On Market Inefficiencies

Where could be better to dig for an overlooked gem of a business than in the small-cap space? Nowhere as far as I'm concerned. This does not mean that there aren't bargains to be found in other areas of the markets, but the glaring inefficiencies in the form of undervalued assets are far more likely to be found where nobody is looking.

An efficient market is likely to have a relative balance of potential buyers and sellers and relatively little emotion from those participants. Thus the larger anomalies of market peaks and troughs coincide with maximum optimism and pessimism in market participants. Where more eyes are fixed on a given security, ultimately its price is going to be closer to its intrinsic value. In general, markets may not be precisely right all the time, but they are approximately right most of the time.

So, where a stock has very few followers, and relatively little understanding of its products out there in the investment community, you're more likely to find something significantly mis-priced than in the over-analysed world of large-cap investing.

Take Lo-Q. I first came across this stock when a friend told me about her family's outing to Legoland Windsor. The family had used a 'Q-bot' device to avoid having to physically queue for popular rides for the day. The device sounded a bit clunky, but the basic service of cutting down physical queuing times struck me immediately as something that society at large would happily pay a decent price for. The other great thing was that remote queuing remained 'fair' to everyone as you had to pay for the service and you joined the queue with the same waiting time as if you had joined the physical queue.

The next morning a technology sector stock screen at work showed the business trading at a very, very low price versus its prior year's earnings and cash on the balance sheet. For some reason the market thought that a business growing at 20%+ a year with £2m of cash and £2m of pre-tax profits (for the prior year) was worth around £10m. Fair enough if that profit level is illusory, but I felt it was certainly worth a little investigation.

Well, 6 months on and there is now over £4m in cash, still no debt, pre-tax profits are at £2.4m and the market cap still reflects a high degree of scepticism in the business model at £13.5m. To be fair the clearing price may actually be higher than the market cap as the brokers won't sell me as many shares as I want to buy - my first taste of the annoyance of illiquidity issues in small-cap investing.

Anyway, it probably helps that I learned the business has survived the attempts of over 20 competitors (all of whom have failed) over the years, but I found this out from a simple phone call. I honestly quite often wonder if many investors go to the trouble of reading an annual report (or even the balance sheet and income statement) before they invest in businesses sometimes. I certainly don't know many private investors who take even 5 minutes to do just that. Peter Lynch once lamented when asked what investors should look for in a stock, "Well, they could start by looking for some profits!”

So, as institutions can’t operate with much less than £20m, say, in assets (1% of which is hardly going to do much more than turn the lights on in The City), any business trading for much less than £50m or so is just going to have fewer people following it. And brokers see no value in producing research on a stock if institutional investors aren’t churning their portfolios through them. So you get some tiny companies growing at astonishing rates, valued as if they about to slide into an imminent decline.

Of course it may just be that you have missed something, but if you’ve done your homework and still think you’ve found a bargain, chances are that you are correct. As Mr Buffett says, “You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right – and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.”