Monday, July 28, 2014

The search for inefficient markets - are we all trying too hard?

Time and time again I hear people saying investing is about exploiting market mispricing. Sophisticated investors search the globe to find that hidden gem, that scuttlebutt that leads to the earning beat, the thesis that says "I'm right, market is wrong".  To find market inefficiency, people look for under-covered companies, spin-offs, bankruptcies, penny stocks in Kazakhstan…etc.

I don’t dispute that inefficient names may present better risk/return profiles. But how if you are just trying to achieve some satisfactory return target? Did Buffett shy away from Coke just because it’s one of the most liquid and well covered companies in the world? And how about all these people who made fortunes from Apple, Google, and Microsoft – where’s the market inefficiency in that?

People forget that the market can be perfectly efficient and investors can still make money. I’m not talking about buying the SP500 index. It is conceptually similar though - you’re just picking up that required return on equity.

It’s easier to illustrate this with an example. Let’s say company A disclosed a plan to grow earning at 10% CAGR for next 3 years. The market takes that and builds the 10% into consensus EPS outlook. Here are consensus EPS and forward multiples.

The market assigns a 15x forward multiple to expected year 1 earnings of $1.1, for price of $16.5 per share.  Year 2 forward multiple is thus 13.6x. After one year passed, company achieved its 10% grow and EPS reached $1.1/share. So everything went exactly as planned and market was right. Your model would look something like this:

Mr. Market now looks at year 2 consensus EPS of 1.2/share. Is it going to put a 13.6x multiple on it?  No, market will assign the same 15x multiple if outlook has not changed. So price goes up to $18.2 (15* $1.2/share), a 10% gain from the initial $16.5.  Even if company misses earning, say earnings grew at 9% instead of 10%, and multiple contracts slightly due to lowered growth expectation, you might still make money.

The point is there’s nothing wrong with picking up a nice solid return in plain sight. The blogosphere is full of smallish, speculative names that nobody’s heard off in search of market inefficiency. Not saying those are bad ideas. On the other hand, if your goal is 8%-10% return a year and CVS has a reasonable plan to get you there at a reasonable price, do you really need to say “No, I’m not buying it because 20 sell side analysts already cover it, and everything’s priced in?”.  Or do you say, maybe, just maybe, upon through analysis of industry dynamics, competitors, management strategy, financials..etc,  the stock promises safety of principal and a satisfactory return?

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