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Inefficient Market Theory: Bargains in a Market-Wide Crisis

As Shakespeare wrote in Julius Caesar, "there is tide in the affairs of men." For value investors, that tide usually arrives as a market crash or some other event that chases many other investors out of the market and discounts the prices of good companies.

In chapter nine of "Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd", author Jeffrey C. Hood offered strategies and tactics for finding bargains when there is market or macroeconomic crisis.


Not surprisingly, he encouraged investors to pay attention to the psychology of the market as well as the prices of stocks. "There will be a continual drumbeat of bad news, accompanied by massive selling of stocks that will drive down prices to bargain levels. The fear of loss will be paramount in people's minds, and it will be hard to not follow the herd," he said.

He named the renowned investor Sir John Templeton as an example of what to do. Templeton was quite aware of the need to remain level-headed at times of maximum pessimism and optimism. Still, he did not trust himself to make hard decisions during panics. So, in normal times he would create lists of stocks he would buy if they were less costly, then would place buy-limit orders on those stocks at very low prices. Should prices plunge, he would be positioned to buy what he wanted without getting tangled up in the emotions of the day.

For the rest of us, Hood recommended that we first do careful valuations, and do them dispassionately. But that's not enough by itself, and investors should develop a variant perception and inefficient rationale, as discussed previously in this book.

Several psychological factors usually emerge during crises, starting with loss aversion, fear, recency bias and herd mentality. As the author added, all these factors can act together to produce a lollapalooza effect (which is a magnification of these factors combined). In addition, the foolish crowd usually has a short-term perspective and fails to see a return to normalcy.

Also contributing to a panic is the way it puts pressure on leveraged buyers; they receive margin calls and are forced to sell, putting even more downward pressure on stock prices.

Social influence can be a positive influence in times of crisis. When talking about social influence, Hood was talking about seeking out the company of like-minded value investors,


"A key recommendation is for the investor to join an online value investing forum and read, and actively participate in, the commentary from other value investors. During a macroeconomic crisis and a resulting large market decline, the investor will be able to read intelligent commentary from others about the foolishness of the market, and even more importantly will be able to correspond and interact with others who are actively buying securities. Such forums can be a huge support network for the investor, providing constant reminder that the investor is not the 'only one' who is going against the mainstream."



His other key recommendation was to follow the actions and commentary of great value investors (that can be done at GuruFocus). From his own experience, he gives the example of making major commitments in three deeply discounted stocks during the sovereign debt crisis of 2011: Berkshire Hathaway (BRK.B), AIG (NYSE:AIG) and Bank of America (NYSE:BAC). All three and many other financial stocks had been considered in danger when there was a possibility that countries in Southern Europe would be unable to meet their debt obligations. Hood wrote:


"One of the main things that stiffened my backbone during this time was an interview given by Bruce Berkowitz (Trades, Portfolio) of the Fairholme Fund (Trades, Portfolio)s, where he explained his thesis on Bank of America and AIG. Every so often, with the rampant, widespread pessimism all about me, when doubt would begin to creep into my mind, I would go back and replay the interview and listen again to his presentation of the investment thesis. Here I was struck by both the merits of his arguments both from a valuation perspective and a psychological perspective, as well as the confidence he displayed despite his positions initially being underwater."



The author also addressed the issue of trying to buy at the bottom of cycles. He recommended following the advice of Benjamin Graham, who distinguished between the "way of timing" and the "way of pricing". For Graham, that meant buying when stocks are quoted below their fair value and selling when they rise above fair value.

According to Hood, investors could also benefit from consulting with a wise crowd, which is to say fellow value investors and the great value investing gurus. In his opinion, many great value investors would begin making their purchases relatively early. So, he recommended to other investors that they follow the lead of the gurus, but lag behind by some period of time.

He also pointed out that during crises, members of the herd will sell their securities indiscriminately, "Consider the financial crisis of 2008-9, where the financial sector was the obvious source of the crisis. During this time the greatest movement in the herd was out of financial stocks, and hence the best bargains lay in the financial sector."

Conclusion

When an author writes a book that deals with investor emotions, as Jeffrey Hood has done, she or he likely has some advice on understanding and taking advantage of macroeconomic and market panics.

Hood has done so, obviously. He has recommended that investors find a variant perception, analyze the inefficient rationale and take advantage of social influence (interacting with wise crowds made up of fellow value investors and value investing gurus).

The advice in chapter nine of "Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd" should help us weave our way through future crises with less stress and self-doubt.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

  • Inefficient Market Theory: Berkshire Hathaway and Indexation
  • Inefficient Market Theory: Wells Fargo and the Subprime Crisis
  • Inefficient Market Theory: The Tylenol Poisoning Case



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This article first appeared on GuruFocus.