In Search of Inefficient Markets
"Fish Where the Fish Are"
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Efficient vs. Inefficient Markets
During a 2007 Berkshire Hathaway Shareholders meeting, an attendee asked Warren Buffett and the late Charlie Munger if they were starting out in the investment field today, where would they look for investment ideas. Munger answered that “the place to look when you’re young is in the inefficient markets.” It naturally follows that in a market where assets are being widely mispriced, a shrewd investor could exploit inefficiencies for profit. In today’s article, we will be reviewing the common characteristics that lead to market inefficiencies.
“Inefficiency is a necessary condition for superior investing. Attempting to outperform in an efficient market is like flipping a fair coin: the best you can hope for is 50/50.” – Howard Marks
The efficient market hypothesis (EMH) has been the central proposition of finance for over fifty years. In the classic statement of the hypothesis, Eugene Fama defined an efficient financial market as one in which security prices always fully reflect available information. The efficiency in pricing, according to the theory, stems from the collective efforts of rational profit-seeking market participants who will buy securities that become too cheap and sell securities that become too expensive, ensuring that prices do not diverge from economic realities. In layman terms, quoted stock prices are always correct at any given moment, both in the absolute and relative to each other. It is our belief that while markets are mostly efficient in pricing all available information, market prices reflect the consensus view of that information, and the consensus (made up of fallible human beings) is not fully rational or always motivated by purely economic reasoning.
The most convincing arguments against the efficient market hypothesis involve stock prices that rise far above historical levels of value during mania induced bubbles, only to come crashing down thereafter. For example, in January 2021 AMC was valued at $8.25 per share. In June 2021, just six months later, the same shares traded for approximately $231. A proponent of EMH would need to argue that the market was correct in pricing AMC in both instances. While EMH is critical in understanding market dynamics over long periods of time, anomalies that occur during market bubbles and crashes indicate that stock prices are not always determined through economic rationality.
Those who object to EMH have proposed the idea of an inefficient market: one in which an asset's price does not accurately reflect its true intrinsic value. Some of the greatest value investors of all time such as Warren Buffett, Seth Klarman, and Howard Marks attribute their success to exploiting market inefficiencies by purchasing assets far below intrinsic value. In the next section, we will review some of the common characteristics that lead to market inefficiencies. These characteristics include noise traders, market sentiment, and motivated selling.
Noise Traders
Noise traders, also referred to as retail investors or speculators, are typically non-professional individuals who trade stocks using largely incomplete or inaccurate data. The Bureau of Labor Statistics reports around 2.8 million professional investors in the market today. On the other hand, the number of non-professional traders in the market today is estimated at somewhere around 50 million, boosted by the emergence of self-directed trading platforms. In a study titled, How Noise Trading Affects Informational Efficiency, researchers questioned whether the aggregate trading of retail investors affects the informational efficiency of asset prices. The results suggested a causal link from greater noise trading to the deterioration in equity price efficiency. In other words, the greater amount of retail investors trading a stock, the greater the propensity of inefficient pricing.
Market Sentiment
Market sentiment is the general prevailing attitude of investors as to anticipated price development in a market. If the sentiment is positive, investors expect a positive future where asset prices will rise. If negative, they believe that asset prices will fall. A long-running debate in finance concerns the possible effects of market sentiment on asset prices and future returns. In a 2005 study published by The Journal of Business titled Investor Sentiment and Asset Valuation, researchers found that investor sentiment largely predicts market returns over the next 1-3 years and that this measure can explain deviations from intrinsic value as measured by historical standards. In short, positive market sentiment can cause prices to rise above intrinsic values and vice versa.
Based on our research, there are five major cognitive biases that investors can experience when making decisions under uncertainty. See below for definitions and examples.
Recency bias: the tendency to place too much emphasis on experiences that are freshest in your memory. (i.e. stocks that have done well over the recent past will continue to do well in the future.)
Representative bias: the tendency to make snap judgments on individual assets based on the class of assets they belong to. (i.e. tech stocks make for good investments)
Anchoring bias: the tendency to rely on past information as a reference point when judging new information. (i.e. the stock used to sell for $300 a share and now it’s only $50, it must be a bargain. BUY.)
Conservatism bias: the tendency to emphasize pre-existing information over new data. (i.e. the company had a bad quarter but will turn it around next quarter.)
Confirmation bias: the tendency of people to pay close attention to information that confirms their belief and ignore information that contradicts it. (i.e. seeking bullish articles about a company you already own.)
Motivated Sellers
Investing in the stock market is a zero-sum game. As such, for every buyer who purchases a stock with the expectation that it will increase in value, there is a seller on the other side of the transaction believing it will decrease. So how would a buyer increase their chances of being on the correct side of a trade? One way is to identify what might be called a motivated seller, someone who is selling for a noneconomic reason. When assets are sold for noneconomic reasons, the most common explanation is some type of institutional constraint that obligates the owner to sell.
For example, when a stock is removed from a major index, fund flows decrease and price falls merely because the stock is no longer in the index. Traders who understand the downward pressure of fund flows sell in anticipation of the removal, creating a doom loop. This downward pressure has little to do with a fundamental change in business value, but shareholders will ultimately suffer due to market dynamics. Some other examples of noneconomic selling pressures include spin-offs, distressed debt, and credit rating downgrades. These situations create an institutional imperative to sell due to regulations of what institutions can and cannot own.
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Until next time,
Jack Beiro, MBA
JB Global Capital