Mythbusters

But wait, Nelson. You’re a value investor. Hell, you even have a whole blog dedicated to value investing. The whole point of value investing is exploiting an inefficient market.  How can you say with a straight face that the the whole notion of market inefficiency is just a myth? Have you pulled an Andrew Hallam and decided to go to the world of indexing once and for all? Oh please, just tell us and stop with this introduction that’s going on way too long!!!!

Geez, relax straw man. Have you tried booze? I don’t normally recommend it, but still. You should try it.

If you spend as much time as I do reading Seeking Alpha, Motley Fool (WHOO! REPRESENT!), Value Investors Club, Gurufocus, and the 31 other investing blogs I check from time to time, you’ll notice a few patterns, especially from the folks who exclusively dabble in the world of large-cap stocks.

Value investors, dividend growth investors, and momentum investors seem to universally love the same stocks. Fiat is more recommended in the value investor community than a mediocre chain restaurant is to tourists. We’ve already talked about how dividend growth investors LURVE the same 40 stocks. We get it guys, you like Coca-Cola. And for whatever reason, growth investors are actually quite okay paying 303030303030303 times earnings for Amazon.com, because by the year 2022 you’ll actually be able to log on and buy yourself love.

When it comes to market inefficiency, there’s the big problem. The vast majority of investors spend most of their working on the 500 biggest stocks in the market. If you combine that with all the pension funds, hedge funds, and mutual funds that are limited to the largest stocks out there because of their size, you have a universe of stocks that’s very well covered.

There’s so much competition in the world of large-caps that you have to be a special kind of delusional to think you have an edge. Hedge funds have all the money in the world to spend on research. The big mutual funds have dozens of research analysts who have already forgotten more about finance than the average investor knows.

Not only are you competing with all of those guys, but you’re also competing with all your peers. Add all that up, and there are probably millions of man hours dedicated each year to trying to figure out whether Johnson & Johnson will outperform McDonald’s. And you really think you’re going to get ahead in this world?

This is why it cracks me up whenever I hear investors who live exclusively in the world of the S&P 500 (or the ~150 largest companies in Canada) talk about market inefficiency. They’ll talk about Exxon Mobil like they have an opinion on it that matters, and it’s so, so, cute.

This is one of the reasons why I hate dividend investing so much, specifically the dividend aristocrats. Not only is it survivorship bias at its finest (spoiler alert: when you drop all the crap from an index, you tend to outperform it), but it’s essentially a bunch of work for no additional result. Since the dividend aristocrats consist of many of the U.S. market’s largest stocks, it’s essentially an index matching exercise with perhaps the benefit of a little lower downside when the market blows up.

No, if you really want to go somewhere where there’s an inefficient market, you have to venture into the world of small-caps.

Go small young man

Let me bold and italicize this next sentence, because it’s really important. If you’re going to pick stocks and you’re not investing in primarily smaller companies, your chance of beating the market over the long-term is practically nil. 

But here’s another TRUTH BOMB for you. Even in the world of small-cap stocks, most are efficiently priced too.

There aren’t as many people cruising the world of small-caps, which makes it more likely that they’re inefficiently priced. But there are still thousands of investors that have scoured the balance sheet of Reitmans or Yellow Media. Your chances of finding an undervalued gem still aren’t terribly high.

Then why value invest at all? Firstly, just because a stock is efficiently priced doesn’t mean it won’t go up. The economy tends to grow, and a management team who consistently tries to improve their business will most likely catch onto something. And secondly, most small-cap stocks are priced efficiently for the short-term, while the market discounts long-term trends.

Besides, buying cheap assets tends to turn out well, provided they aren’t encumbered by too much debt. The potential for upside tends to be bigger when you’re buying stuff that’s already on sale.

There’s a reason why I continue to say most people reading this blog should stick to indexing. It’s hard to find stocks that are inefficiently priced even if you know what to look for. By adding in the handicap of avoiding the small-cap universe, it’s virtually impossible to beat the market. And if you’re not beating the market, why try?

 

Tell everyone, yo!