Seven Patterns of Inefficiency in Pricing of Quality Businesses

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:

  1. The market’s inability to appreciate the probable future value of higher quality businesses with very long runways (something I covered here);
  2. 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;
  3. 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;
  4. The market’s inability to spot an emerging moat that is growing slowly over time (the “boiling frog syndrome”);
  5. 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;
  6. The market’s propensity to misunderstand the integrity of an entrepreneur;  and
  7. 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:

Necessary Arrogance
“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]

19 thoughts on “Seven Patterns of Inefficiency in Pricing of Quality Businesses”

  1. Monitoring the ROC ( Return on Capital ) ratio may be one of the was to turn the spotlight on such quality businesses which are inefficiently priced

  2. Mr Vamsee your selection of stocks looks appropriate to me . Incidentally I find that all these companies are earning ROC ranging from 25% to 60% .Exception is Piramal Enterprises for different reasons .
    I observe that these ” Patterns of Ineffeciancy in Pricing of Quality Businesses ” acts as a formidable margin of safety , even when a quality business is bought at a high price .One rarely looses on buying quality .
    Thank you Professor Sanjay for the thoughtful article .

  3. Thanks for sharing this wonderful piece of information. As the last statement from Seth Klarman’s excerpt above, this framework provided by you would help forming a rationale to explain market inefficiency in pricing quality businesses.

  4. Sir, how about this?:

    “Inability of the market to sidestep the previous track record of a company and be suspicious about turnarounds?”

    1. In my mind, turnarounds come under class Graham-and-Dodd style of investing which has its own patterns of inefficiency of which you cited one.

      Turnarounds must be distinguished with cyclicals. A great business may have cyclical earnings but is unlikely to be a turnaround candidate unless it has suffered from managerial errors which are now being fixed.

      Moreover, statistical evidence shows that Mr. Buffett was right when he said: Turnarounds seldom turn. However, “Seldom” does not mean “never.” The payoffs of successfully spotting a turnaround can be very high but that kind of investing requires a different mindset (and lots of diversification)…

  5. Dear Sanjay Sir,

    Your checklist for searching a pattern of confirmation in a wonderful business makes investing much easy. Can you also write about value traps or checklist to avoid a mediocre business. As all one wants to know is where one can die in investing and avoid that in all possible way.

    P.S: If you already written about it please share the link


  6. Prof Bakshi,

    Thanks for sharing the above. A great read for all value investors. I would also like to draw attention to one other factor which I believe is responsible for the inefficiency in pricing excellent quality businesses. I believe inefficiency also emerges due to the conventionally prevailing valuation techniques & the generally accepted economics and finance principles which rely too much on mathematics and using what essentially is gut feeling in substitute for a ‘scientific model’ is not an acceptable practice in investment management.
    Most portfolio manages have to strictly adhere to portfolio weightages which are churned out by a computer using a mathematical model.And all such mathematical models work on the premise that economics works in a similar manner to hard science, and that past is a perfect (or at least good) predictor of the future. Against all this, if a fund manager decided to allocate a larger portion of his portfolio to a particular stock which he believes is a good quality business, he is putting his own neck on the line. Good performance, which would vindicate him would be taken as an example of luck, whereas any poor performance would be regarded as sheer incompetence, and hence creating incentives to go with the mathematical model.

    Some other factors could be growing popularity of index funds and herd behaviour (safety in numbers)

    Would request Prof. Bakshi to kindly share his thoughts on the above.


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