Market Inefficiency Equals Market Opportunity For Investors

Even in the best of times it is difficult for the average investor to earn market beating returns in the stock market. There are many reasons, among them which are two that explain to a great degree the difficulty: market efficiency and investment expenses. You see, in a "normal" market, individual stocks reflect a consensus value by money managers, traders, analytical computer models, and individual investors, at any particular moment in time based upon all information that is publicly available. This is the essence of market efficiency. In order to outperform the market, therefore, one must know something that others don't or see something that others can't. And contrary to popular perception, professional money managers are not clairvoyant or investing wizards. In fact, money managers that actively select stocks are subject to the same market efficiency and the net performance of their funds are hampered by management fees.

Of course, these are not "normal" times for the stock market. Hedge funds subject to margin calls have been selling their stock holdings indiscriminately into a falling market. Professional money managers have been forced to sell stocks and bonds, regardless of valuation, to meet shareholder redemptions. And individual investors have been paralyzed by the falling market for fear of drawing even more blood reaching for falling knives. The market is not working efficiently. Individual equities and bonds can now be found that bear no relationship to their intrinsic value based upon their expected future cash flows and, for the first time in years, offer out sized potential returns going forward. It is times like these that individual investors have the opportunity to take advantage of this situation and significantly outperform the market. The trick now is figuring out where the market is wrongly valuing these securities and buying them for the long term.

Let's take one stock that I follow, Linn Energy (LINE), as an example. Linn Energy is an energy exploration and production company that owns long-lived mature oil and natural gas assets with slow rates of depletion and a reserve life of about 21 years. They are structured similar to a master limited partnership and thus pay out the majority of their profits in distributions to shareholders with certain tax-favored benefits. Management had the foresight to hedge their production to protect their future cash flow and thus their shareholder distributions. In fact, approximately 100% of their production is hedged for the next 3-5 years, and still a high percentage is hedged beyond that. As a result, they should be able to maintain their current distributions to shareholders despite the low price of oil and natural gas. And should energy prices resume their upward climb, they have structured about 30% of their hedges as puts allowing them to book increased cash flows but with downside protection. Despite their many advantages, the stock price has been clobbered, down 48% to $12 over the last few months resulting in an astronomical yield of about 22%.

Why has Linn Energy dropped so far despite their obvious strengths? Well, the stock price has not been helped by the fact that the largest holder was Lehman Brothers, the failed investment bank, and the position has been liquidated into a falling market. In addition, Linn Energy had raised a large sum of capital to expand production and purchase cheap assets through the use of PIPEs (Private Investment in Public Equity) over the last couple years resulting in large holdings by a number of energy related hedge funds. Many of these same hedge funds have shorted the stock to protect their investment or have liquidated their positions to meet margin calls.

So, what is an individual investor to do? Well, far be it from me to recommend anyone purchase a security, but I have been buying. I haven't been forced to meet margin calls and I am not subject to shareholder redemptions. And I love the fact that Linn's production is mature, stable, growing, and hedged. A 22% yield hedged for at least 3-5 years in a tax-favored structure? Are you kidding me! Of course, there is more to the story than what I have the time and space to address and everyone must do their own due diligence. But, Linn Energy may serve as but one example that this could, in fact, be the buying opportunity of a lifetime for individual investors who can find market inefficiencies and have the courage to take advantage of them.