“Edge means generating excess returns because of mispricing”¹
In the first post on unconstrained investing, I outlined the basic rationale and objective behind an unconstrained equity strategy. This post focusses on the importance of investment edge in finding undervalued shares. I will first explain what edge means and then illustrate the concept in practice with a recent example.
The stock market is a collective discounting machine. Every day, lots of hard working investors and analysts examine all the publicly available information, draw conclusions and make buy and sell decisions. The prices that we see on the screen are the net result of all this work. It seems reasonable to assume that most of time these stock market prices will be a pretty efficient reflection of underlying value. In certain situations, however, stock market prices may be wrong. Edge is the ability to identify and exploit these situations. Edge can be analytical or behavioural.
Analytical edge occurs when the examination of the fundamentals leads to a conclusion that is materially different to the consensus view. It is “the ability to systematically distinguish between fundamentals and expectations.”² For example, there might be a powerful growth driver, a hidden asset within the business, or a potential catalyst to change the fundamentals. If these are not reflected market expectations then an analytical edge may exist.
Behavioural edge incorporates the psychological aspect of investing. The herd mentality of the stock market can, at times, cause particular companies or sectors to be subject to heavy buying or selling pressure, resulting in significant departures of price from value. Sometimes, specific circumstances such as index changes or spin-offs cause structural selling pressure as certain groups of investors become forced sellers, again causing price to move away from value.
The best investments often incorporate both an analytical and a behavioural edge. If you have a unique insight into a company and you can also identify behavioural reasons why it might be mispriced then you could be onto something special. A classic example occurred recently in a well-known UK household name: Daily Mail and General Trust (DMGT)3.
Aside from owning the Daily Mail newspaper and (at the time) a collection of regional newspapers, DMGT also owns a number of business-to-business (B2B) media companies. For example, RMS, a leading provider of risk and modelling software to the insurance industry, is a very profitable, niche business that on its own would command a high stock market valuation. Other valuable assets include Zoopla, the online property search business, Daily Mail online, and a stake in Euromoney.
At the beginning of 2012, DMGT shares were very lowly valued. The primary reason for this was the print newspaper business, which had been suffering for years from declines in advertising spend driven partly by the recession, but mostly from migration of advertising spend online. As a result expectations for the company were very low. However, due to the hidden value in the B2B assets, it was possible to demonstrate that the market was applying virtually no value to the print business anyway. Since these businesses were still profitable, the shares appeared significantly mispriced.
Things got even more interesting in April when the company announced that FTSE – the organisation that compiles the main UK indices – had decided to eject the shares from the FTSE All Share index due to the company’s unusual shareholder structure, which no longer complied with FTSE’s requirements for index inclusion. As a result of this, over the course of the following two months, UK index tracker funds were forced to sell DMGT shares ahead of their removal from the index. This caused a very significant (and obviously completely unwarranted) fall in the share price. For a short period of time, it was possible to buy the shares on 7x forward earnings, which in my view was an exceptionally attractive price for a group of decent quality assets.
This example illustrates how the combination of a behavioural factor (the forced selling of shares) and an analytical insight into the value of company’s assets can create attractive investment opportunities. These are the types of situations I am particularly fond of. They offer upside potential that vastly outweighs the downside risk, and as such they warrant backing with conviction. I only wish they would occur more often!
In the next posts on unconstrained investing, I will outline an unconstrained approach to risk and portfolio construction.
1. “Untangling Skill and Luck: How to Think About Outcomes – Past, Present and Future”, Mauboussin, M, 15/07/2010, p.25.
3. This is no recommendation or solicitation to buy or sell any particular security