeover in the logistics industry where the current market price stands at barely 60% of the standing and valid bid price; a now completed equity capital increase taking place in the infrastructure construction space where the exchange-listed offering rights traded at a small fraction of their implied value; several holding companies being quoted at 30–50% discounts to net asset value derived from their publicly traded subsidiaries’ securities and/or estimated private market values; and a range of asset-heavy companies where net tangible assets (such as land, proven reserves of natural resources or other assets) are worth a multiple of the current stock price.

We detect three main structural circumstances which create such inefficiencies. First, equity investing as a whole is becoming ever more “indexed” and “relative”. Nowadays most investable funds tend to get allocated to stocks that have been going up and withdrawn from stocks that have been going down, akin to a simple momentum or trend style of investing. As this phenomenon keeps growing mostly for institutional reasons, so do potential mispricings (i.e., momentum gets expensive versus the rest). Shying away from trends and anything that’s popular and pricey during any given period, we find ourselves in a unique position to exploit an ever increasing set of compelling bargains due to such crowding effects.

Second, nowadays most conventional institutional investment programs prize liquidity and trading volume well above other criteria such as indicators of value. Widely-known statistics show, for example, that over the course of the last five decades securities turnover in the average US and UK equity mutual fund has risen dramatically. Also, recent data from UK asset managers suggest that buy-side small-cap research budgets are being cut substantially. Despite overwhelming academia and empirical evidence that frequent trading tends to hurt investment results, there seems to be a strong need by portfolio managers to be able to change opinions fast and consequently, trade in and out of stocks easily. The danger with this approach, besides the obvious drawbacks such as brokerage fees, price impact and opportunity costs, is that it may lead to emotional short-term decision-making. As buy-and-hold investors we are able to take advantage of these behavioural abnormalities by patiently accumulating long-term positions in less liquid or temporarily unfashionable securities. 

And third, market participants have become significantly more averse to temporary price declines in stocks and other securities, as evidenced by the on-going popularity of hedge funds and other low-correlation or low volatility strategies. Paradoxically enough in the case of long duration investment programs such as those of pension funds and insurance companies, the fear of short-term downward fluctuations in portfolio value appears to weigh much more heavily than the potential reward for long-term wealth creation. Thus, stocks subject to recent volatility or subpar performance tend to get shunned by the market. Luckily, by nature of our contrarian investment style, we depend precisely on these price drops in order to buy the particular set of companies we like on favourable terms.

Because all these appear to be entrenched dynamics embedded into today’s structure of professional portfolio management, they are destined to continue for a long time to come. By extension, the validity and attractiveness of our investment approach in all likelihood is set to last as well.

Sincerely,