Inefficiencies Abound

One theory still widely taught in today’s finance classes is that stock prices are rational, i.e. they accurately reflect all publicly available information. It follows then that trying to pick individual stocks is a futile effort versus, say, buying a basket containing all stocks. It is true that for most investors, investing in a broad market basket is the right strategy due to lack of time and resources to do the analytical work. Many professional investors fail at stock picking because they get impatient, have misaligned incentives or follow widely accepted but inaccurate narratives.

Take Apple, for example. Its stock slumped to $36/share in late 2018 from the high of $58 that year (a 38% decline) with financial media sounding an alarm over competitive pressures and the escalating trade dispute with China threatening to derail the business. The stock was trading at less than 10x forward earnings per share at the time offering a 10% earnings yield for one of the best brands in the history of business. Fast forward to today and the stock is trading at $240/share or roughly seven times the December 2018 levels with the competitive concerns having abated and despite the ongoing slowdown in China.

Apple is one of the most followed companies in the world with 45 analysts from the largest, best-resourced banks in the world scrutinizing its prospects and publishing reports for the investing public. Microsoft, the second largest company by value, is followed by 52 analysts. Add to that a large army of investment analysts and portfolio managers following and investing in the two companies.

And yet, Apple’s stock price fluctuated by more than 40% in each of the last four years.

Similarly, Microsoft’s price fluctuated by more than 50% annually during 2020-2023 before settling down somewhat in 2024. If there is that much pricing inefficiency among the very largest stocks, by definition, there must be more inefficiency to take advantage of among smaller, less followed ones.