Being a contrarian is one thing; being a knowledgeable contrarian is another.
As Jeffrey C. Hood pointed out in chapter seven of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” successfully investing against the herd demands some sophistication. To help his readers develop that sophistication, Hood provided a three-plank approach.
Before we get ahead of ourselves, however, the first step is to do a fundamental analysis. He wrote, “There is simply no substitute for estimating the value of the business and insisting on a large margin of safety between your estimate of intrinsic value and the asking price of the stock.”
It’s important that we do these analyses thoroughly because we will be tested on our conclusions: We are buying or selling when most investors around us are doing the opposite. Being a contrarian means being out of step with conventional wisdom and that can stimulate self-doubts. But if you are confident there is a significant gap between your valuation and the market price, then you know there may be an opportunity.
Awareness that a stock is mispriced is called the “variant perception.” It is one of three planks provided by the book; the others are the “inefficient rationale” and positive social influence.
Variant perception
Hood framed his case this way: “In general, in order to make outsized gains in the stock market, the investor must 1) take positions that are contrary to the general consensus; and 2) these positions must be “correct” from a valuation and margin of safety standpoint.”
To support the first argument, he pointed out that if an investor believes a company is likely to grow faster than the market—and everyone else believes the same thing—then this outstanding earnings growth will inevitably be factored into the current stock price. To generate those outsized gains, an investor must do something the crowd is not doing.
The author reported that the term “variant perception” was popularized by successful hedge fund manager Michael Steinhardt. In his book, “No Bull—My Life In and Out of Markets,” Steinhardt explained to an intern that he should be able to provide four pieces of information in two minutes:
- The idea.
- The consensus view.
- His (the intern’s) variant perception.
- A trigger event.
Steinhardt indicated the difficulty of the process by referring to it as “No mean feat” and added that if there was no variant perception, he was not interested. He would reject a solid growth recommendation if it was “within consensus.”
Hood summarized, “Before making an investment, the investor should be able to identify a variant perception or contrarian view about the company and its prospects that is different from the consensus or market view.”
The inefficient rationale
Having a variant perception means you are at odds with the crowd, but can you explain why the crowd is wrong?
That’s the challenge that’s known as the “inefficient rationale.” Hood wrote that investors should ask, “Based on my understanding of the wisdom of the crowd, and in particular my understanding of the criteria necessary for the wisdom of the crowd to be applicable, what is the explanation as to why the crowd wisdom is incorrect – why is the market mispricing this stock?”
Being more specific, he went on to state that a contrarian investor needs to know why members of the crowd are selling for reasons other than price. What behavioral or systemic market inefficiency or inefficiencies are producing an incorrect price?
“In addition to developing a well-founded viewpoint or thesis that is the contrary to the mainstream crowd (the variant perception), the investor should also develop a rationale or thesis, typically from a psychological standpoint, as to why the mainstream crowd is wrong (the inefficient rationale). Armed with this rationale as to why the wisdom of the crowd is not reflected in the current stock price, the investor is better able to identify or confirm such mispricings and is poised to act with conviction when such mispricings are identified.”
Social influence
Hood begins this section with a powerful subheadline: “Using Social Influence to Your Advantage – The Wisdom of a Select Crowd.”
Social influence is based on the idea that people generally look to others to know how to think and act. Hood pointed out that this is often a useful mental shortcut because of the wisdom of the crowd. However, it is not always true or accurate. Sometimes social influence will lead us over a cliff with the rest of the herd. So we have a dilemma.
But there is a solution. He wrote, “Here it is critical that the investor turn what would normally be one of his biggest disadvantages, the influence of the irrational crowd, into perhaps one of his greatest advantages. The way to turn social influence to your advantage is by selecting a smaller, more intelligent crowd to join and follow.”
In other words, join a crowd with which you share value investing principles and share “at least a partial understanding of the nature of the Foolishness of the Crowd.” Obviously, you have found such a community at GuruFocus. With that came a couple of recommendations from Hood:
- During big market declines and gains, you have an opportunity to “read intelligent commentary from others about the foolishness of the market” and interact with others who have similar issues.
- Follow the actions and opinions of great value investors when the markets are overly irrational. While their thoughts should be viewed with what Hood called a “critical, skeptical eye,” their information will be of more value than that of conventional financial news.
In a summing up moment, he wrote:
“Thus the investor can gain the benefit of the true wisdom of an intelligent crowd – the wisdom of a smaller value investing crowd which understands: a) fundamental valuation (and hence is able to formulate an intelligent variant perception) and b) the criteria for market inefficiencies (and hence is able to formulate an inefficient rationale). Unlike the mainstream crowd, such a value-investing crowd will generally not suffer from any type of Foolish Offset that would obscure its wisdom.”
Conclusion
With these three planks—value perception, inefficient rationale and the social influence of a wise crowd—Hood has laid out a framework for his inefficient market theory. It is a theory that at the same time builds on and challenges the efficient market theory.
All of this presumes that investors do a good job of fundamental research; after all, an investor can hardly have a variant perception without a confident intrinsic valuation.
In the next chapter, Hood will take us through several case studies illustrating the role of the variant perception and the inefficient rationale in several classic corporate disasters.
Read more here:
- Inefficient Market Theory: Finding 'Foolish' Bargains
- Inefficient Market Theory: The 'Foolish Offset'
- Inefficient Market Theory: Drivers of Irrationality
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