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Robert Abbott
Robert Abbott
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Inefficient Market Theory: An American Express Case Study

A true story that illustrates how the inefficient market theory works in practice

November 25, 2019 | About:

To illustrate his new framework for enhanced value investing, Jeffrey C. Hood provided several case studies in chapter eight of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd.”

We touched briefly on the first one in chapter six, the so-called ”Salad Oil Scandal.” In this chapter, Hood further developed the case to illustrate how “variant perception” and an “inefficient rationale” played a part in one of Warren Buffett (Trades, Portfolio)’s brilliant investments. For other information about Buffett and the scandal, see these GuruFocus articles by Rupert Hargreaves and Tannor Pilatzke.

The scandal publicly erupted in November 1963, when a small American Express (NYSE:AXP) subsidiary became aware it had been tricked by a customer. The subsidiary issued warehouse receipts for $40 million worth of soybean oil, and the customer then used those receipts as collateral for multimillion-dollar loans (according to the New York Times). When the customer defaulted on his loans, the subsidiary discovered one tank was mostly filled with seawater and topped off with a few inches of salad oil (apparently, the subsidiary’s inspectors had checked only at the top of the tank). Two other tanks were empty and a fourth was only partially filled.

Brokers, banks, import and export firms and others had been defrauded of tens of millions of dollars and went after the subsidiary, which went broke. And while American Express might have argued that is was not responsible for the losses, it decided it would make good on them to protect its brand.

Given the bad news and many millions of dollars involved, the price of American Express shares dropped from $60 in November 1963 to $35 in early 1964.

Buffett’s variant perception

A variant perception is awareness of a gap between intrinsic value and market value of shares, a gap caused by psychological biases of the crowd. If the crowd drives prices down too far, then it is also an opportunity for a savvy investor.

Of course, Buffett was and is a savvy investor. As Hood observed:

“Buffett’s variant perception was that the monetary loss that American Express was likely to suffer would not bankrupt the company, but rather the American Express business franchise was intact and would fully recover. In fact, Buffett commented at the time that the money American Express was offering to settle the claims could more intelligently be viewed as “a dividend check that got lost in the mail.” As previously discussed, in forming his variant perception, Buffett visited a number of businesses where American Express products were used to convince himself that American Express’ business franchise was intact.”

Hood went on to note that once Buffett thought American Express was still financially strong, he would have likely assumed that “the power force of reversion to the mean” would bring share prices back to a higher level. As it usually turned out, Buffett was correct—the shares reached $73 less than a year later.

The inefficient rationale

According to the author, “Buffett, who understood the foolishness of markets perhaps as well as anyone, also very likely developed his own 'inefficient rationale' as well. His inefficient rationale would probably have been based on his understanding and experience that the market had a tendency to overreact to bad news.”

The inefficient rationale refers to the reasoning why the crowd is mistaken. In this case, Hood attributed the crowd’s overreaction to a combination of uncertainty, fear and loss aversion, which was subsequently magnified by the herd mentality. All of those factors acting together led to American Express’ stock becoming mispriced. He added that during times of uncertainty and fear, most people find it hard to envision “normal, more placid times”; they have a short-term perspective.

A summary

Hood summarized the case this way:

  • The consensus view was that American Express faced a very serious financial situation and had the potential to go bankrupt (at least among uninformed investors and observers). It had an uncertain future and shareholders could experience a loss, so the share price was being severely discounted until that uncertainty could be eliminated.
  • The variant perception was that the company’s franchise remained intact (the subsidiary was a very small part of the overall business). Consumers were still using its traveler’s checks, credit cards and other services, so the overall business was sound. Buffett also ferreted out the fact that the company’s financial resources were strong (Pilatzke reported that at the time, American Express had $263.8 million in cash as well as $515.6 million in security investments at market value, while its liability was expected to be no more than $45 million).
  • The inefficient rationale was that many investors were thinking short term, which prevented them from anticipating a recovery and normalization for American Express. In addition, uncertainty, fear and loss aversion and the herd mentality were responsible for making the market behave irrationally. That meant pushing down the share price too far.

The Salad Oil Scandal helped build Buffett’s reputation as a legendary investor. He was able to avoid the snares of the crowd and find his way to making a very profitable investment. As for the man who perpetrated the fraud, Anthony "Tino" De Angelis, he was eventually sentenced to seven years in prison on fraud and conspiracy charges.

Conclusion

After several chapters of laying a foundation, we now have a clear example of how the inefficient market theory works in practice. It’s not surprising that Hood should have chosen Buffett for his first case study, given that he cited the guru as saying, “The Wall Street analysts are brilliant people; they are better at math, but we know more about human nature.”

To analyze a situation from the inefficient market theory perspective, start by identifying a consensus or mainstream view of a stock in trouble. Second, check for a variant perception, which is a gap between what the crowd believes and what you believe. Third, be able to explain the inefficient rationale, the reason or reasons why the crowd is wrong.

Done well, this approach has the potential to deliver better-than-average investing results.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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