Investors seek certainty, a desire to know what tomorrow holds. Discounting future earnings demands an element of predictability with cash-flows. In reality, there is no certainty of what tomorrow will bring regardless of what we believe. After all, how obvious was Brexit or the Trump Presidential victory? How many times was the Fed going to raise rates until they didn’t?
There are two factors to consider with information. First, is it accurate? For example, initial reports of the tragic accident in 2015 of Malaysian Air flight 370 had the fatal crash occurring in the South China Sea. Once disproved, reports pointed to a possible sighting of the aircraft in Pakistan, then possibly an Indian Ocean resting place. While in fact, to this day, almost two years later, the whereabouts of this doomed flight are still uncertain. When the news was first reported, global markets reacted predictably. Yet, the fact remains, the information upon which market participants acted was wrong. The second factor to consider is when correct information is misinterpreted. This scenario is harder to pinpoint because it is generally recognized retrospectively. Misinterpretation of facts is the cornerstone of market inefficiency. Let’s take a hypothetical situation in which we assume a bona fide piece of data is released and broadly known by all market participants. If participant ‘A’ interprets this known accurate data point to have a positive implication while participant ‘B’ concludes the opposite, then each would likely react in a different manner. One might BUY while the other might SELL. To some degree either A or B will have in fact interpreted the data more correctly than the other and thus have gained an information advantage.
Evidence suggests that information is imperfect and the future is difficult to predict. A well-known industrial automation company recently announced its 2016 Q3 earnings news. The table below shows how real market participants reacted to the news, which was released some 90 minutes before the stock began trading, suggesting participants had ample time to read, review, and analyze the information in advance of reacting. With such advance notice, we believe the trades below were not a “ready, fire, aim” response:
|Prior Day (11/2) Close:||$18.84|
|Opening Trade:||$18.10||trades down from prior day close by 4%|
|Low Trade:||$15.54||immediately trades down by 15%|
|High Trade:||$18.53||gradually trades higher (+20% from low trade)|
|Closing Trade:||$18.10||closes day unchanged from opening trade|
|Current (11/25) Price:||$22.09||+22% from 11/2 close (over about three weeks)|
Master investor Seth Klarman, in his classic text Margin of Safety, makes the following observation about investing:
It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. Investing would be much simpler if business values did remain constant while stock prices revolved predictably around them like the planets around the sun. If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot.
A minority of investment professionals have been able to gain a consistent information advantage which has resulted in above average rates of return. Rather than thinking of this group as outliers it is more probable these investors simply have had the conviction and courage to think independently. They have made correct analytical conclusions more often than not, particularly when the relative importance of the decision amplified the return on investment.
Regrettably for many investment professionals and individual investors, a preponderance have come to believe that achieving an “average” rate of return is a worthy objective or goal in the capitalist market system. This prevailing belief is evidenced by the extraordinary shift of investment assets into a passive indexed based investment strategy. What this means is investors have come to accept that it’s not worth trying to analyze investments to exploit pricing inefficiencies as illustrated above in the stock table – which has become a normal reaction by market participants. To further support this banal strategy, many of Wall Street’s largest brokerage institutions have perpetuated this behavior with marketing material supporting a so called Efficient Market Hypothesis as well as a low cost fee proposition that diminishes the value of professional investment advisors. Or, as William James said, “There’s nothing so absurd that if you repeat it often enough people will believe it.” The marketplace has become overwhelmed with product salesmen pushing unsuspecting investors into passive index strategies.
A recently published and widely acclaimed text, Concentrated Investing by Allen Benello, extols the advantages of holding relatively few securities in a portfolio. Benello documents a variety of notable investors who achieved above average results in large part as a consequence of having concentrated portfolios. Once again, this evidence contradicts the currently popular Wall Street advice to hold an excessively diversified portfolio of securities across industries and asset classes. This dubious but popular advice comes from many entrenched financial institutions.
Part of the challenge for every investor is separating fact from fiction. Hard and accurate data is critical to meaningful analysis. Good research and analysis is essential to producing above average long-term investment results. However, what was correct today may not be so tomorrow. Good research and analysis requires constant review and updating. Companies generally report earnings on a quarterly basis, so nearly all company earnings analysis is stale after 91 days. Not only do analysts need to correctly interpret news, but they need to perpetually review and update their analysis.
Because of the intensive work required to monitor and analyze each company, and the need to be correct more often than not, holding relatively few securities in a portfolio is not just logical, it’s a precondition for outstanding results. In fact, to the extent an investor has a high level of confidence in his analysis, the need for overly-broad diversification is minimized.
Misinformation, incorrectly interpreted information and investor emotion all contribute to pricing inefficiencies. We live in a world in which precise measurements are desired. This often collides with the imprecise discipline of security analysis and valuation. Alert, thoughtful investment analysis and proactive portfolio management create circumstances under which investors can generate superior long-term returns on investment.