“Are there pockets of inefficiencies in markets? The answer is yes.”
Michael Mauboussin, Credit Suisse
I recently enjoyed a one-on-one interview with Michael Mauboussin, Head of Global Financial Strategies at Credit Suisse, in his New York City office. The interview is shared exclusively with members of The Manual of Ideas and below is a handpicked highlight from our conversation:
Q. Are there certain patterns that create mispricings?
That’s the key thing we think about: are there pockets of inefficiencies in markets? The answer is yes. In fact, there have to be inefficiencies because there has to be some benefit to participating to offset the cost of gathering and impounding information. Those costs and benefits may be roughly in line with one another, but both have to exist.
What are the pockets of inefficiency? One is when an institution competes with individuals. Where this has been studied carefully, the evidence has come back pretty strongly that institutions tend to do better than individuals. In effect, this is like being the smart player at a poker table. You’re the smarter player, so over time you’re going to take the money away from the less smart players. There was one very paper that reviewed a Taiwanese market. The researchers demonstrated that the institutions gained at the expense of the individuals.
A second pocket of inefficiency is someone selling or buying for non-fundamental reasons. And there are a couple examples of why that may be. One, which is an ongoing thing, has been spin-offs. Spin-offs have been a remarkably good strategy for a very long period of time. Typically, large institutions get this little stub of equity. Often not the prettiest thing, often levered, and rather than deal with it, they just sell it, and that can create an inefficiency for someone on the other side of the trade. That’s another good example. Another one’s a leverage cycle – so if someone’s buying with leverage and then they have to un-lever. They’re getting margin calls, so they’re selling for reasons that are non-fundamental. That’s the second one. And the third one – I’ll appeal back to what we talked about just a moment ago – and that is the wisdom of crowds, and how does the wisdom of crowds become the madness of crowds? The wisdom of crowds can exist when three conditions are in place. One is what we call diversity, so we need the underlying agents, underlying investors to be diverse. The second is a properly functioning aggregation mechanism, something that would bring that information together. And the third is proper incentives.
When one or more of those conditions are violated, the wisdom of crowds can flip to the madness of crowds. By far, the most likely to be violated is diversity. Rather than us acting in different ways, thinking about the world in different ways, we correlate our behaviors, which leads to price extremes. Again, taking the other side of those trades can be very beneficial. Those are some examples of the kinds of things we might articulate as pockets of inefficiencies and, again, the key thing to stress in all those cases is they’re often very difficult to do emotionally. They’re easy to articulate, but they’re very difficult to do emotionally. There’ll be a lot of fibers in your body telling you not to do something. But that’s where the value investor can come out ahead.
(Slightly edited for readability)
A high-quality transcript, complete with links to the referenced studies, is showcased in the current issue of The Manual of Ideas. A complete video is available to our Premium Members.