In examining mispriced stocks in financial markets, Jeffrey C. Hood has emphasized the role of irrationality, or the foolishness of the crowd. That’s how psychological biases lead many in the market to succumb to fear, uncertainty and the herd mentality.
But he has also pointed to systemic issues in his book, “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd.” One of those systemic issues is indexation, which can distort stock prices with forces that have little to do with the company itself.
Just being included or excluded from a stock index may lead to mispricing. When a specific sector is expected to do well, many investors will buy indexes for the sector and push up all stocks in it. The same is true, but in the other direction, when investors expect a sector to decline in the near future.
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) was caught in a particular kind of indexation problem during the Southern European debt crisis of 2011. Hood explained, “Consider a situation where company A is part of a sector specific index, but generally does not share the characteristics of that index, or perhaps has much less of those characteristics than other companies in the index.”
That problem was magnified by the fact that Berkshire Hathaway was the largest single component of a financial index in 2011, making up 9.12% of the fund. According to the author:
“This index contained companies such as Bank of America, JPMorgan Chase, Citigroup, AIG, and other financial companies, all predicted to perform extremely poorly in 2011. As a result, as of November 30, 2011 there were 247 million shares short of the Financial Select Sector SPDR ETF (XLF, Financial), which tracks this index. By the mere fact that Berkshire Hathaway was heavily weighted in this financial index, Berkshire had effectively become one of the most heavily shorted stocks in the United States.”
Yet, informed investors knew that while the company had some exposure to the financial sector, it was much more than just that. What’s more, when compared with the banks and other financial entities, Berkshire Hathaway was conservatively capitalized, used little or no leverage and had little, if any, exposure to potential sovereign debt default issues then roiling the market.
Its price was being driven down by its association with the banks and financial stocks that were the real targets of the short-sellers. That association was through the financial index, and not because it was exposed to financial crises among the so-called PIGS nations of Southern Europe: Portugal, Italy, Greece and Spain.
At the same time, it owned a host of thriving businesses including Coca-Cola (KO, Financial) and Geico. But many in the market failed to realize these facts:
“Even though Berkshire did not share the same characteristics as the other financial institutions in the index, it had been subject to the same massive sell-off merely due to its presence in the index. Berkshire stock was hence likely mispriced for at least this reason alone. This is a systemic inefficiency that would form the basis of an inefficient rationale – a rationale for the likely undervaluation of the respective stock.”
A summary
- Consensus view: In 2011, there was considerable concern about the ability of several European countries to meet their debt obligations, leading to potential defaults. That could affect American banks and other financial entities in the near term, which led many investors to sell their financial stocks and for more aggressive investors to short these stocks. All of that was enough to significantly depress their share prices.
- Variant perception: Berkshire Hathaway should not be lumped in with other financial stocks because it had little or no exposure to European debt. It also had been a net provider of capital during the 2008-09 financial crisis and it had a stable of non-financial businesses that would be unaffected by the crisis. Hood observed, “Berkshire’s main businesses will largely be unaffected by this 'crisis,' e.g., people will not stop drinking Coke products or buying Geico insurance merely because Greece is experiencing debt problems.”
- Inefficient rationale: The market was experiencing uncertainty, fear and loss aversion because of the news. That concern included Berkshire Hathaway because it was part of a financial index that was being sold off and shorted. The crowd was unaware that the company’s share price was being driven down by a systemic inefficiency, indexation, rather than real problems.
Hood reported that Berkshire’s A shares dropped from more than $127,00 to less than $100,000 because of the European debt crisis. But it quickly recovered, as this GuruFocus chart shows:
Hood also wrote, “Thus the development of both a variant perception and an inefficient rationale is a powerful combination, providing the investor with considerable confidence and resolve in going against the mainstream consensus, i.e., in making a large bet that goes against the herd.”
Conclusion
In this case study, Hood has provided another example of why it is important to critically examine what the crowd is thinking.
Indexation caused the share price of Berkshire Hathaway to be depressed, but investors with a variant perception would have seen through the irrational behavior of the crowd. The company was being punished—not for something it had done, but for simply being included in a financial index.
As a result, investors who had a variant perception and understood the inefficient rationale were well-positioned to buy stock in one of the world’s great companies at a steep discount.
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: Wells Fargo and the Subprime Crisis
- Inefficient Market Theory: The Tylenol Poisoning Case
- Inefficient Market Theory: An American Express Case Study
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