{"id":5204,"date":"2023-11-01T00:00:47","date_gmt":"2023-11-01T00:00:47","guid":{"rendered":"https:\/\/connectwithfund.com\/investment\/how-to-profit-from-loopholes-in-the-efficient-market\/"},"modified":"2023-11-01T00:00:48","modified_gmt":"2023-11-01T00:00:48","slug":"how-to-profit-from-loopholes-in-the-efficient-market","status":"publish","type":"post","link":"https:\/\/connectwithfund.com\/?p=5204","title":{"rendered":"How To Profit From Loopholes In The Efficient Market"},"content":{"rendered":"
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Stock picker Ken Farsalas at Oberweis Asset Management is proving that the best way to trounce index funds is to fill your portfolio up with little known, earnings-beating companies.<\/h2>\n

By <\/sub>Hank Tucker<\/sub>, Forbes Staff<\/sub><\/h4>\n

E<\/abbr>ugene Fama, University of Chicago economist and father of the efficient market hypothesis, has long been a thorn in the side of active stock managers. His Nobel Prize-winning research dating back to 1970 argues that stock prices reflect all available information and are therefore fairly priced. In other words, trying to beat the market is futile over the long term.<\/p>\n

However, even Fama has trouble explaining one disturbing pattern. In a 1998 paper in the Journal of Financial Economics<\/em>, he addressed the phenomenon that stock prices continue to move up or down in the direction of an earnings surprise for as much as a year, describing it as the \u201cgranddaddy of under-reaction events.\u201d<\/p>\n

Fama dismissed this challenge to his efficient market hypothesis attributing it to pure chance, but a quarter-century later, the effect known as \u201cpost-earnings announcement drift\u201d (PEAD) stubbornly persists. Nowhere is the proof greater than right in Fama\u2019s backyard, 25 miles west of Chicago in Lisle, Illinois, at a firm specializing in small- and micro-cap stocks called Oberweis Asset Management.<\/p>\n

Check out these returns: For the decade ending September 2023, Oberweis\u2019 $400 million Micro-Cap Growth fund has had an average annual return of 14% versus 3% for its Russell Micro-Cap Growth index. Its Small Cap Opportunities fund, also around $400 million in assets, has returned 12% annually versus 6.7% for the Russell 2000 Growth index. All at a time when small caps funds have been largely left for dead by investors. The recent results are even better. Over the last three years, its micro-cap and small cap funds have generated 27% and 21% returns, respectively. Oberweis\u2019 secret? Ferreting out tiny companies with positive earnings or revenue surprises.<\/p>\n

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\u201cInvestors tend to cling to preconceived beliefs and notions and disregard new information that shows up in an earnings surprise,\u201d says Ken Farsalas, 52, lead portfolio manager and director of U.S. equities at Oberweis. \u201cInvestors are guilty of anchoring bias, confirmation bias, commitment bias, herding bias, groupthink\u2013all of these different biases come into play. They mess with investors\u2019 ability to make effective decisions.\u201d<\/p>\n

Ironically, Farsalas and Oberweis president, James W. Oberweis, and his father, firm founder James D. Oberweis, all received their MBAs from the University of Chicago\u2019s Booth School of Business.<\/p>\n

\u201cWe kind of got brainwashed into the market efficiency stuff there,\u201d says the younger Oberweis, 49. \u201cIt\u2019s mostly efficient, but there are these pockets of inefficiencies in small asset classes where our stock selection process has been able to add value.\u201d<\/p>\n

Oberweis Asset Management was founded in 1989 by Oberweis Sr., a former teacher and stockbroker who began publishing a stock newsletter, The Oberweis Report<\/em> in 1976. In 2001, Oberweis Sr. went into Illinois politics and son Jim W. took over. Initially the firm\u2019s approach followed what it called the \u201cOberweis Octagon,\u201d investing in stocks with sales and earnings growth of at least 30% in the most recent quarter, among other metrics. Then, beginning in 2015, Oberweis handed the reins of the U.S. funds to Farsalas, who overhauled the strategy to revolve around growth relative to expectations rather than absolute growth to produce better diversification and less volatility.<\/p>\n

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Farsalas, his co-portfolio manager David Covas and senior analyst Kevin Cowell find ideas exclusively from a daily screen of every small-cap and micro-cap stock that reported earnings in the previous 24 hours. If a company\u2019s earnings or sales significantly beat Wall Street analysts\u2019 consensus expectations, it enters a 17-step process. Farsalas\u2019 team combs through the company\u2019s last few earnings reports, reads conference call transcripts and ensures that it has a strong balance sheet and positive free cash flow. Then the team looks at valuation multiples like price-to-earnings and enterprise value-to-Ebitda multiples to decide if the price is right.<\/p>\n

Farsalas comes up with an \u201cOberweis estimate\u201d for how much a stock will earn in the ensuing one to two years based on that research and compares it to the street\u2019s consensus estimate, which is slower to react to earnings results. The larger the gap between the two estimates, the more enticing the stock. Oberweis\u2019 funds end up investing in about 15% to 20% of the stocks that make it through the screen, which Farsalas says typically align with one of four categories: an under-appreciated new product cycle or application, a change in management, a stimulus infusion from \u201cgood old Uncle Sam\u201d or a recent acquisition that\u2019s performing better than expected. Earnings surprises that the team can attribute to fleeting or insignificant events get discarded.<\/p>\n

Recently Farsalas has been finding earnings surprise stocks in the semiconductor business. Take the case of Axcelis Technologies (ACLS)<\/strong>, a $4 billion (market cap) company which specializes in ion implantation, a key part of chip manufacturing. In the third quarter of 2019, the Beverly, Massachusetts company reported earnings of two cents per share to beat consensus analyst expectations of a one-cent loss per share, with new bookings accelerating. After the stock popped up on Farsalas\u2019 daily screen, research revealed that silicon carbide semiconductors, which conduct electricity more efficiently than regular silicon chips, were becoming the product of choice for electric vehicles and have exponentially higher ion implant requirements, heightening demand for Axcelis\u2019 services. He invested in the stock in November 2019 at around $20 per share, and it\u2019s still one of his top holdings after growing more than 500% to $126 today.<\/p>\n

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Axcelis is not the only semiconductor firm to have passed Oberweis\u2019 earnings surprise screen. Other top holdings include Fremont, California\u2019s Aehr Test Systems (AEHR)<\/strong>, which does \u201cburn-in testing\u201d for silicon carbide semiconductors, a rigorous process that tests for defects for as long as 24 hours. Its shares have gained 30% this year to lift its market cap to $700 million, though it has slipped since doubling in the first half. Both Aehr Test and Axcelis were down sharply Monday after large cap chipmaker ON Semiconductor, a customer of both, offered weak fourth-quarter guidance, but Farsalas viewed this move as an overreaction. Israel\u2019s Camtek (CAMT)<\/strong>, another stock in his portfolio which performs inspections of layers added onto \u201cadvanced packaging\u201d semiconductors, has more than doubled this year.<\/p>\n

\u201cThe wonderful thing about micro-cap and small-cap companies is they can attack niche markets,\u201d says Farsalas. \u201cApplied Materials and Lam Research are the 800-pound gorillas in the semiconductor capital equipment space. The silicon carbide testing market for those companies is too small to bother with, but it\u2019s not too small for Aehr Test [2023 sales: $65 million]. It\u2019s huge and it\u2019s very meaningful.\u201d<\/p>\n

Tech stocks make up 22% of Oberweis\u2019 small cap fund and 29% of its micro-cap fund and have helped drive its strong returns, but the firm also has large exposure to healthcare and industrials, not always mainstays in a growth stock portfolio. In February, Oberweis invested in school bus manufacturer Blue Bird Corp. (BLBD)<\/strong>, one of the top five holdings in its micro-cap fund as of the end of June. A fourth-quarter 2022 revenue beat with $236 million in quarterly revenues sent the stock soaring by 30% in one day, and though performance has been stagnant since then, Farsalas figures it still has more room to run.<\/p>\n

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\u201cYou had two-plus years during Covid where school districts weren’t buying new buses, so there was some pent up demand. On top of that you have the government really pushing an electric vehicle effort for school buses,\u201d says Farsalas. \u201cBlue Bird has about 33% share of the school bus market. We think they’ll take similar market share with electric vehicle orders.\u201d<\/p>\n

Farsalas shuns the riskiest areas of the market like small-cap biotech stocks, which often don\u2019t even have any revenues to compare to expectations and can crumble in an instant if data from clinical trials is poor. The vast majority of the businesses he buys are profitable or self-sustaining and operating around break-even to continue investing in new products. He\u2019s quick to sell if a stock in his portfolio misses earnings expectations\u2014PEAD goes both ways, and investors typically underreact to negative news as well. The sooner the better to cut bait, says Farsalas.<\/p>\n

Despite micro-caps\u2019 notorious volatility, this approach has helped Farsalas avoid steep drawdowns like many growth investors suffered through last year. His micro-cap fund fell 10.4% in 2022, preserving most of its 54% gain from 2021, while the Russell 2000 Micro-Cap Growth Index plummeted 30% last year after only gaining 1% in 2021. Performance numbers for Oberweis\u2019 small-cap fund were similar.<\/p>\n

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Even though Farsalas\u2019 funds have been on a tear recently, he is more proud of his performance in 2019 and 2020, when his micro-cap fund gained 22% and 30%, respectively, lagging its benchmark. During 2019 and 2020 the Russell Micro-Cap Growth index was up 23% and 40%, respectively, but according to Farsalas it was chock full of tiny unprofitable companies trading at outrageous multiples.<\/p>\n

\u201cA lot of my peers in the growth space either never learned that valuation was important, or just chose to ignore it. I guess it was easy to do when we were in a zero interest rate environment, but now we have a cost of capital again,\u201d he says. \u201cWe weren’t paying 30 times sales for software companies. To me, that was the biggest bubble I had seen since 1999 and 2000 at the very start of my career.\u201d<\/p>\n

With small caps still unloved by the market and lagging large caps, Farsalas continues to believe there are earnings-beating bargains to be had. Small caps represent less than 4% of the market capitalization of the total U.S. stock market, the lowest level since the 1930s. Farsalas points to the 1970s and early 1980s, when inflation and interest rates were high and small caps outperformed.<\/p>\n

\u201cValuations of small caps relative to large caps are the most compelling they\u2019ve been since the late 1990s,\u201d says Farsalas. \u201cSmall caps will whip large caps over the next decade. I don\u2019t even think it\u2019s going to be close.\u201d<\/p>\n

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MORE FROM FORBES<\/strong><\/h4>\n<\/div>\n

Read the full article here<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

Stock picker Ken Farsalas at Oberweis Asset Management is proving that the best way to trounce index funds is to fill your portfolio up with little known, earnings-beating companies. By Hank Tucker, Forbes Staff Eugene Fama, University of Chicago economist and father of the efficient market hypothesis, has long been a thorn in the side of active stock managers. His Nobel Prize-winning research dating back to 1970 argues that stock prices reflect all available information and are therefore fairly priced. In other words, trying to beat the market is futile over the long term. However, even Fama has trouble explaining<\/p>\n","protected":false},"author":1,"featured_media":5205,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[40],"tags":[],"class_list":["post-5204","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-investment"],"yoast_head":"\nHow To Profit From Loopholes In The Efficient Market | ConnectWithFund<\/title>\n<meta name=\"description\" content=\"Stock picker Ken Farsalas at Oberweis Asset Management is proving that the best way to trounce index funds is to fill your portfolio up with little known,\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/connectwithfund.com\/?p=5204\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta 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