Thread by @eboroian

There’s lots of discussion on twitter regarding competitive advantage, growth/quality etc. I’ve learned a lot from it.

There is much less on mispricing. Would be interested in starting a discussion on this...

Going back to first principles, why do things become mispriced?

In my experience, there are mainly 2 reasons:

- investors are missing something (analytical, informational)
- investors are exaggerating something (behavioral)

Almost all of the reasons behind mispricing fall into one of those two buckets (although there are multiple forms)

On exaggeration, much time has been spent writing about the psychological factors and the biases that cause investors to exaggerate, ie the ‘why’.

Less has been written about how this happens in practice…

It seems like extrapolation is the culprit in most instances. It can occur at a general level (for instance during a recession, when things are bad, and investors price things as if they will get worse or at least continue to be bad), or at the company specific level

If there’s a mispricing related to this for a buyer, it often (but not always) starts with the fact that there are problems at the company.

The key question relates to the extent to which those problems are temporary vs structural. Perhaps inverting is worthwhile here...

In what scenarios are the problems not likely to be temporary (ie value traps)?

I have approached this from my own experience, and by screening for European companies that have declined 70% or more and never fully recovered, then analyzing them...

Some of the reasons include:

- too much debt (bankruptcy)
- single product in fast moving industry (fads)
- large customer or supplier (going concern risk)
- technological change (obsolescence)
- poor accounting (frauds)
- legal liability (payouts that can’t be met)

- lower barriers to entry (structural competition, low cost)
- poor industry structure (new/different trends, oversupply)
- regulation

Interested to hear of any others I’ve missed!

Then the question moves to: what type of problems are more likely to be resolved/temporary, and how do you anticipate that it’s moving in the right direction prior to it being obvious?

Again, interested to hear input from people

On investors missing things, I’ve noted a few that I think are interesting (outside of the obvious ones like micro caps, frontier markets etc). The first is operating leverage

I’ve often seen sell side analysts (and indeed many buysiders – including me) not model this correctly

either because of duration (ie they don’t look out long enough), or in terms of magnitude (they get some of it, but not enough).

For example, I remember looking at Rightmove years ago. I read quite a few notes on the company. Quite a few analysts got the growth right

Despite commenting on fixed cost nature of business, not a single analyst was even remotely close to the 2000 bps operating margin expansion we’ve seen. I’m not sure why (time horizon?). Maybe forecasting margins expanding to this extent would be seen as ridiculous by clients?

Either way, I think that there are mispricings to be found looking for resilient advantaged businesses with long/structural growth runways that have a high proportion of fixed costs. If the growth goes beyond 5 years, it’s likely missed on margins, or FCF when reinvestment slows

Another situation where things might get missed, which is quite well documented, and thus perhaps becoming less relevant, is spinoffs. But not any spinoff.

I’ve found that things get missed most in three situations:

- spinoff is a much smaller capitalization than the parent
- spinoff in a different segment/industry to core business
- spinoff has different geographic exposure

In each case, the historic investors are likely to sell almost irrespective of fundamentals, which are thus missed

– but only if they’re of decent quality. Some recent examples of this include Lamb Weston, Post holdings, Epiroc etc… In some instances, if the spinoff is of low quality, then the parent might be mispriced (Philips)

Another type involves companies that invest mostly via the P&L, for example via customer acquisition costs or R&D.

The company under-earns over the short term, but the NPV of those investments is potentially substantial. Recent examples of this include Netflix, Zooplus etc.

Would be very interested to hear what other people have found to often get ‘missed’ by other investors and why?

Or any other views and experiences people have on mispricing, including any interesting reading material. Thanks!