I wrote this back in 2015.. but its still relevant so I thought I share it:
The underlying assumption behind ALL fundamental analysis is that the markets will eventually recognize the underlying value of the security. If you are long a stock, you believe that there’s a divergence between price and value – and that the markets are incorrectly pricing it below what it’s actually worth. If you are short a stock, you believe that the market is placing a far greater value than whatever the business is actually worth.
In truth, learning how to value a business is the easiest part of investing. Through careful study and due diligence, it is not hard to arrive at an estimate of what a business is worth. The difficulty comes in waiting for the market to recognize what we believe to be true.
The traditional bread and butter approach of a value investor is to find companies trading at a discount to intrinsic value, and then waiting for the markets to revalue them to what they are really worth.
Let me present to you a variation of this, one still anchored from the foundations of a focus on intrinsic value, but borne out of my own experiences from how financial markets work. For us to do that, we need to establish the premise behind exploiting this “market inefficiency”.
Humans are rationally irrational. Even after thousands of years, all of us, regardless of our origins are governed by the same fundamental emotions of greed and fear. Investment opportunities that are widely purported to make money (whether they do so is another question) are often exploited by other people. Witness the junk bond mania of the 1980s, the dot-com frenzy of the 1990s, and the sub-prime crisis of the 2000s.
Thus while we invest on the premise that the price of an underlying security and its intrinsic value will eventually converge, the truth is that for the most part, they don’t. Believing that markets operate rationally is the surest way to folly as they reflect so little of what reality is. In the short run, the stock market is like a voting machine. It’s driven by a herd like mentality – and emotions.
Consider this, while value investors like to talk about investing for the “long-run”, the truth is no one knows just when this revaluation will take place, if it ever does (if you know someone who does, my advice is to run for the hills). It could be weeks, months or years. The whole point of speaking in broad specifics is that it affords us the margin of error seeing that we have no clue when it would happen. We have our rough ideas and our expectations, but they are rarely right. If there existed an exact science of forecasting, investors would have no need of portfolio diversification.
In the real world, prices for most transactions are governed by the fundamental laws of demand and supply. When the number of buyers exceeds the number of sellers, prices rise, and when the reverse happens, prices fall. The deeper the market, the greater the liquidity, the smaller the mis-pricings between the prices of what buyers and sellers demand.
The real investment opportunity comes when the normal state of the markets are thrown into turmoil without warning. Consider for example, panic selling in the wake of market wide declines. The number of sellers who want to get out of their positions far outweighs those who are trying to get into the market. They are highly motivated to get out and sometimes not because they want to, but because they are forced to due to margin calls, excessive leverage etc. You are essentially playing the role of a trader, exploiting the differences in positioning that both parties have.
And that’s why sometimes intrinsic value doesn’t matter at all. If you are a large institutional firm taking a huge short position, and word gets round that you need to get out for your position, you are screwed. The market is going to make use of your need to cover your shorts to extract the highest possible price because you have no say in the matter. It doesn’t matter whether your thesis is right or wrong. Let’s say you’re house is being foreclosed and being auctioned off. Now, the value of your property conservatively valued might be $500,000. But more often than not, you won’t get anywhere close to that sum. You aren’t in a position to bargain. Intrinsic value doesn’t matter.
One of the reasons why distressed debt investing is so profitable isn’t that the underlying businesses behind them are great. They aren’t. Rather investors can pay such depressed prices for their debt that it far compensates them for any risk that they are required to assume. They are placed in a superior bargaining position to demand lucrative prices. If you pay 20 cents for bond with a par value of $1, a lot can go wrong and you can still make a lot of money!
If I could sum this “market inefficiency” in one sentence, it’s that investors should be waiting for situations where the number of sellers far exceeds the number of buyers. This is different from the traditional associated form of “ how copy trade works tips web site”, because it requires you to be highly tuned in to the market. You take on the mind of a trader, keeping up with the latest developments, waiting for situations to unfold. These investment opportunities normally only exist for short spans of time.
Closer to home, let’s take the situation of the locally listed company – Olam.
When word that Muddy Waters had taken a short position in Olam, market value of its listed debt and equity declined considerably in value. Investors were highly motivated to get out of their positions. Like every other time, it was a case of do first, think later. Now, depending on what you though Olam was actually worth, there was a significant chance to buy the same company at a significant discount to what it was trading just a couple of days earlier – literally a contrarian trade with a short time horizon and not one where the holding period was years