Here are some of broad patterns of inefficiency that I have encountered over the last few years of practicing value investing in better quality businesses:
- The market’s inability to appreciate the probable future value of higher quality businesses with very long runways (something I covered here);
- A niche business which is doing something remarkable but it belongs to an unremarkable, largely unprofitable, commodity-type industry and the market is failing to make the distinction;
- Mispriced B2B businesses which are enormously profitable but remain below the radar because, unlike B2C businesses, their output doesn’t show up in the final product or service;
- The market’s inability to spot an emerging moat that is growing slowly over time (the “boiling frog syndrome”);
- The market’s inability to forgive an entrepreneur “learning machine” who has learnt very important lessons from his or her past mistakes and is unlikely to repeat them;
- The market’s propensity to misunderstand the integrity of an entrepreneur; and
- Because of its intense dislike of conglomerates, the market’s inability to treat as exceptions, the great capital allocators who create well-managed, and highly profitable diversified conglomerates over time.
There are several other patterns that play out in classic Graham-and-Dodd style cigar butts but the above list pertains only to patterns that I could identify with in better quality businesses misunderstood by markets.
I am not citing examples because I don’t want to talk my book. Nevertheless, some of you may find this framework useful in two ways: (1) It may help you relate what you already own to one or more of these patterns; and/or (2) It may help you find new opportunities which conform to one or more of these patterns.
Note: Among other things, this post was inspired by a wonderful excerpt I recently saw from “Margin of Safety” by Seth Klarman in which he writes:
“At the root of value investing is the belief, first espoused by Benjamin Graham, that the market is a voting machine and not a weighing machine. Thus an investor must have more confidence in his or her own opinion than in the combined weight of all other opinions. This borders on arrogance, the necessary arrogance that is required to make investment decisions. This arrogance must be tempered with extreme caution, giving due respect to the opinions of others, many of whom are very intelligent and hard working. Their sale of shares to you at a seeming bargain price may be the result of ignorance, emotion or various institutional constraints, or it may be that the apparent bargain is in fact flawed, that it is actually fairly priced or even overvalued and that sellers know more than you do. This is a serious risk, but one that can be mitigated first by extensive fundamental analysis and second by knowing not only that something is bargain-priced but, as best you can, also why it is so. You never know for certain why sellers are getting out but you may be able to reasonably surmise a rationale.” [Emphasis mine]