Inefficiency 2 - Informational

Informational: You never realize, until you work in the industry, how superior the information is of certain investors over others. While illegal insider trading activity is always present in a market system, the US regulation is fairly strong and deters much of this. What we are referencing is the informational advantage that certain investors have as a result of spending more time and resources finding the information.

For example, if you run a $20B fund, you have the resources to hire the best and brightest people with the largest rolodexes of industry contacts and you can afford to have each of your analysts focus on only one industry or even one or two companies. Since your analyst may only be focusing on a few companies and working 100 hours per week, he or she will be calling every supplier, every vendor, every former employee, and every industry contact to get as much information as possible. You can spend millions of dollars to hire the best lawyers to understand legal outcomes, or you may even be able to purchase proprietary satellite imagery to count the number of cars in Walmart parking lots to deduce levels of economic activity.

If you have better information, you can better determine the intrinsic value of a business and therefore better understand how a stock should be priced. More information does not always equal better information, but having more resources available to you as an investor to dig up this information can create a significant edge.

How We Take Advantage of Informational Inefficiencies

David Einhorn, a very successful hedge fund manager, has described his thought process around buying a security as being a somewhat arrogant decision. What you are saying is that you know more than the person selling you the security. Sometimes the person selling could have owned the business for multiple years and know more about the business than you do.

What we do is try to avoid buying from someone who knows more than we do (and is selling for a good reason). One way we do that is we simply avoid (for the most part) purchasing larger securities and competing against the $20B fund who undoubtedly knows more than we do about the business and is the one selling us the stock. Instead, we focus on smaller companies whose stockholders are unlikely to have spent the same amount of time we have understanding the industry and the business. As you have heard us say, we would much rather compete against the local dentist than against Warren Buffett.

In these smaller businesses there is a much greater likelihood that we can find something that the average retail investor can’t. This requires reading a lot of filings, talking to management, talking to competitors, etc. These are things the average retail investor just doesn’t have the time to do. So if they want to sell us their stock because they are tired of owning it or just need the cash for other reasons, we are happy to buy when we feel we have superior information.