There's an old joke about two finance professors walking down the street and seeing a dollar lying on the sidewalk. One leans over to pick it up, but the other one stops him, saying, "Don't bother -- the market is efficient. If that dollar really existed, it wouldn't be there anymore."
It's kind of a cheap shot. There are plenty of people who take undue aim at the Efficient Market Hypothesis in order to forward their own agendas, including, oh, everyone you've ever seen on CNBC. Let me pay homage to the greats of Fama, French, and their ilk by saying that their hypothesis is certainly one of the great advancements in the history of financial theory.
Me, I believe that the stock market is largely efficient. But "largely efficient" and "totally efficient" are two very different things. If you don't believe this is true, go out and try to play basketball with a mostly round ball.
Rationality or efficiency?
And because we're talking about an ecology that encompasses trillions of dollars, the inefficiencies that exist are, in some cases, worth billions of dollars. They exist because information isn't perfect, the market participants can suddenly lose their diversity in belief, and limits on short-selling mean that companies can become extraordinarily overvalued without sufficient interest on the other side of the trade.
I'll give you an example of how you might take advantage. A few weeks ago, I wrote about some hay I'd made with a position in a small pharmaceutical company called Connetics (NASDAQ:CNCT). The company dropped when it announced that it was in technical default of some of the covenants of a class of preferred shares. I love "technical defaults." They make people lose their minds. This is precisely what happened with Connetics. Five months later, the shares have more than doubled as the company prepares to be acquired.
Basically, the market routinely leaves $100 bills lying on the ground, in copious amounts. Go ahead, pick one up! I can assure you, they spend quite well.
Smart ain't necessary .
What causes these periodic dislocations? Too many things to count. If you remember, the stock market only exists as an amalgamation of the decisions of millions of investors. To me, the market's biggest opportunities lie in information, knowledge, and time.
Warren Buffett has famously said that being a great investor doesn't necessarily require great intelligence. He's right -- there isn't a direct correlation in between smarts and stock returns. But it's sort of easy for him to say that. He's the product of some outstanding universities, Columbia and Nebraska, and he can do discounted cash flow calculations off the top of his head.
Suffice it to say that in investing, smart ain't necessary, but stupid don't help. Smart is what's needed to figure out, as Joel Greenblatt did with Liberty Media (NYSE:L), that there were rights and warrants that offered tremendous advantages over common shares. The market essentially threw money out of an airplane window, and most shareholders didn't bother to look. Joel Greenblatt scooped it up by the barrelful.
But being smart isn't everything. Buffett's right. I stand in awe at the types of opportunities that investors by the score shun because a stock isn't "acting right." If you look across the pantheon of the best value investors, they've piled into companies such as Dell (NASDAQ:DELL), Home Depot (NYSE:HD), and even Wal-Mart (NYSE:WMT) on the notion that they're cheap. And they are -- ridiculously so. But these stocks have been disappointing for years, and so I believe fully that there is a lot of money waiting for these companies to go up before people buy them.
Your advantage
If it can happen in large caps that everybody knows about, it can really happen in international companies that are pretty obscure to U.S. investors. These companies aren't even necessarily small or speculative -- British advertising giant WPP Group (NASDAQ:WPPGY) isn't necessarily a known name to most Americans, yet most would be shocked to know how much of the U.S. ad market the company, along with its French competitor Publicis (NYSE:PUB), controls.
The end result is that investors avoid situations because of apparent risk or unattractiveness, based on factors that have little to do with companies themselves. We've put together a newsletter based on identifying a number of these hidden opportunities for international companies: Motley Fool Global Gains.I invite you to join us as we go around the world, picking up hundred-dollar bills, be they denominated in lira, yen, or rand.
Bill Mann is the advisor of The Motley Fool's newest investing service, Global Gains . We invite you to b ecome a charter subscriber today! Bill owns shares of Connetics. Dell, Home Depot, and Wal-Mart are Inside Value recommendations. Dell is also a Stock Advisor recommendation. The Fool has adisclosure policy.
