It’s time to take advantage of mis-priced stocks
If the current market is shaking your confidence, don’t worry – you’re not alone. Right now we’re seeing many lower quality businesses being bid higher, while high quality businesses are getting hammered. Is this a rare opportunity to take advantage of mis-priced securities? We think so, provided you’re willing to ignore market noise and think longer term.
Investors who pursue active equity management implicitly assume that equity markets are not entirely efficient. In other words, we believe that equity markets sometimes mis-price securities, and that an astute investor with stock selection skill can identify and act on these mis-pricings in a repeatable fashion over time.
If we accept that mis-pricing occurs (and as active managers we clearly do), there are some interesting implications that flow from this, and it can be helpful to keep them in mind.
One corollary of market mispricing is that even an investor with the ability to perfectly value every security in the market is not assured of consistent outperformance. If our super-investor buys a security in the absolute knowledge that the market has priced it too cheaply, there is nothing to stop the market from continuing to price it cheaply, and indeed pricing it even more cheaply. Knowing what a stock is worth doesn’t’ tell you anything about when the market may come to agree with you.
We would certainly expect our prescient investor to chalk up some good performance numbers over a reasonable period, but the mechanism that allows that performance (mis-pricing) means that in the short run, performance numbers will be rather more random.
Even the best investors fall well short of perfect valuation insight, and if our super-investor can underperform, you can imagine that a mortal investor who falls short of perfect insight will experience meaningful periods of underperformance. The noise added by the inevitable valuation errors will add to the variability of results, such that luck will play a significant role in shaping short run returns.
With this in mind, a good question to ask is “how long is short run?”. If your investment strategy is producing disappointing results, at what point do you ascribe the results to noise and at what point do you have grounds to think that the strategy is fundamentally flawed?
The answer, I think, is much longer than many people realise. As a rough guide, we believe that a very good manager has perhaps a 70% chance of beating the market in any 12-month period. This implies that in any three-year period, we should expect to find ~1 year of underperformance, but finding two years of underperformance would be well within the realms of probability. For this reason, any assessment of manager performance that covers a period of less than three years is unlikely to tell you very much.
If you find you are tempted to reach conclusions on much shorter runs of data, you are certainly not alone. There is no shortage of industry professionals who fail to appreciate the role of short term noise and the real nature of investment performance numbers. To my mind, being able to cultivate this understanding is one of the hallmarks that distinguishes the genuinely good investors.