It's raining cats and dogs outside. My wife and kids are making cookies and pizza and so I thought I'd write a post.
In a prior post, Malx1 touched upon something very important. The market is not efficient.
In this post, I’d like to express why I believe the market is not efficient.
When I was studying finance in university, I was taught that markets were efficient. When I had to take the three-level CFA, again the Efficient Market Hypothesis appeared.
Warren Buffett once said that he is able to beat the market averages because countless students have been taught that the markets are efficient and you cannot beat them so you shouldn’t even try. Finding mispriced securities was easy for him because few other “investors” believed it was possible for them to exist.
These students were taught that
it doesn’t pay to think. Spring is approaching and in that spirit I’d like to turn the topic over to baseball. I assure you there is a point in all of this.
Baseball I’m a big baseball fan. I played organized baseball from the ages of 5 – 24. I love baseball strategy but nowadays I find there is less of it due to the game being turned into a home run hitting contest.
When I was a kid, my older brother enlisted me into playing a baseball board game based on the players’ real life statistics. He needed and extra person to fill-out his three-player league. I wasn’t thrilled about this because I preferred video games but since I really liked baseball, I agreed.
We picked teams out of a hat. Unfortunately I got stuck with the worst team in the NL, the Atlanta Braves who won 63 games and lost 97. I had to face the Oakland A’s who were 99-63 and the New York Mets who were 87-75. I wasn’t hopeful. I played the conventional way and lost my first 6 games. This wasn’t fun.
I had to do something so I put in a lot of time and examined the board very carefully. I noticed interesting things. For example, if my player had above average running ability, different from base stealing ability, and he attempted to bunt for a base hit, there was a better probability of getting on base (either as the result of a hit or an error on the play) than if I had him hit. Knowing this, I traded for players that did not have good batting averages but had above average running ability and I had my players constantly bunt for base hits. I noticed other issues with the board and player cards and exploited them to my advantage. The result was that I finished in first place.
The point is
it pays to think.
In baseball, a right handed batter hits for a higher average when facing a left handed pitcher and a left handed batter hits for a higher average when facing a right handed pitcher. The reason is that the hitter sees the ball better.
The great Baltimore Orioles manager, Earl Weaver, used to employ a specific strategy when constructing his lineup. Not knowing if the opposing starting pitcher would be a right hander or southpaw, he would invariably put his previous days starting pitcher hitting in the third spot in the lineup instead of his DH. When he finally saw if the opposing pitcher was a right hander of left hander, he would still let his pitcher come up to the plate to hit in the third spot. He would then come out of the dugout and call time, walk up to the home plate umpire and remove the hitter (his pitcher from the previous day) from the game. In his place he would put in a DH that hit from the opposite side of the plate that the pitcher was throwing from.
The point here again is that
it pays to think. Note that MLB put in a rule called the Earl Weaver rule that prevents a manager from doing this today. A hitter must have one full plate appearance before he can be removed from the game, unless he must be removed before the full plate appearance due to injury.
I don’t think any more examples need to be given as we’ve probably already reached the point of diminishing returns.
Turning to investing.
Basically, the efficient market hypothesis says all information is already reflected in a stock’s current market price and no amount of analysis helps you to find a mispriced asset because there are no mispriced assets as they are always trading at their fair price. The theory and the university professor that developed it is saying that
it does not pay to think.
The theorists have even come out with three levels of the efficient market hypothesis: The weak, the semi-strong and the strong.
In the strong version, the theory states that not only is all public information already reflected in current stock prices but even that all non-public information (inside information – think Gordon Gekko of the movie Wall Street) is also already reflected in current stock prices. Yes, university professors have too much free time on their hands.
And now, to disprove the silly notion that markets are efficient.
If pressed, I’m sure I could come up with a large number of examples off the top of my head but I’ll focus on one particular situation. It involves a company that I know very well because I’ve been a shareholder since 2004 and it is my single largest holding.
My objective in this post is to disprove the efficient market theory and not to “advertise” the company that I am a shareholder of and so the company shall go nameless.
It is important for you to know that the company is not in the technology industry. It is in a very boring industry. I’ll start by examining the three year period prior to me becoming a shareholder: 2001 – 2003
Year Free Cash Flow / Share Return on Invested Capital
2001 $0.09 165.8%
2002 $0.10 72.6%
2003 $0.10 73.7%
A word about Return on Invested Capital (ROIC): If a company has a ROIC of greater or equal to 15% for more than a five year period, it most likely has a competitive advantage and more digging needs to be done to uncover what it is and how long it can last. Capitalism is basically tearing down the other guy’s business and so competitive forces bring down margins to be in line with industry averages, unless there is a competitive advantage. This competitive advantage allows for higher margins and ROIC. This higher ROIC allows for higher increases in the price of the stock thereby creating outsized returns over time.
Now you can see from the above that this company’s ROIC is off the charts and more than likely will be reflected in the company’s stock price relative to its free cash flow per share. In plain language it should trade at a higher multiple than its peers.
Now we will look at three other categories for this company:
Year Net Cash / share Stock Price Free Cash Flow / EV
2001 $0.26 $0.36 86.0%
2002 $0.25 $0.35 96.5%
2003 $0.29 $0.34 208.0%
The above is off the charts. Allow me to explain: In 2001, the company had no debt and had $0.26 of cash for every share outstanding
and the company was trading at only $0.36 per share. When you strip out the $0.26 of cash per share from the stock price, you are really getting the stock for $0.10 per share and the company is earning $0.09 per share in free cash flow. Unreal. So if you owned the entire company you would be making an 86.0% return (not 90% because this data is from my spreadsheets and I use decimals there) in year one. An aberration you say. Remember markets are supposed to be efficient.
Let’s go to 2002. $0.25 in net cash and a stock price of $0.35. Strip out the cash and you are paying $0.10 for the stock. The company earned $0.10 in free cash flow per share and this provides a 96.5% return (again not 100% due to my spreadsheet). Are markets still efficient?
Now for 2003, where it gets crazier. Strip out the $0.29 in net cash per share from the $0.34 cent stock price and you are paying $0.05 per share for the stock. It earned $0.10 in free cash flow per share for a 208.0% return.
Now, if the industry in trading at a multiple of say 15X free cash flow, you would expect this stock to be trading at much, much higher multiples. What multiples was it trading at?
Year multiple of free cash flow
2001 1.1X
2002 1.0X
2003 0.5X
This stock has been extremely mispriced for three full years. You would not expect that of a company that has a strong competitive advantage with sky high ROIC.
Where is the efficient market now?
Why it took me three years to find this only my psychiatrist knows but I finally came to my senses in 2004 and became a shareholder and remain to this day. The competitive advantage remains fully intact and in some ways has widened.
Here is the pertinent data starting with 2004:
Year Revenues (000’s) Free Cash Flow / Share Stock Price
2004 $15,508 $0.22 $2.15
2005 $18,615 $0.28 $3.70
2006 $22,398 $0.36 $6.55
2007 $30,526 $0.57 $12.80
2008 $34,239 $0.64 $6.85
2009 $51,538 $0.81 $9.00
2010 $66,886 $0.96 $13.11
2011 $78,465 $1.03 $15.21
2012 $96,220 $1.36 $20.20
2013 $101,360 $1.58 $31.50
2014 $115,177 $1.66 $34.95
2015 $145,203 $1.63 $31.47
2016 $191,275 $2.38 $50.16
2017 $276,083 $3.18 $52.24
2018 $353,303 $3.27 $65.58
2019 $550,900 $4.10 $55.92
2020 pandemic $511,117 ($0.23) $51.65
2021 pandemic $551,903 $4.45 $55.19
Notice how during the Great recession the company's revenues and fee cash flow kept on their upward march:
Year Revenues (000'S) Free Cash Flow pe share
2007 $30,526 $0.57
2008 $34,239 $0.64
2009 $51,538 $0.81
This company was trading at such low levels from 2001 – 2003. That should not have happened for a company of this high caliber.
Even in 2004, the stock could be purchased for less than 10X free cash flow, with a high ROIC of 54.7% and net cash of $0.11 per share.
In fact from 2004 – 2015 the company increased free cash flow from $0.22 per share to $1.63 without issuing any debt or any additional shares and had an average ROIC of 44.9%. All of this was accomplishe with cash that was generated internally from operations.
The company initiated a dividend of $0.18 per share in 2011 and it currently stands at $0.84. Think of the investors that bought their shares between 2001 – 2003 and paid something like $0.30. They are getting a 280% dividend yield on their original purchase.
This company in not in the tech industry or biotech or any other sexy industry. It’s in a dull industry but has a very strong competitive advantage of long-duration. The market mispriced this stock from 2001 – 2012. That is twelve years of inefficient pricing and anyone who simply analyzed this company would have seen that it was an incredible buying opportunity.
It pays to think.
Unfortunatle the hypothesis and the professors that teach it say it is not possible to do what I did in 2004 by using the analysis and thinking that I employed in 2004.
The above demonstrates two very important elements:
- The market is not efficient
- What a strong long-lasting competitive advantage can do over time
GH is currently very mispriced. No efficient market there either and over time it will get corrected.