Opportunity in less efficient parts of the market

October 16, 2024
Written by Sharon Wang
Opportunity in less efficient parts of the market

As published in the Conseiller on October 14, 2024 (In French)  |  Image: Freepik

The efficient market hypothesis states that share prices reflect fair market value. Since everyone has access to the same publicly available information, every known and relevant piece of data is already baked in and reflected in the current price. By this reasoning, there can be no under- or over-valued shares and no incentive for investors to pursue price discovery to try to outperform the general market.  

Not every investor subscribes to this view. Some investors consistently outperform the overall market which gives the lie to the notion that markets are always efficient. For those investors whose goal is to outperform the overall market, exploring the inefficient parts of the market can be financially rewarding.  

Admittedly, some parts of the market are more efficient than others. Large cap stock indices, for example, tend to be quite efficient. One reason for this is, every day, millions of traders and analysts, are following these companies—poring over quarterly and annual reports, attending conferences, and producing reams of analyst reports. This means there is a lot of available information on these companies, and it is reflected in their share prices. But there are other parts of the market, such as smaller public companies, which are overlooked, relatively illiquid, and less efficient and where market prices do not reflect true value.  

The popularity of passive or index investing has given rise to greater market inefficiency. Index funds must comply with certain restrictions. These can include restrictions based on the market capitalizations of the companies they own, or the requirement to buy all representative companies in a sector regardless of their current prices. This disregard for price discovery means that market-cap weighted index funds may contain shares of companies whose prices have risen dramatically, and which now represent an outsize position in the fund, making it less diversified than investors realize. In addition, some types of mutual funds are based on mirroring certain indices. When a company is added or removed from an index, these funds must buy or sell the shares to maintain accurate fund tracking. These trading decisions are not based on the investment worthiness of the companies, but on an administrative requirement. This could lead to a price differential between the company’s value and its current price.  

Inefficiency can arise whenever there is an asymmetry of information about a company. For example, smaller, owner-led companies may be poorly followed by the market. Few people know about the company if there is no analyst covering it or issuing an investment report. At the same time, the owners and senior management know a great deal about the company’s prospects, but this is not yet reflected in the share price. Companies which are underfollowed (by analysts and the financial media) can provide a lucrative investment opportunity because, as the company becomes better known and more widely followed, the price gap is likely to close. This may be one reason why value small cap companies outperform larger companies over the long term.  

Some businesses are misunderstood making it difficult for the average investor to determine fair value. For example, a company may have a core legacy and a new business where growth in the legacy segment is slowing, and this temporarily masks the much-faster growth rate of the new business segment. Investors who do not take the time to understand the relative strengths of the different business segments may misjudge the value of the company.  

Everyone needs love and businesses are no exception! Some companies or sectors are unloved by investors for a wide variety of reasons. For example, the cannabis sector was loved and is now unloved as many investors lost interest. Energy had a long period of being unloved and is now generating investor interest again. Within each of the unloved groups are high-quality companies. 

A caution here: great companies can remain unloved and underpriced for a long time. A catalyst must occur to close the price gap. This catalyst could be internal or external. External catalysts include events such as a merger or acquisition, greater analyst coverage, a large shareholder initiating a proxy fight, or some other type of exogenous event. Internal drivers could include management surfacing the value by raising capital. 

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