Mispriced Stocks

We believe that over time, stock and bond markets are essentially efficient (priced correctly). However, we also believe that inefficiencies can exist, especially in the pricing of stocks, over shorter periods of time. In fact, mispricing can and does occur every day.

This happens because investors, driven by their emotions, often overreact to good news – and to bad. They also overreact to a stock’s recent price performance, expecting that it will continue rising (or falling) forever. As a result, stock prices tend to fluctuate with more volatility than the underlying company fundamentals.

Over time, the market is efficient enough to recognize companies that have been penalized too harshly or valued too richly by returning its stock price to a valuation that is more in line with what the company is really worth. We call this reversion to the mean and we aim to take advantage of it through “systematic investing” – a disciplined and transparent investment selection process that has no emotional attachments or biases.

Systematic Investing

Systematic investing is a disciplined, rules-based, repeatable and transparent investment selection process with no emotional biases and is designed to take advantage of market inefficiencies. It strikes a balance between two competing approaches to investing – passive versus active – providing the best of both worlds.

Passive investing involves buying the entire market, usually done through a fund or ETF (Exchange Traded Fund) that buys stocks to replicate an index such as the S&P 500. Investors who opt for this approach typically feel that markets are efficient (stocks are not mispriced) and managers cannot out-perform markets consistently over time. Advantages to passive investing include low management fees, being fully invested in the market (no market timing by the manager) and ensuring a rate of return that is equal to the market (less fees and transaction costs). If however, you feel that markets, or sectors within a market can become mispriced, then active management can enhance returns by taking advantage of these inefficiencies. Active management is usually the domain of “stock pickers”, managers that may use a variety of tools – either fundamental analysis or technical analysis – to look for characteristics such as value, growth or momentum to help outperform the market. The drawback for the investor is that returns are only as good as the individual picking the stocks and management fees are higher than passive investing.

Rather than rely on market returns (passive investing) or an individual’s stock-picking ability (active investing), systematic investing relies on quantitative research that tests the ability of strategies to achieve superior risk-adjusted returns. In essence, it combines the potential for out-performance of active management with the discipline and objectivity of passive investing. It does this by imposing a discipline on the investment process, as the strategies are always fully invested similar to an index fund, but also allows for the potential to outperform, as the portfolios do not mirror the index but tilt to where the greatest opportunities are deemed to exist. In doing so, it does not rely on the manager trying to uncover the opportunities, but does so by using back-tested strategies. It removes emotion from the investment process and helps avoid traps that can occur when market psychology drives market sectors to extreme valuations. Both passive and active management can fall victim to this. The former because the weight of past winners will naturally increase in a cap-weighted index, leading to greater exposure to those areas, and the latter because of emotional desire to chase past winners.