Saturday, August 22, 2009

Market Ineffeciency

Value investing is based on the availability of mispricing of securities. It is important to understand the source of these inefficiencies. The financial market today is dominated by professionals that manage money for other individuals and institutions. It is the institutional imperative of these professionals that give rise to most of the market inefficiencies from time to time. One of the best explanations of this imperative I have read is by Jeremy Grantham at GMO in his letter to investment committee in Oct 2004:

Everything important about markets is ‘mean reverting’ or, if you prefer, wanders around a trend. Prices are pushed away from fair price by a series of “inefficiencies” and eventually dragged back by the logic of value.

In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes “keep your job.” Career risk reduction takes precedence over maximizing the clients’ return. Efficient career risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because others are buying.

Prices are eventually pulled back to fair price by the need for the return of each asset class to relate sensibly to its risk. This is the force that exercises a persistent gravitational pull on inefficient prices and this force is generally described as ‘value’. An investor in equities in the ultra cheap markets of 1982 or 1945 who is receiving 10% or 20% a year real return for owning equities will sooner or later get a lot of company to bid down the returns. Conversely, all investors in 2000 faced with a market p/e of 33x, and an embedded return of under 3% a year while bearing full equity risk, will eventually lose heart and sell. A mix of behavioral inefficiencies and value based efficiencies means that bubbles will form and all of them will break.

The problem with bubbles breaking and going back to trend is that some do it quickly and some slowly. So at extremes you will always know what will happen but never when. You will know something certain about the indefinite future, but usually nothing material about the immediate future. This is why asset class prices resemble feathers in a hurricane – all certain to hit the ground, but lord knows when. If the timing was also knowable, it would be an arbitrageable situation: if you knew what would happen and when, then, like a Star Trek “paradox,” it would be anticipated and could, therefore, never occur.

But not knowing the timing creates critical career and business risk, which has molded the business of investing. If you are smarter than most and want to take no career risk, then anticipate other players and be quicker and slicker in execution, or as Keynes said, “beat them on the draw.” Refusing on value principles to buy in a bubble will, in contrast, look dangerously eccentric and when your timing is wrong, which is inevitable sooner or later, you will, in Keynes’s words, “not receive much mercy.”

The more the investment industry has become specialized and the more carefully benchmark deviations are measured, the greater the career risk of moving outside your narrow style. This has weakened the arbitrage mechanism and guaranteed increasingly larger and longer market distortions. Today the challenge is not getting the big bets right, it’s arriving back at trend with the same clients you left with, and GMO, for sure, has not solved this problem. The key investment task is to structure a firm where you can make more of these long-term mean reverting bets and live to tell the tale.

The good news is that human nature, which leaves its mark on all financial markets, will never change and we will always have these great opportunities to make money and have dangerous careers.

Or if you prefer serious brevity ...

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