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Mispricing mechanisms in markets – Moneyweb

CIARAN RYAN: Choosing which assets to invest in often comes down to how markets are mispricing specific assets or companies. They can either be over-priced or under-priced. Understanding these market mechanisms normally underpins whether a specific asset is a good opportunity to invest in or not. Market volatility, macroeconomic and geopolitical events are just some of the factors that determine whether share prices are over- or under-priced, and knowing how to spot these differences goes a long way in identifying attractive investment opportunities.

Joining us to discuss this further is PSG Wealth chief investment officer Adriaan Pask. Hi, Adriaan. Investment success is generally made when markets misprice specific share prices – I’m sure you’d agree with that. Investment professionals like yourself spend your career spotting these differences to find attractive opportunities. What is PSG Wealth’s view on this, Adriaan?

ADRIAAN PASK: Hi Ciaran, thank you for having me. Yeah, I think that’s absolutely right. Markets are effectively pricing mechanisms, and they look at the prospects and risks to the earnings prospects of companies, and then they try to price those in accurately. Obviously, it’s highly susceptible to the opinions of individual analysts and fund managers who trade these stocks, which makes the process prone to error and mispricing. So, I think the trick for investment professionals is to identify the areas where other investors are potentially making mistakes, and then use those mispricing opportunities to generate investment answers for clients.

I think a useful rule of thumb is when markets are on the up and opportunities are often overestimated and risks underestimated, and all the focus is on the good news. Contrary to that, when markets are under pressure, what we often see is that the risks are over-estimated and the opportunities under-estimated – which then creates some opportunities as well.

CIARAN RYAN: Can you give us a few examples of instances where we’ve seen this kind of mispricing going on in the market, and you’ve been able to take advantage of that?

ADRIAAN PASK: Yeah, maybe some of the more recent examples. If you cast your mind back to last year when South Africa went through the sovereign downgrade, you could see – at least in our view – that markets were starting to price in the risk of that sovereign downgrade taking place, and with the pandemic striking obviously we saw that risk escalate. Our yields went from 8.5%, to 9% and to almost 12% as soon as that news broke. Shortly after that markets calmed down again, and they actually recovered following that downgrade. It just goes to show that often that risk is overestimated. When the sentiment is very, very poor then investors become very sensitive to the risk component of it. But ultimately things tend to recover.

Another good example, a similar example, would be in the US. Tapering is very topical now. When they went through the tapering exercise back in 2013, we again saw bond yields spike up from 2% to 3%. But then in the following year, in 2014, they came back all the way from 3% to 2%. It just goes to show that investors again over-estimated the risk when the pressure was on, and there was actually opportunity there the following year.

I think maybe something to look forward to, if we’re looking just recently, the US equities are in a similar space now. Again, there’s so much good news now it seems like the market is completely over-estimating the good news and under-estimating the risks. That’s something that we think we need to look out for in the coming months.

CIARAN RYAN: What are the datasets that you are looking at when determining whether markets are mispricing assets or shares?

ADRIAAN PASK: Well, I think there’s a healthy combination of top-down factors like the macro and the geopolitical elements that you mentioned in your introduction. I think those things are obviously quite important.

But then also, if you look at a stock or security’s specific level, it becomes quite important to understand what’s happening there. The biggest cyclical trends in the industries and in the economies are very important right now with all the monetary stimulus going on. But it’s definitely the case that some stocks offer better protection than others. You don’t want to be overspending on any stocks, for example, at the moment.

So, if you can find something that’s of decent value – preferably on the lesser side of the market – but also offering you a big margin of safety on the valuation, and you can see the stock benefiting from a change in the macro environment, that’s typically something that you would consider.

You can tell from the information the type of data that you would need from the financial statements on security to macroeconomic data. And then also, obviously, just some good judgement on the overall situation, including geopolitics. Those are factors that you don’t typically find data for, but you need to factor them into your investment process otherwise you can be caught out.

CIARAN RYAN: Okay, so what advice do you have for investors where they can use this information of mispricing that we’ve been talking about to their benefit?

ADRIAAN PASK: Well, I think if we go back to the example around what happened with South African bonds, for example, I think many investors would have got that completely wrong. So there’s something to be said for experience in navigating markets. I think if you’re going to invest for the long term it helps to partner up with someone. Find a financial planner, wealth planner or investment manager, and make sure that you use experienced individuals who have seen these things before, and often deal with the way that markets overreact to news, and how markets can at times completely underestimate risks. So, you would need someone who has demonstrable skills in the long term in terms of a track record of success.

And then I think a portfolio should in general always be prepared for the unexpected. Even the best wealth managers or investment managers out there can’t completely foretell the future. Something like the pandemic, for example, is a very good way of explaining why a portfolio should be prepared for the unexpected.

There’s no way that anybody could have realistically foretold a pandemic. You would have been caught out if your portfolio wasn’t diversified properly. So in that sense, how do you make sure that you are prepared for the unexpected?

I think there are really two things.

Obviously diversify the portfolio for that unexpected event – whatever it might be. And then also have realistic expectations around what markets do over the short and the long term. So, we often see investors fall into these traps over the short term when the stresses are on and they want to over-estimate the risks, and then do silly things with portfolios.

But if you’ve got realistic expectations that a decent market correction or a serious market event is something that you’re going to see along your journey, I think that will really help quite a bit in making sure that you don’t make those mistakes when they do come.

CIARAN RYAN: Great advice. We’re going to leave it there. Thank you very much. That was Adriaan Pask, who is chief investment officer at PSG Wealth.

Brought to you by PSG Wealth. 

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