Many of my friends recently attained a hunting licence. I am also a hunter, but in a slightly different sense. I am hunting for …
mispriced securities is what I am looking for. What was true in ancient times is still valid today: scarce resources should be used wisely. Our time is a very precious resource. Thus, we should ‘invest‘ our time in a way to maximise our payoff.
Certainly there are better and worse hunting grounds for investors. Better hunting grounds give us a better chance for excess-returns on your hunting efforts (time), enabling you to bring home more meat to your cave. Better hunting grounds, could persists due to a variety of reasons. (i) There could be much more tastier deer that (ii) might be easier to hunt (it is slower) that is (iii) not killed by other less competitive hunters (less skilled or not in possession of your superior weaponry). In the same sense, for value investors there are
less efficient market segments which can turn the odds in our favor, because the game is less competitive. For switching from hunting grounds to market segments one of my favorable Quotes from Michael J. Mauboussin comes to my mind (the source is definitely worth a look!) but stay with me 😉 Every novice or non-prfessional investor should dwell and think on that observation.
»Excess returns equal skill times opportunity. All the skill in the world is for naught unless you have an opportunity to apply it. Before figuring out how you will win the game, figure out which game to play.« – Michael J. MauboussinM. J. Mauboussin, Reflections on the Ten Attributes of Great Investors
Read the above quote again, please. And once more, just to be sure. To understand and internalize the above statement is very important! In general, it’s is obvious, that
Desirable markets that give us investors better chances (odds) to achieve above average returns and are marked by the following characteristics …
- market prices are often wrong, and thus
- offered risk-adjusted returns are often out of line, and
- international sophisticated investors are scarce, accordingly
- professional analysts are few, and ideally
- many less skillful investors are involved, because …
A lot of crazy investors in a certain market might very much improve our own profit potential, as Whitney Tilson explains, since they might amplify swings farther away from fair value (in both directions).
A better research process yields better investment opportunites on average over the longterm (expected value). As value investors, we want to discover more companies that are more severly undervalued and are thus easier to value or understand so that we have the highest possible conviction (less uncertainty or risk). Important ingredients for such markets are (not limited to):
Small capitalization stocks come with less competition. Big funds just cannot buy these stocks or they do not want to buy them, since it would not move the needle for them. Accordingly, there is no money to be made for brokers (missing commissions) and there are not many analysts and our (high) skills might actually be worth much. Such market segments come with less skilled investors and should offer more mispriced securities. Additionally, these stocks might be much more easier to understand when compared with huge conglomerates with constantly changing segments, reporting structures.
International and emerging markets might exhibit the same desirable features as small cap stocks. In addition they may boast an investor base that is on average less sophisticated and more fickle. During crisis international investors often sell emerging market assets, amplifying any economic upheavals creating higher volatility. For value investors, volatility provides opportunity, since it likely increases the number of mispriced securities (staying rational is important of course). Main markets are very crowded places. Stocks are covered by armies of investment analysts and media outlets and the biggest asset managers invest their money, lots of it passive money nowadays. Foreign exotic martkets are less crowded in general.
Index inclusion is a factor. From The Economist: A paper in 2011 by Jeffrey Wurgler finds that whether a share is part of an index influences its price. Shares that are included in an index go up in value relative to similar shares that are not. When shares drop out of an index, they tend to fall disproportionately. And once in the index, a share’s price moves more in sympathy with others that are also included […] index inclusion leads to a higher correlation with index prices. Inclusion also spurs a reduction in “information production”: fewer requests for company filings, fewer searches on Google, and fewer research reports from brokerages. Even so, the authors conclude that more intensive effort by the remaining active investors may counter any adverse effects.
Ugly companies and out-of-favour industries is the place to look for undervalued businesses. Basically it is the opposite of glamour stocks that everybody loves to talk about at cocktail parties (and of course own it). That does not mean, that we aren’t able to make a nice return investing in Apple, but: What is our chance (or base rate) that we have a real edge here, that we understand the business better than armies of analysts and industry insiders? Bruce Greenwald sums it up as buying the opposite of glamour stocks:
»You are looking for things that are ugly, cheap, boring, out of fashion, small and obscure or otherwise on the other side of the existing finance industry mania.« – Bruce GreenwaldBruce Greenwald (source)
I hope you enoyed this post. I plan to visit the most promising hunting grounds more often next year. I wish you nice holiday, a merry christmas and a happy new year.
- My micro-page About Efficient Markets and Investors‘ Edge (work in progress)
- Andrew Rosenblum on The importance of investing in inefficient markets