4. Where room is left: where big money cannot go

Level 8: What is priced in and what is not

Let us pull the previous modules together. Efficiency is not an absolute, but a degree depending on how much competition there is in each place. Information is exhausted fast where a lot of people are looking. And correcting a wrong price requires capital, time and stamina that many do not have. Out of all three together comes the useful question of this level: where are few people looking, and where can the people who do look not act even if they want to.

The professional's constraint is the private investor's opportunity

The professional manager seems to have everything: information, a team, access, tools. But he operates inside a cage of constraints the private investor does not have:

• He has to report every quarter to clients who confuse a bad quarter with a bad manager.
• He has a minimum position size below which the idea does not change his result.
• He has a written mandate forbidding him from buying perfectly reasonable things.
• He has career risk, which is not the same as investment risk: being wrong in company costs your job far less than being wrong alone.

The private investor is not paid to manage, publishes no results, answers to nobody and can hold a position of whatever size he likes. That does not make him a better investor. It gives him access to a different set of situations, and that is the whole point. Howard Marks insists that performing differently requires acting differently, and acting differently almost always means accepting that you will look wrong for a while.

Corners created by size

The arithmetic is merciless. A 20 billion fund that does not want positions below 1% of its portfolio needs to place at least 200 million in each idea. If on top of that it cannot exceed 10% of a company's capital, any company worth less than 2 billion falls outside its universe, whatever it is worth.

It is not that the fund does not want to look there: it cannot. And the same applies to the analyst working for it, who will devote his time to what his fund is able to buy. That is why analyst coverage is concentrated in large companies and vanishes entirely in small ones. Fewer eyes, less informed prices, and the margin Grossman and Stiglitz were talking about is still available.

Corners created by mandate and by rulebook

An enormous amount of capital is obliged to behave in a particular way, with no room for judgment:

• A fund tracking an index has to sell a company when it leaves the index, at any price.
• A fund with an investment-grade mandate has to sell a bond that loses that rating, even if its analysis says the bond is cheap.
• A large-cap fund cannot keep the shares of a spun-off subsidiary that is too small for its mandate.
• Many vehicles cannot hold companies in insolvency proceedings, nor securities without an official listing, nor positions exceeding certain concentration limits.

Note the pattern: in every case somebody sells without having decided they want to sell. The resulting price contains no opinion about value. It contains an obligation.

Corners created by discomfort and by horizon

There are situations nobody wants on the list of holdings they send to clients: companies in high-profile litigation, sectors in public disgrace, boring companies with no story to tell, businesses whose thesis takes four or five years to materialize.

The cost of holding those positions is not economic, it is reputational and psychological. And as we saw in the previous module, that cost is real and is therefore paid for. That is where the extra return survives the competition: not because the others cannot see it, but because seeing it is not worth their while.

When somebody sells because they have to sell

The clearest case is forced selling. In an episode of stress, whoever needs liquidity sells what they can sell, not what they want to sell. Redemptions force funds to liquidate their most liquid positions, which tend also to be the healthiest. Collateral demands force leveraged positions to be closed at any price.

At those moments, someone with no leverage, no redemptions and no committee asking questions is on the right side of the table: they are among the few who can buy. This is the practical translation of the whole previous module. If the limits of arbitrage explain why the price goes wrong, they also explain who is left available to take advantage of it.

Real case, and what this does not guarantee

In March 2020, the liquidity strain reached corners it should not reach. Several exchange-traded funds holding investment-grade corporate bonds traded at discounts of several percentage points to the value of the portfolio they contained, something that in theory cannot persist because a creation and redemption mechanism exists to correct it. It was not corrected for days, and the reason is exactly the one from the previous module: the intermediaries who were supposed to close that gap had their own balance sheets under strain and their own capital already committed. It took the announcement of the central bank's purchase facilities for the discounts to close within a few sessions.

And now the honest part, which matters more than everything above. That a corner is thinly populated tells you where it is worth looking, not what to buy. The absence of competition means the price may be wrong, and being wrong includes being wrong on the downside: many small companies with no coverage are cheap because they are worth little. Uncomfortable companies are sometimes uncomfortable for very good reason. Forced selling is sometimes the start of a bigger fall.

What you have learned in this level is not a list of opportunities. It is a map of where margin may be left and why. Turning that margin into something usable requires the entire job of working out what a company is worth, and that job remains untouched. This is education, not a recommendation about any particular security.