(August 23, 2012) — Equity investors must distinguish between fundamentals and expectations, says Michael Mauboussin, chief investment strategist at Legg Mason Capital Management.
In other words, the key to generating excess returns is the ability to distinguish between price and value. Therefore, the most basic question investors must always answer: what’s priced in?
Mauboussin writes: “The key to successful investing, then, is to explicitly distinguish between fundamentals — the value of the company based on financial results in the future — and expectations — the market price and what it implies about those results. This is really difficult for at least a couple of reasons. The first is that normal humans prefer to be part of the crowd and that preference is what simultaneously leads to market inefficiency and an inability to take advantage of it.”
According to Mauboussin, the natural tendency among investors is to blur the distinction between fundamentals and expectations. He notes that when fundamentals are good, investors want to buy; when they’re bad they want to sell.
He continues: “At this point, there should be no doubt that price and value diverge — and sometimes significantly. The problem is in taking advantage of it. And therein lies the key: The very factors that cause market inefficiencies make them difficult to exploit. That’s why finance professors are so smug when they condemn active money managers — the professors don’t doubt the existence of inefficiencies; they doubt the existence of investors who can systematically exploit those inefficiencies (especially after costs).”
Despite the skepticism of active managers, a 2011 paper co-authored by Robert Jones of Arwen Advisors notes that active management will always have a place in “mostly efficient markets.” And while many academic studies indicate that the average active manager doesn’t add value, Jones told aiCIO, “Its [it’s] the combined activity of all these active managers that keep markets efficient and thereby hard to beat, and efficient markets mean better capital allocation, and thus greater growth and wealth for society as a whole.” He concluded, “To reap this huge benefit, markets must encourage active management, which they do by heaping huge rewards on SAMs. Our paper also highlights that it may be possible for fund investors to identify superior active managers (SAMs) in advance based on various metrics and characteristics.”