In his book – Margin of Safety, Seth Klarman discusses how the madness of crowds creates opportunities for value investors. Here’s an excerpt from the book:
A second important reason to examine the behavior of other investors and speculators is that their actions often inadvertently result in the creation of opportunities for value investors. Institutional investors, for example, frequently act as lumbering behemoths, trampling some securities to large discounts from underlying value even as they ignore or constrain themselves from buying others.
Those they decide to purchase they buy with gusto; many of these favorites become significantly overvalued, creating selling (and perhaps short-selling) opportunities. Herds of individual investors acting in tandem can similarly bid up the prices of some securities to crazy levels, even as others are ignored or unceremoniously dumped.
Abetted by Wall Street brokers and investment bankers, many individual as well as institutional investors either ignore or deliberately disregard underlying business value, instead regarding stocks solely as pieces of paper to be traded back and forth.
The disregard for investment fundamentals sometimes affects the entire stock market. Consider, for example, the enormous surge in share prices between January and August of 1987 and the ensuing market crash in October of that year. In the words of William Ruane and Richard Cunniff, chairman and president of the Sequoia Fund, Inc.,
“Disregarding for the moment whether the prevailing level of stock prices on January 1, 1987 was logical, we are certain that the value of American industry in the aggregate had not increased by 44% as of August 25. Similarly, it is highly unlikely that the value of American industry declined by 23% on a single day, October 19.”
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