December 2020 - Searching for Sharemarket Blind Spots
As an active equity we believe that the market is not completely efficient at accurately gauging the share price of every company, all of the time. An opposing view is described by the Efficient Market Hypothesis, which states that the market cannot be beaten as share prices accurately reflect all relevant information. While we disagree with that hypothesis, we do however accept that the share market gets most companies’ share price right for most of the time, especially if you allow for the share price to deviate by up to 15% from the intrinsic value of the company.
However, we believe the market has blind spots when the share price and the intrinsic value of the business can be quite severely dislocated. Such dislocations can happen to large chunks of the market at certain times. A great example would be early March 2009 when a large portion of listed shares were trading well below the true value of those businesses. Such dislocations do not occur often though, in fact, investors had to wait for 11 years for another such dislocation, March 2020. That is a very long time between blind spots.
The other way to find blind spots in the market is to cast your net wider than the standard “safe” blue chip companies. For example, blind spots can occur at any time with smaller sized businesses, not once every 11 years. Part of the reason for this is that a large number of market participants avoid straying into this part of the market. There are many factors that contribute to this reluctance. One of those is that smaller companies are seen as “risky”. This increased risk comes in a number forms.
Smaller companies can be more prone to going bust. Sometimes they are collapsing, tired and messed up, former market darlings that look like they might implode completely, like Air New Zealand when Ansett went under. The other end of the spectrum is an earlier stage company with a new product or service that is unproven, a situation was in four years ago.
Smaller companies are often very illiquid. The daily traded value of the shares of smaller companies is less than large capitalisation companies, which means positions can take weeks to build and weeks to exit, thus favouring a buy and hold approach. This can be a real roadblock as many investors like being able to sell out of a company in one day of trading. In fact, this is often a mandate stipulation for growth investors, who know that a profit warning for a growth company can be disastrous for the share price.
Smaller companies have less analyst coverage, often none, which means investors have to do their own research and build their own conviction. This can put investors off as it is time consuming and requires a level of expertise.
Smaller companies carry reputational risk for institutional investors as they are not in the main market index. Everyone can hold hands and sing “Kumbaya My Lord” around the campfire while Fletcher Building falls 70%, from $10 to $3, without facing any criticism or questioning because it’s a decent weight in the S&P/NZX50 index, so everyone in New Zealand owned it. But own a company like Macmahon Group that goes from 7.5c to 3c in the space of a week and you look like an incompetent investor because you were the only investor in New Zealand that held it, we know how that feels.
Smaller companies can have a limited operational track record. This is not always true or always relevant. Take IVE Group, an Australian smaller cap company that operates a print and advertising business that just celebrated 100 years. One could argue that it is taking its sweet time to become an overnight success but you cannot argue it doesn’t have a lengthy track record. At the other end of the spectrum, sometimes a business explodes onto the scene with a new product or service that is an overnight success story. As already mentioned, was established in 2015 and investors who waited for it to have a 5-year track record missed out on a fantastic investment opportunity. As an aside, smaller companies are often easier to understand operationally, they are not multinational conglomerates whose own management don’t even fully understand all the moving parts, never mind external analysts.
A2 Milk is possibly the best recent New Zealand example of a small company blind spot. A2 Milk in 2015 was already a $250 million business, but in the following 3 years the share price rose over 2,500% as its operating performance continually caught the market by surprise. Today that opportunity has largely gone, the company is covered by over a dozen brokering analysts, it has one of the largest weights in the S&P/NZX 50 index, it counts Blackrock and Vanguard as some of its largest shareholders. It has moved out of the blind spot into the mainstream where the share market gets most companies’ share price right for most of the time, with a 15% margin of error. The far greater return was there for the active investor that was prepared to do their own research and take on the perceived risks of smaller company investing.