The market is never efficient

By | November 28, 2017

(This article was originally written in Chinese and published here. Please pardon the inaccurate translation here from original article)

In 1970, a man named Eugene Fama put forward the theory of efficient markets, believing that any open market information has been reflected in the prices of real-time financial products (stocks, bonds, etc.) and therefore individual investors have no chance of beating the market. As soon as this theory was introduced, there was a lot of support (including some fund managers who could not explain why they couldn’t beat the market), and many others built many theories using market efficiency as foundation, most notably the modern portfolio theories such as CAPM models and Efficient Frontier Hypothesis. Such theories quickly dominated the textbooks of business schools, and groups of brightest and smartest finance major students pretty much grew up with these theories.

This has given countless opportunities for value investors to make money.

Why? Because when a market crash, or a stock plunge, without these theories, who will become a seller? Only these MBA students at Harvard/Yale/NYU, who grew up with these theories, are calling their stockbroker to “Sell! Sell! Sell! Because the market is working, all the information is there! There must be a reason for the sell-off! ” Value investors therefore happily buy those quality companies from them at a heavily discounted price.

Similarly, as the market keeps rising, the same group of people will keep buying – “Buy! Buy! Buy! Behind every FANG stock (Facebook, Amazon, Netflix, Google) because the market must know what we do not know, Even if they look high valuation, but who I am, I do not know what the market is aware of, so the price must be soaring for some reason! “So the value of investors will graciously unload their overvalued positions to these group of “financial professionals”.

It should be said that Fama’s followers helped true value investors add a great deal of alpha in their historical track records.

I will use my four examples of the past two years to illustrate how the market is not efficient, in fact, probably the most emotional buyer/seller that you may ever deal with. Note: There are two types of companies in my portfolio. One is a great company with fair price and one is a fair company with great price. The latter is generally from opportunities in a volatile market. In the past two years, due to the bull market and huge amount of funds looking for opportunities, we were extremely cautious about such tactical play. We only invested in four opportunities which can demonstrate market inefficiency, in case you suspect selection bias. In addition, some of these four examples I still hold or increase position, while others may have been note. We will not update this article in future if any of such positions were increased or decreased. 

  1. Lumber Liquidator (NYSE: LL)
    LL mainly buy flooring / carpet and other similar products. They have stores in 46 states in the United States, with more than 1,000 employees. In 2013, LL was questioned by consumers about the presence of certain harmful carcinogenic gases in some of its low-cost laminate flooring introduced from China. Some consumer rights lawyers accused that a number of cancer cases were related to the laminate flooring they sell. Meanwhile, the U.S. Commerce Department is investigating whether they are in violation of Lacey’s Act. Lawsuits, coupled with the late CEO’s inefficient handling of such negative news, led to a fall in its share price from $ 120/ share in early 2013 to nearly $ 12/ share in early 2016. After the CEO suddenly disagreed with the board of directors, the stock price was under pressure. Tom Sullivan, the founder, returned to work as a temporary CEO to clean up the mess.
    LL started to attract our attention in early 2016. After conducting a balance sheet (public information) study, we concluded that the price of $ 12 / share is well below the company’s liquidation value and that there is also a margin of safety (a discount on inventory). Also after we looked at all the legal trial material (all in public information), we think the company’s valuations are still low, even after doubling LL’s own lawsuit losses. So on May 13, 2016, we recommended LL. The closing price of the day was $ 11.34.
    As of 2017/11/17, closing at $ 29.06, investors enjoyed a cumulative return of about 156% in a year and a half. I need to be grateful to the former shareholders who sold us LL at $ 11.34. At the same time, thanks to Fama for producing excellent people who are dealing with us.


  1. Atwood Oceanics Senior Debt
    2015-2016 Although the macro-US market is relatively stable, the same can’t be said for energy companies. Oil prices continue to decline, lots of highly levered oil companies have closed down or started debt restructuring. The market is pessimistic about such companies (note that this is a big premise, pessimism). Atwood Oceanics is a company that builds drilling rigs. The entire industry is affected not only by crude oil prices but also by shale oil using new lower cost drilling technology. The situation arose: its senior debt matured in 2018, during which stable contract revenues far exceeded the debt interest requirements and sufficient common stock and other subordinated debt obligations to keep principal safe while Their senior debt is only due to a pessimistic market, with a price of 75 and a yield of 9%. Based on this opportunity we have no reason to refuse, so start 75, less than a year market price of oil to reply, the mood turns steady, 95 to leave. Less than a year price return of 26%, 9% return on interest and 35% total return, the risk is in the senior debt level, with Common and other sub-pave the way to provide the principal margin of safety.
    Note: All these analyzes are conducted on open market disclosures. Some of the data have been disclosed for a certain period.
    Another note: We also looked at the Common Equity valuation, at the time was about $ 6 / share, attractive but speculative price. This company was recently acquired by a competitor for $ 10.7 / share.

  2. HRTG hurricane panic
    HRTG is a major insurance company covering Florida. In early September 2017, Hurricane Irma is expected to land at Cat 4 to Cat 5 near Miami, on the southern tip of Florida. For some time markets have panicked and all Florida insurers and Reinsurance are being sold wildly. HRTG was immediately sold low for $ 1 / share, from the previous $ 11.2 / share to $ 10.2 / share and HRTG had about 30 million of common stock. That is, the pricing of the market at that time thought the company would lose a market value of at least $ 30 million. The next day, the market continued to panic selling HRTG shares once fell to $ 9.2 / share, which means the market believes the hurricane will cause a loss of $ 60million in market value. However, it seems that no one cares about the public information:
    1) HRTG has been selectively avoiding certain regional policies in the past year mainly because they do not see future hurricanes, but because they think that there is too much hot money in the market and insurance policies are not enough to cover the commitments risk
    2) HRTG has long purchased Reinsurance of over $ 20million up to 2 Billion unless the hurricane caused more than three times the loss of Hurricane Andrew and HRTG lost $ 20million, or $ 0.67 per share.
    3) HRTG has unused short-term lending channels, and their Reinsurance providers are high-quality, high-credit-rated reinsurers.

So when the market thinks that HRTG will lose $ 60 million or $ 2 / share, we keep those panic selling at $ 9.35- $ 10.25. The rest is history.
Note: It is noteworthy that the price jumps back to $ 12 / share as the market admits overly pessimistic about Irma’s estimates before management hurriedly announced the acquisition of a Northeast-based insurance company to diversify its Florida concentration, This was the right strategy, but it was ignored before, so after Irma, the market valued some of the company’s management’s right strategies and the stock reevaluated. At present I think the valuation is reasonable, slightly high.


  1. retail business e-commerce panic
    Since 2016, Amazon has almost become the killer of stock in all retail companies. Every time Amazon releases a message: I want to enter this area ~ the retail stock in this area will be sold first say it. The United States has a saying called “Shoot first, ask question later”. In particular, ETFs are becoming more common nowadays. Both ordinary investors and institutional investors are focusing what they call “Sector Exposure” (which is also an irresponsible strategy), but giving more space to value investors. Imagine if there were 20 companies in an industry in the S & P 500 and some of the ETFs tracked those companies. Once someone bought and sold the ETF, all the companies were bought or sold at their market capitalization. The result is those with the largest market capitalization, which typically receive the largest amount of money in such payouts or sell orders. However, the market value is really proportional to the business situation? Or, if an industry is considered pessimistic in the future, there will be some mergers and bankruptcies. Is not it that such leaders in industries with lower borrowings and larger market shares are more likely to survive or even be better?
    So after about two years of pessimistic sales, many good retail companies have highlighted the value. As this case involves a larger position in the company, and is in a sustained overweight, not with the specific code here as an example. Our clients will read the detailed analysis in the quarterly report. What can be said now is that retail stocks can earn high returns (of course, the premise is that the correct judgment of individual stocks, due to the industry in transition, requires a rigorous fundamental analysis).
    To illustrate the issue, the company currently does not have any hot technology stocks in its portfolio, but retail stocks outperformed this year’s S & P 500 index by more than 8%. This means that YTD 20% -30% level.


Finally, a brief summary: the market has never been effective. Anyone who tells you that any other conclusion may be trying to sell you something. Emotional volatility in the market is the greatest opportunity for value investors, of course, the prerequisite is that you have already done your homework, have liquidity and can mentally handle it.

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