Clear Market Inefficiencies vs Differences Of Opinion

NBR Articles, published 18 May 2021

This article, by Te Ahumairangi Chief Investment Officer Nicholas Bagnall, originally appeared in the NBR on 18 May 2021.

Debates between advocates of active portfolio management and advocates of passive investment can get somewhat tiresome, as proponents of both points of view trot out the same old arguments, and often fail to address the point that the other side is making. In this context, I’m somewhat hesitant to jump into this debate. In this article, I give a few current examples of what I think are clear market inefficiencies, and try to contrast these inefficiencies to simple differences of opinion.

Markets sometimes price securities poorly, but many funds aren’t good at exploiting this.

Many people closely involved in investment markets are believers in market inefficiency (a.k.a. mispricing) because they’ve personally seen it in action. A recent example of this was when the share prices of Contact and Meridian were pushed up in late 2020 and the first few days of 2021 because inflows into clean energy ETFs caused those ETFs to buy heavily into their shares. This was followed by the share prices of Contact and Meridian collapsing over the following two months when those companies were down-weighted in the benchmark indices used by the clean energy ETFs. I doubt that any rational person who observed these behaviours believes that the main influence on Contact and Meridian's share prices over that period was an efficient market response to changes in the outlook for these companies' profitability.

Like other market participants, I've seen enough such instances of market behaviour that have nothing to do with investment fundamentals to convince myself that investment markets are at least sometimes inefficiently priced.

But advocates of passive management also have a strong point: in most markets around the world, the majority of actively managed funds available to retail investors have failed to beat market benchmarks on a post-fee basis, such that retail investors have generally been better off investing in passive funds rather than in actively managed funds. Further, some surveys have indicated that retail investors in actively managed funds experience worse results on average than would be expected based on a simple average of the performance of actively managed funds.

Why do investors do poorly in actively managed funds despite obvious market inefficiencies?

To my mind these apparently contradictory observations above can be easily reconciled with the following conclusions / observations:

  • Many market fund managers aren't very good at exploiting market inefficiencies. Rather than looking for obviously mis-priced securities, they convince themselves that they are so smart that they can predict the future better than anyone else for extensively-followed companies. I will expand on this point below.
  • Some actively managed funds give up a lot of performance through poor execution of market trades. They try to enter and exit positions too rapidly, placing orders for volumes that are bound to push market prices around. A whole ecosystem of high frequency traders and proprietary traders feeds richly off the morsels created by how these funds execute their trades. However, this is not necessarily a problem that is restricted to actively managed funds – passively managed funds often destroy even greater value through the inflexible way that they go about executing market trades.
  • Many fund managers charge too much for active management of retail funds. Most fund managers specialising in listed equities will accept large wholesale mandates at fee levels that are just 0.2% to 0.3% above than the costs of passive management, but when retail investors come knocking the fund managers shepherd them into to funds that often charge 1% more than those retail investors would have to pay for passive management. The proportion of fund managers who achieve pre-fee outperformance of much more than 1% per annum in any given decade is too small to justify paying such exorbitant fees.
  • Retail investors are often not that great at picking fund managers. They tend to direct their monies to those fund managers, market sectors, and management styles that have performed well over the last several years, and therefore often end up skewed in exactly the wrong way when the "tide" of market pricing changes direction.
A few examples of inefficiently priced equities

You do not have to search hard to find examples of securities that are almost certainly mis-priced. One common example is that many companies around the world have issued more than one type of security which each carry the same rights to dividends and other economic benefits from the company, but are priced at sometimes quite different levels.  Some examples include:

  • Discovery Inc in the United States has 3 classes of share - A, B, & C - each with the same entitlement to dividend, but differential voting rights. The company has not been paying dividends, and when it buys back shares on market, it has always bought the C shares. At shareholder meetings, the A shares each get one vote on ordinary business, the B shares each get 10 votes, and the C shares get no votes. The C shares have the greatest liquidity, but are currently trading at a 14% discount to the A shares. The B shares are the least liquid class of share, and are currently trading at a 97% premium to the price of the A shares. This is craziness. The economic value of any share is ultimately its right to share in the profits and cashflows generates by a company, and these are the same for all three classes of Discovery share. It is difficult to avoid the conclusion that either the B shares are massively over-priced, or the C shares are significantly under-priced.
  • BHP Billiton is a dual-listed company, with different shares listed in Australia and the United Kingdom. The two classes of shares are both highly liquid and pay identical dividends, but depending on the tax residency of the shareholder, they may be taxed differently (with Australian residents currently enjoying the benefit of Australian franking credits if they hold the Australian shares). Currently, the UK-listed shares are trading at a 19% discount to the Australian-listed shares, which means that dividend yield available to investors in the UK-listed shares (5.13%) is almost 1% higher than the dividend yield available to investors in the Australian-listed shares (4.16%). However, the UK shares may not be quite so appealing to NZ taxpayers, as they miss out on the Australian exemption to FIF taxation rules.
  • In Germany, Henkel's voting ordinary shares are entitled to a dividend that is just 2 cents (1.1%) lower than the dividend paid on Henkel's non-voting preference shares, but the ordinary shares trade at a 14% discount to the preference shares.
  • In Korea, numerous companies have listed non-voting preference shares that are entitled to equivalent or higher dividends as the voting ordinary shares, yet trade at significant discounts. Examples of Korean companies whose preference shares trade at big discounts to the ordinary shares include: LG Corp (21% discount, providing a 0.6% higher dividend yield); Samsung SDI (33% discount, but only a 0.1% higher dividend yield); Hyundai Motor Corp (51% discount, providing a 1.4% higher yield); and LG Chem (52% discount, providing a 1.3% higher yield).

Another common example of apparent market mis-pricing can be found in companies that the market is implicitly valuing at a big discount to the market value of the shares that they own in other companies. Examples of this include: Heineken Holdings (valued by the market at a discount to the value of the shares it owns in Heineken); Samsung C&T (valued by the market at less than half of the market value of the shares that it owns in companies such as Samsung Electronics, Samsung Biologics, Samsung Life, and Samsung SDS); LG Corp (valued by the market at significantly less than the value of the shares that it owns in other companies such as LG Chem, LG Electronics, and LG Household & Health); TBS Holdings (valued by the market at significantly less than the value of shares it owns in other companies); and Keisei Electric Railway (valued by the market at less than half of the market value of the shares that it owns in Oriental Land Co). In each case, a convincing argument can be made that some discount is appropriate, due to tax and cost inefficiencies associated with "holding companies", and uncertainty about what the holding companies will do with the future cashflow that they receive from their listed investments. But in most of these cases, a continuation of the status quo would most likely see an investment in the holding company deliver better long-run returns than investment in the companies that it owns shares in (due to higher cashflow to shareholders), and in each case there is potential for significant upside if the "holding companies" simplified their structures by distributing or selling the shares they own in other companies.

What funds actually bet on

In contrast to exploiting the sorts of anomalies described above, the largest risk exposures of most funds are essentially bets about the future earnings of large companies.

For example, consider the world's most valuable company, Apple. Apple is valued at about 28 times its trailing earnings (which have boomed following the successful launch of the iPhone 12 late last year). This represents a trailing earnings yield of 3.6%, which may rise to something like 4% once earnings reflect a full year of selling the iPhone 12. With outsourced manufacturing, Apple has a very capital-light business model, and is therefore able to distribute about 100% of earnings to shareholders through dividends and share buybacks, meaning that we can probably anticipate total shareholder distributions from Apple of close to 4% per annum. If Apple's valuation multiples remain at current levels, the average annual return that shareholders get from owning Apple shares over the next couple of decades should therefore be almost 4% greater than the compound rate of growth in Apple's profits. (This may be a slightly generous estimate, in view of the fact that Apple’s earnings seem to be close to a cyclical peak. It is also worth noting that Apple’s effective tax rate is likely to increase, which means that growth in post-tax profits will likely lag its pre-tax profitability).

Different investors and fund managers will place different probabilities on different scenarios for Apple's future growth. At the bullish end of the spectrum, some will see a significant chance that Apple can grow its pre-tax earnings a percent or so faster than the 5% per annum growth that Apple is likely to have achieved between its 2015 earnings peak and its (seemingly imminent) 2021 earnings peak – under this scenario, pre-tax returns from investment in Apple shares might be something close to 10% per annum over the next 2 decades. More middle-of-the-road scenarios might see Apple growing its earnings at something more akin to global GDP growth (maybe 4% per annum, implying an annual return from Apple shares of close to 8% per annum), after a slight dip in 2022 as the boom in sales from the iPhone 12 launch fades away. But some investors and fund managers will also consider more bearish scenarios, where Apple's profits could fall significantly, possibly because another company eclipses the iPhone with a more desirable product (in the same way that the iPhone eclipsed Blackberry and Nokia phones) or because courts or regulators could force Apple to license its iOS operating system to other phone manufacturers. In these downside scenarios, long term returns from Apple shares could be zero or negative.

Different investors are essentially placing different probabilities on these different scenarios for Apple's future, and will also have slightly different views on what represents a sufficiently attractive rate of return for Apple shares. In theory, and seemingly in practice, Apple's share price probably reflects an average opinion regarding the range of possibilities for Apple's future growth and the appropriate return that investors should require from Apple's shares.

While we and other investors will have slightly different views about the probabilities for the various scenarios discussed above, it would be bold to conclude that the expectations implicitly built into Apple's share price are so wrong that the pricing of Apple shares should be characterised as "inefficient".

To my mind, the uncertainty that any humble investor should properly have about the superiority of their forecasts for Apple's future earnings stand in contrast to the far greater certainty we can have that (to use one of examples previously discussed) LG Chem preference shares are highly likely to outperform LG Chem ordinary shares over the next 20 years. But many investors and fund managers place great confidence on their ability to forecast earnings for companies like Apple, and therefore take large "bets" based on these views, whilst at the same time having such a strong preference for liquidity or index-inclusion that if they invest in LG Chem (the world's largest manufacturer of electric vehicle batteries), they will choose to buy LG Chem ordinary shares at twice the price that they could have instead paid for the LG Chem preference shares.

A more intelligent form of portfolio construction would aim to scale the size of the positions to the degree of certainty that the fund manager can truly have that they have genuinely recognised a market-beating return.   

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited. Te Ahumairangi manages client portfolios that hold shares in the following companies mentioned in this article: BHP Billiton plc; LG Corp; LG Chem; Heineken Holdings; Samsung C&T; Samsung Electronics; Samsung Life; Keisei Electric Railway; and Apple.

Many investors and fund managers place great confidence on their ability to forecast earnings for companies like Apple, and therefore take large ‘bets’ based on these views