An investment or purchase of poorer quality than you were led to believe is frequently referred to as “buying a lemon”. Discovering something is worthless after a price is agreed and the transaction concluded can leave the buyer with a bitter taste!
Nobel prize winner, Professor George Akerlof, is a well-known economist who explored the lemon theory in a 1970’s paper titled “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” The research unpacks the concept of asymmetric information, which he illustrated via the used-car market. When buyers cannot adequately assess the quality of a car they are buying, it creates information asymmetry. The seller has the advantage of more information about the vehicle than the buyer. The buyer will pay a price based on what they know about the car at the time, however, may discover flaws after the purchase. They bought a lemon!
Constructing a robust portfolio that can deliver Truffle investors inflation beating returns over the long term is as much about avoiding the losers as picking the winners. To identify these winners and losers, we need to develop an information advantage. In an era where deluges of information are available in one click and multiple platforms are constantly delivering content to catch attention, we need to distinguish fundamental critical information that impacts asset values over the longer term from market noise that creates investor hype or fear and market volatility.
Finding the advantage
Importantly, an information advantage is not insider information. Rather, it is about taking publicly available information and determining through thorough analysis and research what information matters most and will help ascertain the true value of an asset.
When investing in a company, important aspects to understand and analyse may include:
- The company’s competitive moat: What gives them an advantage over others in the same industry? And how is it changing?
- Capital allocation and returns: How they invest in their business and whether this will deliver inflation-beating returns to investors.
- Quality of management: Understanding whether management are good stewards of the business. Are they adapting to changes in technology and their environment?
- Free cash flow conversion: Is the company able to generate cash to pay its investors dividends. Earnings often do not reflect the true underlying health of the business.
- Risks: Both quantifiable and unquantifiable.
An information advantage enables Truffle’s investment team to establish an intrinsic value for a share and understand the worth of the share versus what the market is currently willing to pay.
Finding the information advantage when choosing investments is more complex than appears. The most valuable tool is a specialised team of investment professionals with the ability to distinguish between noise and important information. Having invested through numerous cycles and crises including the dot.com bubble, interest rates at 24%, the Great Financial Crisis of 2008 and the Covid-19 pandemic, the investment team at Truffle has developed significant market experience and industry knowledge. The diversity and depth of skill and open team-based environment also ensures that ideas are explored from all angles and are well covered and debated. Our bottom-up fundamental research process means we unpack the detail to find as much relevant information as possible to determine a company’s fair value.
Agile execution is another key factor. An information advantage has a shelf-life. In certain opportunity sets, the value of information decreases as time elapses. Thus, it is not only about knowing what information matters but also knowing when it matters and for how long. Being decisive and executing (investing or disinvesting) with agility on our research and knowledge is critical to achieving investment success.
Avoiding a lemon
Truffle’s decision in 2022 and 2023 to hold an underweight position in South African telecommunications company, MTN, illustrates how our information advantage helped avoid a “lemon”. MTN was a market “darling’ for many years as the South African cellular phone industry was growing rapidly and shareholder returns were high.
Over time, MTN looked to enter other emerging markets which also had high-growth potential and expanded into countries such as Nigeria, Ghana, Sudan, and Iran. This created complexity and the need for deeper company research to establish the intrinsic value of the business. As recently as August 2023 the stockbroking community were very positive on MTN, rating the company as a “buy”. Earnings also looked superficially healthy.
However, the accounting earnings, whilst technically correct, did not reflect the underlying economic reality of the business.
MTN’s Nigerian operations were very material to the overall group and were translated for accounting purposes at the official Naira vs USD exchange rate, which was pegged. This official rate was significantly overstated when compared to what is known as the parallel rate, which more accurately reflected the economic reality in Nigeria.
More importantly, cash flows were repatriated out of Nigeria at an exchange rate closer to the parallel rate. Thus, the Nigerian reported earnings were not representative of the cashflows which could be repatriated to MTN group to settle group debt and pay dividends.
At the start of 2023, when earnings from MTN’s Nigerian business were still translated at the official Nigerian exchange rate, the parallel rate had blown out to the point that the official rate was some 50% overstated (as seen in the chart below). When the Naira was floated in July 2023, the official exchange rate collapsed which resulted in a “collapse” in MTN earnings as MTN Nigeria was now being reflected at the lower exchange rate as the currency was trading freely.
Through research and analysis, Truffle had developed an information advantage. A review of “true” earnings, cashflow generation and dividend payout at the parallel rate revealed in advance that the price of MTN did not reflect the group’s “true” ability to generate cash and deliver returns to investors.
MTN reported a significant drop in earnings when the Naira floated, which resulted in significant wealth destruction for MTN investors, of which we were not one. Through finding the information advantage Truffle’s investment team uncovered information that enabled us to establish a fair value for the MTN business and make a decision not to invest. We believed the market price at that time did not reflect the “true” value of MTN.
Information asymmetry matters
Information is everywhere. Information asymmetry can lead to an opportunity to invest in a solid business that is currently undervalued or to avoid buying a lemon. Finding the information advantage requires a skilled, knowledgeable, and diverse team that knows what information matters, when it matters and can execute investment decisions with agility.
