Octagon Asset Management (Octagon) as an active investment manager and we aim to deliver superior investment returns by being active (as opposed to passive). Octagon uses its active approach to enhance the returns available from investing in markets – be they cash, fixed interest, property or equity markets and even foreign currency markets.

Octagon believes that a disciplined investment process that focuses on the reasons why markets may not always accurately price assets on their fair value can lead to superior returns over time. The process of identifying and understanding any mispricing is critical to what we do. With an understanding of why mispricing may occur, and a discipline that allows you to take advantage of under or over valued assets, we believe active management can enhance investment returns.

It is always useful to start with a definition in investment markets. Active management means being “different” to the market. Being “different” is what creates the opportunity to beat the market return – but it also creates the risk of earning returns that are lower than the market. Passive on the other hand means investing in exactly what the market owns, in exactly the same proportions. Taking fees into account, you will never beat the market, as you're simply mirroring what the market in question holds. By doing this you will never beat the market. This is because while your returns might match the market, fees still need to be deducted, meaning your actual return is less than the market. 

I give two very high level examples here of why we think active management can enhance market returns. In February this year, the Japanese stock market set a new record high level. The remarkable thing about that is that it last set a record high in 1989, 35 years ago. In 1989, if you had been a passive investor in global equities, your biggest allocation would have been to the Japanese stock market. Over the last 35 years you have had zero return from that market.

At the stock level, in 2000 at the height of the tech bubble, Cisco Systems was the largest stock by market cap in the world. In the 24 years since, Cisco’s earnings have grown nearly 10 fold, yet its share price is 39% below the level in 2000. Again, a passive investor in global equities would have had their highest allocation to the biggest stock, which still trades below the price of 24 years ago. Passive investors have no view on valuation, they simply want to replicate the market return, less fees.

These two examples are not suggesting it is easy to be an active manager, and hindsight is a wonderful thing, but what they are pointing to is that it would seem there is an opportunity for active managers to find a way to add value.

Octagon looks for logical and repeatable reasons why assets might be mispriced by the market. We have devised a process for valuing assets and understanding why the market might be valuing them differently to us. I discuss five reasons why assets might be mispriced below. Not all of these reasons are present in every asset at all times, but a disciplined approach can take advantage of these opportunities as they arise.

Limited detailed market knowledge of an asset. In the United States, companies can have over 50 broker analysts writing detailed research about them – discussing their prospects, looking at the company accounts and providing views on valuation. In New Zealand, there are some sizeable companies that only have one analyst covering them. The chance of an Octagon analyst or portfolio manager discovering something about a company that allows us to form a different view on valuation to the market is likely to be higher in thinly covered stocks.

Excessive focus on near term results. Companies are formed with no definitive end date – in theory they can last for ever. Yet markets can react violently to the latest report covering as little as the last quarters’ trading results. A strong conviction on long term valuation potential, grounded in facts and experience, creates the opportunity to find mispriced assets.

Market dislocations and liquidity events. The rise of passive investing and algorithmic trading – which by definition has no view on valuation – can and does skew prices. When others don’t care about valuation, having a strong understanding of valuation creates opportunities for active investors to move in and around passive trading flows.

Temporary governance failures by directors and management. The most common governance failure we find is where a board goes on an acquisition spree, particularly into new markets or countries where it has little experience. When the poor investments are sold or wound down and management refocuses on the core business, returns can bounce back strongly. Fletcher Building is an example of this – despite its most (very) recent travails, focussing back on its core business has resulted in positive share price performance.

Irrational investor behaviour. Markets generally assume investors are rationale beings, as do most valuation models. Whilst this might be true most of the time, it is definitely not true all of the time. The occurrence of market bubbles are the poster children for this type of asset mispricing. There are always examples of investors having fallen deeply in love - or severely out of love - with an asset and seemingly abandoning their long standing valuation principles. 

There are a few other reasons why asset mispricing might occur, but these five are relatively intuitive and tend to occur more frequently across most markets to a varying degree. Octagon continues to find assets we believe to be mispriced in the pursuit of superior returns for our investors.

Disclaimer: This article has been prepared in good faith based on information obtained from sources believed to be reliable and accurate. This article does not contain financial advice. Some of the Octagon portfolios own securities issued by companies mentioned in this article.