Portfolio manager says finding mispriced securities is hard and investors must adapt to a changing world
Humility is one of the most important qualities for a successful investor and can prove invaluable when you’re at the “poker table” of market trading.
It’s a view held by Felix Narhi, CIO and portfolio manager at Penderfund Capital Management, who argues that common sense, buy-low sell-high investing often fails to account for behavioural biases and a changing world where data for future business models don’t exist, government regulations are evolving and trades wars have the potential to disrupt markets.
Investors, therefore, have to adapt if they are to find opportunities and mispriced securities in what Narhi called a more volatile “Trumptopian world”.
He said: “One important thing that has not changed in investing is the need to understand the thinking on the other side of your trade. As a default, one should assume that in most cases, the participant on the other side of the trade is very smart and probably knows just as much, if not more, than you do. And if you are unsure if you have a defendable edge, you probably don’t.”
Many aspects of the poker analogy ring true – the targeting of weaker players for “easy games”, the use of math and probability, studying opponents for “tells” and making a move when the odds are in their favour. These are done with the belief that, over the long term, the more skilful will end up with the bigger pot.
Narhi likes the poker-investing comparison but points out the latter is harder and more multi-faceted than poker, a linear game that follows predefined rules. The rules of the market, however, change over time. Much of what worked for Ben Graham in 1934 would not work in 2019, for example.
Narhi explained: “Focusing on the value of tangible assets doesn’t work as well in an environment like today where intangible assets account for the vast majority of incremental value creation. When investing, it is important to replace old mental models that may no longer work so well with new ones that fit the environment better.”
To help investors navigate this complicated environment, the portfolio manager recommends five “easy games” to find value.
Wealth transfers go largely unnoticed
“Corporations make decisions that lead to large wealth transfers from one group of shareholders to another, namely with M&A-related activities, share buybacks and equity issuances. Pay attention to which types of activities and groups tend to emerge as the long-term winners. Act accordingly.”
Compete against participants who trade without regard for fundamental value
“Both human decisions and algorithm-driven (algo) trading move markets. Participants trade for many reasons. It is important to recognize that markets are not purely event-driven. The vast majority of trading today is machine-led. The good news is that sometimes Mr Roboto has just as much disregard for fundamental value as his manic-depressive human counterpart, Mr. Market, because some algos are programmed to only pay attention to price and volume. As a result, inexplicable flash crashes and other bizarre market dislocations are becoming more common. Investors should accept this new reality and be ready to take action on the other side of the trade. Having cash reserves to draw upon in such situations can be lucrative.
Sometimes even fundamental investors don’t care about fundamental value during periods of market stress. They desperately require liquidity irrespective of value. Pay attention to fund outflows during market panics and the fallout from the leverage cycle for potential mispriced opportunities. The well-documented alpha that is generated by spinoffs, which are frequently sold without regard to fundamental value, are also worth studying.”
Compete against participants who use simple decision rules
“The world is complex. Reliance on overly simple and misguided rules of thumb can lead to mispricing. Of note, passive investors are collectively the largest participant in the market by far and they continue to take share. They have no choice but to follow very simple buy and sell decision-making rules. If fund flows are positive, they must buy. If flows are negative, they must sell. This would not be material if this group accounted for only a small percentage of the total market. But they don’t. And as their share grows, so does their influence as the marginal price setting player. Flows into niche ETFs, based on the hot and cold market themes of the day, can have an even more pronounced impact on stock prices. It is clear that the rise of specialized ETFs and passive investing has increased distortion in some corners of the market. Be alert for such opportunities.”
Hiring a specialist when the task requires a generalist
“To a man with a hammer, everything looks like a nail. That is wonderful if you have a nail. But in many situations, you need a more diverse toolkit, particularly to evaluate idiosyncratic businesses with no close comparables, firms with multiple business lines or those pursing opportunities in fast growing, but still nascent industries. In short, compete against the ‘man with a hammer’.”
