One of the key principles of investing is that you can make good money by exploiting market inefficiencies.

The stock market, made up by the actions of hundreds if not thousands of investors, is not always right when it comes to pricing in good or bad news.

You can often buy a company that is priced too cheaply and hook yourself a bargain. The same applies when the market gets too excited, enabling you to sell something for a nice profit when it becomes overpriced.

Over time most market inefficiencies should even out and a stock will trade at fair value. Your job is to act before that event happens.

Rational investors are the best at exploiting market inefficiencies, in our view.

They don’t get caught up in sudden market movements and follow the herd in terms of whether to buy or sell a particular share. They take time to consider the evidence at hand and work out whether the market is either right or wrong.

This article will illustrate how logical thinking can help you spot market inefficiencies. We will talk through three practical examples so you can see the thought process in action.

Hopefully after reading this article you will be able to approach investment decision making in a slightly different way and question whether significant share price movements are justified.

Rational investors don’t rush; they take time to consider if the market is right or wrong

DON’T PANIC BUY OR PANIC SELL

An irrational investor is someone who is either overconfident when they are investing or panics at the first sign of any significant news. It is important to stress that someone can panic buy as well as panic sell. The former is particularly dangerous if you buy a share because it is racing upwards as could easily have paid too much compared to its intrinsic value.

It is easy to get caught up in the euphoria of a rising share price and think ‘I’ll have some of that, too’. We saw a recent example of this herd mentality in mid-January 2017 when many people made the mistake of buying into Fitbug’s (FITB:AIM) share price rally.

The strategy of ‘act first, think later’ rarely ends well. You could end up overpaying if you raced to buy a share without properly digesting the information at hand. That’s exactly what happened with Fitbug which left shareholders fuming. A rational investor wouldn’t have made this mistake, as we now explain.

WHAT HAPPENED TO FITBUG?

Fitbug is one of several companies that believe the world would be a better place if everyone’s health is monitored and that information used to encourage us to do more exercise and have a better diet.

The small cap business recently announced it had won a contract with a big financial services company in Asia which had 14,000 employees. It said the unnamed client would use its services to help maximise employee performance and reduce absenteeism and risk of chronic illness.

At first glance that certainly sounded positive for Fitbug, particularly has it had been struggling for a while amid intense competition for wearable health devices.

Investors were ecstatic and the share price kept rising and rising as the day went on. It was eventually up 467% by mid-afternoon before being suspended pending another announcement.

You could have avoided losing money on Fitbug with less than 20 seconds’ research

We calculate the market value of Fitbug increased from £2m to £11.4m on that day, directly as a result of the contract win. The market therefore attributed £9.4m value to the new contract.

But had investors really thought this through? Were they caught up in the excitement and raced to buy without thinking through the potential gains for Fitbug?

IT TOOK US 20 SECONDS TO REALISE THE MARKET WAS WRONG

A quick glance on Amazon’s website says Fitbug’s monitoring product sells for £21.99. You can be certain Fitbug aren’t selling them at that price if the new financial services client takes one for every member of its 14,000-strong staff.

Shall we take a guess at £10 per unit? Let’s do the maths: 14,000 x £10 = £140,000 revenue for Fitbug. Not exactly earth shattering money, is it? That kind of revenue would certainly not justify a £9.4m increase in the company’s valuation.

That is a rough calculation of the potential revenue and doesn’t include any service income hinted by Fitbug in its announcement. We find it hard to believe the service income would be of any significance given you and I could buy one of these devices and get all the information at the click of button on our home computer or phone. Furthermore, you need to have spotted another important fact – namely this was only a one-year contract.

If we’d been Fitbug shareholders, we would have considered all the evidence and potential revenue and made a decision about whether the market had underpriced or overpriced the contract win.

The conclusion was obvious: the market had overpriced the news by a significant amount. We would have sold the shares in the belief that they could soon be bought back at a much lower price.

You wouldn’t have waited long for the price to come down. Fitbug’s shares crashed the following day after issuing a new announcement clarifying that it would only get £60,000 revenue for the one-year contract – so even our estimate was far too high.

On the face of it, thumbs up to Fitbug for getting the contract – you never know where it could lead to next. Small companies can benefit from having prestigious clients as can it help with their next sales pitch and adds credibility.

On the downside – a lot of investors probably bought near the top and then nursed a big loss.

Did those investors take the time to examine the evidence and try and work out if the contract was really worth the £9m ascribed to it by the market? Probably not.

But it shouldn’t have taken them long to do some basic maths and realise the market had got carried away and over-priced this information.

WHY THE MARKET GOT IT WRONG ON PHOTO-ME

Photo-Me International (PHTM) saw its share price fall 20% on 23 January 2017 after old news reached a wider audience.

A couple of the national newspapers ran stories about the public being allowed to take photos with their mobile phone for passports – the market panicked that Photo-Me’s photo booth services would no longer be required.

This supposed risk to its earnings wasn’t entirely breaking news, and people had talked about this last year.

For the smart investor, the sell-off presented an opportunity buy a great company at a much lower than normal price.

Yes, the UK is trialling potential changes to passport applications. It is potentially allowing adults aged over 26 to use mobile photos to renew their passport, but only if the photos are of the requisite standard (set by ICAO and ISO), something which is very hard to achieve.

Photo-Me’s UK photo booths only account for an estimated 5% of group profit, so a decline in income from this area of the business wouldn’t have a major impact on group earnings. The earnings threat certainly didn’t warrant wiping off a fifth of the company’s market value.

The company replied by saying it believed accepting photos from mobile phones for official documents was ‘incompatible with developing security requirements’.

In Europe, there is a shift towards more sophisticated security photos including 3D imaging and iris scanning. Therefore you could assume there is a chance the UK Passport Office could rethink its stance towards pictures from phones.

Our conclusion is that the market has incorrectly priced this earnings threat and applied too much of a discount to the share price. Therefore the rational investor could have picked up cheaply-priced shares. And that’s exactly what people have been doing as the shares have subsequently recovered a good chunk of the lost territory.

GB GROUP UNFAIRLY PENALISED

In Photo-Me’s case, some discount is warranted given the threat to part of its earnings – so we aren’t saying the shares shouldn’t have fallen at all. This is an important point to consider.

It is also relevant to a situation last year with data intelligence specialist GB Group (GBG:AIM) whose market value declined by a quarter on a contract delay.

This example shows how it can be harder than you think to judge whether the market has been too cautious about a negative news announcement.

GB Group said on 20 October the roll-out of a Government project had been slower than expected. Its share price fell by 26% to 254p on the day. You might think the market reaction was fair if you didn’t know too much about the company.

In reality, analysts hadn’t expected the Verify project (which validates citizens for online interaction with Government services) to make a big contribution to earnings for a while.

Stockbroker FinnCap said at the time that it expected little impact to group profit in either 2017 or 2018 as a result of the delay. Therefore the 26% share price decline was totally unjustified, in our view.

‘GB Group went into the programme with its eyes wide open to the record of Government IT failures in the past and consequently planned for a very slow take up of the scheme,’ said FinnCap following the news.

‘If the GOV.UK Verify news affects sentiment on the stock it may prove a buying opportunity for investors,’ added FinnCap before the share price collapsed. ‘This remains an excellent, well-run business with a strong position in a growth market, whose earnings are unlikely to be affected.’

There were downgrades to revenue forecasts, but we’re ultimately interested in how much profit is made by a business.

THE POWER OF MARKET SENTIMENT

Interestingly the share price fell even further in the days after the announcement, suggesting the market still felt the news on the Verify project was very negative. Stockbroker Peel Hunt said on 31 October 2016: ‘we believe the market is unfairly punishing GB Group given the strength of the underlying business (despite the adjustments for Verify).’

The rational investors eventually decided the market had been too pessimistic, thereby taking advantage of the share price weakness and the stock soon recovered most of the lost ground.

GB’s example highlights the importance of understanding market sentiment. It can be a powerful force and it is always worth trying to gauge the market’s mood when also weighing up the pros and cons of a news announcement.

Let’s say there was a succession of companies issuing profit warnings as a result of contract delays.

A firm in GB’s situation could easily have been considered as ‘yet another one’ with project delays, so investors could have rushed to sell without examining the evidence.

The other issue to consider is that many investors won’t have understood how much the Verify project was expected to contribute to earnings over the next year or so as GB didn’t explicitly comment on this issue in its trading update.

We only knew about Verify’s minimal profit contribution because we get access to analyst research notes – where they publish valuable information as a result of spending a lot of time with a company’s management. Essentially retail investors are at a disadvantage as the general public can’t get research notes for free.

WHERE TO GET IMPORTANT INFORMATION

You can generally get headline earnings forecasts via financial data websites such as Stockopedia or Morningstar, but you don’t get that breakdown of earnings per division or per project which often appear in analyst research notes.

One solution is to pay £25 a month to use ResearchTree which publishes research notes from a few of the stockbrokers, although the service is restricted to what it describes as ‘sophisticated investors’.

The alternative is to keep reading Shares as we will always endeavour to discuss opportunities where the market appears to have got it wrong.

Overall, the key message is not to get carried away by hype and rush to buy or sell shares. You must always examine the facts carefully before you press the ‘transact’ button.

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