Inefficiency 1 - Technical

Technical: What we term as “technical” inefficiencies are inefficiencies caused by market activities that are unrelated to the underlying intrinsic value and economics of a business. An example would be the forced selling we typically see when a parent company spins off a subsidiary. The big funds holding the parent company bought the stock to own the parent company, not the subsidiary. When they receive the spinoff shares in their account, it is likely too small to move the needle on their big portfolios. As such, these funds will indiscriminately sell the shares of the spinoff without regard for the underlying economics and business value.

Other examples could be convertible bond holders hedging their position, hedge fund liquidations where they are forced to sell to raise cash for redemptions, secondary offerings by large holders (such as when the federal government sold their AIG and GM shares, which was more for political reasons than economic reasons), etc. Every one of these situations can create a large disconnect between the price of the security and the underlying value because you have holders exiting their position for reasons unrelated to their view of the long-term prospects and value of the company.

How We Take Advantage of Technical Inefficiencies

Technical inefficiencies are typically the easiest to find as you usually know they are coming ahead of time so you can sit back and wait. We track and analyze every spinoff, and multiple other specific “technical events”. For spinoffs that are (i) small enough to have significant selling and (ii) in an industry where we understand the economics of the business and therefore its value, we set a price at which we would like to buy it and then simply wait for the technical selling to come.

This process is not rocket science but it does take a fair amount of work to track and analyze these spinoffs. The rewards here can be significant as the spinoffs tend to “re-rate” towards their true business values relatively quickly once the big funds are done selling their shares for uneconomic reasons.