Value investors and others have developed methods of finding underpriced stocks, securities that have temporarily dropped out of favor with most of the market.
In chapter six of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” Jeffrey C. Hood added another method: using the foolishness of the crowd to identify areas where bargains might be found.
With more than 50,000 stocks traded publicly around the world, finding the bargains among them is a challenging job. That’s further complicated, according to Hood, by the fact that “for all our discussion of market efficiency and the Foolishness of the Crowd, the stock market is largely efficient. The degree of efficiency of the market depends in large part on where it stands in the current cycle or movement of the pendulum.”
The “foolishness of the crowd” is a phrase used to capture the irrationality of investors. For example, when the herd mentality infects many investors at the same time, there will be many market inefficiencies available to investors. Hence, Hood’s reference to the pendulum, a metaphor for the way the market swings from a boom extreme to a bust extreme, and back again.
The author proposed using the foolishness of the crowd, and our knowledge of it, as a tool for finding bargains. He wrote, “This knowledge of why the market is not efficient will directly lead us to an understanding of where to look for these inefficiencies.”
Hood began the process with a story told by Michael Mauboussin of Credit Suisse (CS), a story about Jim Rutt, the CEO of Network Solutions (now delisted). In hopes of becoming a better poker player, Rutt had intensively studied the game, trying to learn all about it. Eventually, an uncle gave him some important advice: Quit trying to get better and instead spend your time trying to find weak games. In other words, look for and only play in games involving less competent players.
And that is what Hood is recommending to investors. Find areas in which making winning investments is less challenging. It’s a strategy that’s well known to Warren Buffett (Trades, Portfolio), who said, “I don't try to jump over 7-foot hurdles: I look for 1-foot hurdles that I can step over.”
While becoming a more skilled investor is important, one can also search for areas in which the foolishness of the crowd is more likely to appear. Hood wrote:
“Perhaps the easiest and most important thing that an investor can do to improve his results is to intelligently select areas in the market where inefficiencies, the deviation of stock prices from their underlying intrinsic values, are likely to occur – where market participants will likely have made mistakes in valuation. The investor can then focus his valuation skills on this much smaller, focused universe of potential investments. This universe will by definition contain a much higher percentage of mispriced securities, greatly improving the investor’s chance of selecting good investments.”
Hood argued that some forms of market inefficiency seem to permanently exist because of the short-term orientation of most investors, size limits affecting big mutual funds, fund portfolio constraints and the rise of indexation.
Thus, we would expect the large-cap segment of the market to be relatively efficient because they are big enough to qualify for mutual and pension funds and to be included in market indexes.
On the other hand, smaller companies, especially those with owner-operators and large insider holdings, will be in an area that is relatively inefficient. Hood wrote, “For example, companies run by owner operators with larger insider ownership will often be somewhat underpriced in the market, simply because the large insider ownership results in less overall market liquidity of the stock, thus either reducing the company’s exposure in the indexes or preventing it from being included altogether.”
Markets as a whole tend to be less efficient when emotions run high, that is when fear and greed are extreme. In such situations, he wrote, “What we will quickly discover is that usually it is not just a single factor, a single aspect of irrationality or foolishness, that is producing a mispricing in the stock market. Rather, in most instances a number of different aspects of irrationality combine together to create a Lollapalooza effect, a magnified irrationality effect caused by a number of self-reinforcing aspects of foolishness acting in concert.”
When emotions are high, stocks in the market’s favor will likely be overpriced, while stocks that are out of favor are likely to be underpriced. In the case of out-of-favor stocks, they become underpriced because the market overreacts to what is often a temporary setback. In turn, overreaction is driven by mishandling of uncertainty and the often-mistaken belief that the negativity will continue well into the future.
Hood explained, “When a company is facing problems and the potential for loss is present, uncertainty issues, loss aversion and herd mentality work together to cause people to engage in panicked selling. This panicked selling is for the most part divorced from price.”
Investors who are comfortable with the stock’s longer-term prognosis will buy at the discount price and then depend on reversion to the mean to bring about a recovery over time. A classic example is Buffett’s investment in American Express (AXP, Financial) after it was hit by the “salad oil scandal.”
A shady character had stored containers, theoretically full of salad oil, in a warehouse owned by an American Express subsidiary. The warehouse receipts were then used as collateral for something like $150 million worth of loans. However, the containers were discovered to be mostly full of seawater, with just a bit of vegetable oil on top. The subsidiary was pushed into bankruptcy, and American Express stock took a deep dive.
The company recognized its reputation was at stake, and thus took action to satisfy all liabilities. While all this was occurring, Buffett was watching and waiting. He did his own analysis and investigation, determining that the company would survive thanks to its credit card business. He invested heavily, using 25% of his partnership’s assets, and against the herd. The rest, as the saying goes, is history and the Buffett legend grew even more.
Hood advised that one of the ways of finding companies in difficulties, possibly short-term difficulties, was to search for companies hitting 52-week lows.
Conclusion
In chapter six of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” Hood offered a path toward identifying market inefficiencies that lead to underpriced stocks.
In particular, he has demonstrated that we can help ourselves get better results by choosing to invest in areas of the market where inefficiencies are most common. Examples include smaller-cap stocks and companies that are in short-term jeopardy.
By focusing on areas of the market where inefficiencies are most commonly found, investors are able to gain an edge. It’s a strategy that has served Buffett extremely well for many decades.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Inefficient Market Theory: The 'Foolish Offset'
- Inefficient Market Theory: Drivers of Irrationality
- Inefficient Market Theory: Knowledge and the Wisdom of Crowds in Financial Markets
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