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There is a reason for perceived (but untrue) market inefficiencies

Tong Kooi Ong and Asia Analytica
Tong Kooi Ong and Asia Analytica4/7/2022 03:27 PM GMT+08  • 5 min read
There is a reason for perceived (but untrue) market inefficiencies
If we accept that markets are largely efficient, then why does mispricing exist?
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We are certain there are times you have felt frustrated when the price of your stock remains stubbornly below the expected fair valuation and, conversely, when valuations stay inexplicably high for certain stocks, in the absence of any rational reason based on the known facts. We have felt frustrated, too, but we also believe that markets are generally efficient.

The “efficient market” hypothesis says all known information and intelligence are captured in the price discovery process. Therefore, share prices will reflect the companies’ true intrinsic values (at least over the “long term”). Stocks are then aligned based on their risk-reward propositions. And investors — it does not require every investor to have the exact same information or be equally rational — as a whole can gravitate towards this market pricing. In fact, each investor will be different, and they will buy/sell stocks along this spectrum based on their own risk-reward profiles. Clearly, there is a contradiction here.

If we accept that markets are largely efficient, then why does mispricing exist? It does and oftentimes even persists far longer than it should. This week, we attempt to explain this phenomenon by looking at it from a different perspective. The conventional thinking is based on the assumption that all investors and stocks exist in one universe. In reality, stocks are more fragmented — into buckets that appeal to certain types of investors and, in other instances, by geography, regulations and so on. At certain points in time, stocks can move from one bucket to another, resulting in price gains or losses in the absence of any change in facts. What do we mean by this?

In the real world, we know portfolio fund managers tend to focus on largecap stocks that are liquid and components of key market indices, and avoid illiquid, small-cap stocks. This effectively narrows their universe of “investable” stocks, even when they make the rational trade-off between risks and returns. The effect is further compounded by the sharp rise in the popularity of index-linked mutual funds and ETFs (exchange-traded funds) over the past decade or so. Passive funds invest only in stocks that are components of the relevant benchmark indices. And, in reality, active fund managers also benchmark their performances against market indices. As a result, most fund managers crowd into the same index-linked stocks, thereby driving these stocks to higher valuations — compared to their underlying intrinsic values — than non-index stocks. The positive feedback loop will further reinforce price gains, and even higher valuations.

Individual investors, on the other hand, are likely to buy different buckets of stocks — based on their investing methodologies, risk tolerance, investment horizon and so on. Warren Buffett, for instance, is a value investor with a comparatively low risk profile and who is willing to hold a stock for decades. Similarly, the Malaysian Portfolio’s value investing strategy focuses on discovering stocks that are trading at low multiples relative to their intrinsic values — usually small-mid cap stocks, though not necessarily so — with the expectation that value will eventually crystallise. This group of investors are less bound to mark their performances against market indices that would limit options to index-linked stocks. They seek to beat the market based on their advantages in terms of experience, knowledge and analytical skills.

There are also momentum investors, who follow the crowd and take on high risks with far less consideration of underlying values. This group includes the new generation of young investors who equate investing with gaming. They buy stocks for the thrill or sense of camaraderie as part of a community, for bragging rights or celebrity status and, perhaps most importantly, because it is fun. The stocks in their universe — such as fashionable meme stocks trading at sky-high valuations relative to their underlying values — are likely to be stocks that value investors will avoid at all cost. On the other hand, they are less likely to invest in “boring” stocks, even if these stocks offer good value.

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What we are trying to say is that the aforementioned groups of investors play in different arenas, effectively segregating stocks into different buckets. As we have written many times in the past, the stock market is a market for stocks — prices are driven by those who want to buy and those who want to sell. The eventual price is what is transacted. In other words, the market is largely efficient — within the different universes. Of course, these universes are not static. For instance, a stock can move from one to another when it is included in a widely followed market index. When this happens, it is often followed by a sharp rise in share price — not because there is any change to its intrinsic value but because the stock is now in the universe for a large number of funds. As we said, demand and supply. Price typically rises when buyers outnumber sellers and vice versa. What all this means and the implications to investors will be discussed in future articles.

The Global Portfolio fell 4.5% for the week ended April 6. The biggest losers were Builders FirstSource (-11.8%), ServiceNow (-8%) and Bank of America (-7.7%). Grab Holdings (+1.1%) was the only gaining stock in the portfolio. Last week’s losses pared total returns since inception to 45.2%. This portfolio is underperforming the benchmark MSCI World Net Return Index, which is up 55.9% over the same period.

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Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

Cover photo: Bloomberg

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