»In theory there’s no difference between theory and practice, but in practice there is.« – Yogi Berrafrom The most important thing illuminated
Modern financial theory frequently clashes with (my) value investing philosophy. Each and every finance student will have heard about the efficient-market hypothesis or EMH which basically states that all securities are fairly priced (all of the time). Without going into more detail here, I hold it as Howard Marks:
»Efficiency is not so universal that we should give up on superior performance. At the same time, […] we should assume that efficiency will impede our achievement … « – Howard Marksin The most important thing illuminated
The efficient market theory is neither completely wrong nor right. According to Marks, it is a matter of degree, which I strongly believe is true. Following his observations, main stream financial markets might be more efficient than other less crowded markets most of the time. Thus, it might be a better use of our time to look for profitable investments off the beaten paths.
Desirable markets that give us investors better chances 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 ideally
- less skillful investors are involved
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.
A better research process should yield better investment opportunites on average over the very 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:
Market segments with less skilled investors should offer more mispriced securities. Skilled (professional) investors or market participants are, in the end of the day, profit driven. In the trading in sales business, this means, many small cap stocks are just not worth it to cover, since potential trading fees generated are just not profitable. Additionally, these stocks might be much more easy to understand.
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 as are out-of-favour industries, in general.
Getting an edge
»The single greatest edge an investor can have is a long-term orientation.« – Seth Klarman« – Seth KlarmanSeth Klarman
To be more insightful than others, is a neccessary trait to profit from assets’ mispricings. Our edge can come either from better information or analysis.
»Insight makes money […]. Information costs money.« – Pat DorseyPar Dorsey, at Texas Lutheran
And who doesn’t know that? is always a good and obvious question to ask when considering an investment.
»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 Greenwald on buying the opposite of glamour stocksBruce Greenwald (source)
to be continued …