The Prejudices of Mr. Market

Professor Sanjay Bakshi is an experienced and successful value investor and one of India’s most renowned finance professors. He taught Security Analysis, Behavioral Finance, and Business Valuation at the Management Development Institute (MDI), Gurgaon, from 2001 to 2021. Currently, he serves as the Distinguished Adjunct Professor of Finance at Flame University, Pune. Professor Bakshi holds an M.Sc. in Economics from the London School of Economics and Political Science and a B.Com. (Hons.) from the University of Delhi. He is also a fellow member of the Institute of Chartered Accountants of India.

In addition to his academic contributions, Professor Bakshi is the managing partner at ValueQuest Capital, a boutique investment firm where he applies his value investing principles to portfolio management. His investment philosophy is inspired by the likes of Warren Buffett, and he is known for his patient, long-term approach, with a focus on high-quality businesses that have sustainable competitive advantages.

Professor Sanjay Bakshi is also the author of the blog ‘Fundoo Professor‘, where he writes extensively on topics such as identifying durable competitive advantages in businesses and the psychology of investing. His skill in simplifying complex concepts into engaging and thought-provoking lessons has earned him widespread respect in India’s investment community. With more than 25 years of experience as a value investor, he has established an excellent long-term track record in the field.

In his renowned talk, The Prejudices of Mr. Market, delivered at Google, Professor Bakshi shares his valuable insights into how investors can understand and exploit the emotional and psychological biases that drive stock market behavior. By empathizing with various market participants—including customers, competitors, entrepreneurs, and the market itself—investors can uncover valuable opportunities that might be overlooked due to temporary misjudgments. This blog will delve into the central ideas presented by Professor Bakshi, exploring the role of empathy in investing, the concept of Mr. Market, and the five key prejudices that investors can exploit for profitable investments.

Empathy in Investing: The Key to Uncovering Market Inefficiencies

Empathy might seem like an unusual tool in the arsenal of a value investor, but Professor Bakshi believes it is essential for truly understanding the dynamics of a business and its market environment. At the core of Professor Bakshi’s philosophy is the idea that by empathizing with different market participants, investors can gain unique insights into how businesses operate and, more importantly, how they are perceived and valued by the market.

Professor Bakshi encourages investors to step into the shoes of four key individuals when analyzing a business: the customer, the competitor, the entrepreneur, and Mr. Market himself. Each of these perspectives provides a different lens through which to evaluate a company’s competitive position, growth prospects, and market valuation.

1. The Customer’s Perspective:

For Professor Bakshi, understanding the customer’s experience is essential to evaluating the strength of a business’s value proposition. He emphasizes the importance of identifying why customers consistently choose a particular business and how it addresses their specific pain points. A business that effectively provides solutions to its customers' challenges is more likely to foster customer loyalty, which can lead to sustainable revenue growth and long-term profitability. By empathizing with customers, investors can better evaluate the resilience and durability of a business’s competitive advantage.

3. The Competitor’s Pain:

Evaluating a business’s competitive position requires understanding the difficulties a potential competitor would encounter when trying to enter the market. Professor Bakshi encourages investors to consider the perspective of a competitor and assess the obstacles they would need to overcome to challenge the business. The greater the barriers to entry, the more secure and durable the business’s competitive moat becomes. By empathizing with potential competitors, investors gain a deeper understanding of the strength of the company’s market position and its ability to resist competition.

3. The Entrepreneur’s Drive:

The mindset of the entrepreneur leading the business is another crucial aspect of Professor Bakshi’s analysis. He emphasizes evaluating whether the entrepreneur is a visionary or an ‘intelligent fanatic’ and understanding how they have navigated challenges while building the business. The sacrifices made by the entrepreneur to achieve growth are also significant indicators of their commitment. By empathizing with the entrepreneur, investors can gauge the quality of leadership and the long-term potential of the business. A driven and capable entrepreneur is often the cornerstone of a business's success, particularly during periods of adversity.

4. Market’s Prejudices:

Finally, Professor Bakshi encourages investors to empathize with Mr. Market himself. While Mr. Market is often irrational, understanding his emotional biases can help investors identify opportunities where the market is mispricing a high-quality business. By recognizing the market’s temporary prejudices, investors can bet against the crowd when they have confidence in the underlying fundamentals of the business. This is where the greatest opportunities for value investors lie.

Mr. Market: A Semi-Psychotic Creature

Before diving into Professor Bakshi’s unique interpretation, it is essential to understand the origins of Mr. Market. Benjamin Graham, the father of value investing, first introduced the concept of Mr. Market in his classic book The Intelligent Investor. Graham personified the stock market as a business partner who, every day, offers to buy or sell his shares at varying prices. Sometimes Mr. Market is euphoric, offering exorbitant prices for businesses. At other times, he is deeply pessimistic, willing to sell his shares at bargain prices. Importantly, Mr. Market’s emotional swings often have little to do with the underlying performance or value of the businesses in question.

Warren Buffett, one of Graham’s most famous disciples, has frequently invoked the concept of Mr. Market to highlight the importance of patience and rationality in investing. Value investors are advised to ignore Mr. Market’s emotional gyrations and, instead, focus on the long-term fundamentals of the businesses they are investing in. When Mr. Market is overly optimistic, an investor should be selling; when he is overly pessimistic, it’s time to buy.

Professor Bakshi takes Graham’s concept of Mr. Market further, describing him as a ‘semi-psychotic creature’ who is prone to extreme emotional swings. Mr. Market’s mood can range from euphoric optimism to deep despair, often without any rational basis. These emotional extremes lead to significant mispricings in the stock market, creating opportunities for value investors who can keep a cool head.

However, Professor Bakshi is quick to point out that Mr. Market’s irrationality is not permanent. Over time, as more information becomes available and market participants reassess their views, Mr. Market’s emotional biases tend to correct themselves. This is a crucial point for value investors: the opportunity to profit arises not just from Mr. Market’s initial misjudgment, but from the eventual revaluation of the business as the market comes to its senses. As Professor Bakshi notes, ‘Mr. Market is a learning machine.’ He may be irrational in the short term, but he learns over time, and value investors must have the patience to wait for this process to unfold.

The Five Prejudices of Mr. Market

In his analysis, Professor Bakshi has identified five key prejudices that Mr. Market tends to exhibit. By understanding and exploiting these prejudices, investors can uncover opportunities to invest in high-quality businesses at attractive valuations. Let’s explore each of these prejudices in detail.

1. The P/E Prejudice:

One of the most common mistakes that Mr. Market makes is his tendency to categorize businesses as either ‘cheap’ or ‘expensive’ based solely on their price-to-earnings (P/E) ratios. Many investors shy away from businesses with high P/E ratios, assuming they are overvalued. However, Professor Bakshi argues that this is often a superficial judgment, particularly in the case of moated businesses with durable competitive advantages.

Moated businesses may have understated earnings because they are reinvesting heavily in expanding their moat, which depresses short-term profitability but enhances long-term value. As a result, their reported earnings may not accurately reflect their true economic earnings. By adjusting for these moat-building expenditures, investors may find that a business trading at 25 times earnings is not as expensive as it initially appears.

Professor Bakshi advises investors to look beyond the surface-level P/E ratio and dig deeper into the economic fundamentals of the business. A high-quality business with a durable moat may deserve a high P/E ratio, and what appears expensive today could turn out to be a bargain in the long run.

2. Hidden Champions:

Mr. Market often overlooks smaller, less visible businesses that operate in niche markets or commodity industries. Professor Bakshi refers to these as ‘hidden champions’—companies that dominate their specific markets but fly under the radar of most investors. These businesses often have significant market shares, strong pricing power, and sustainable profitability, yet they are mispriced because they do not attract the same level of attention as larger, more prominent companies.

Many hidden champions operate in the B2B space or provide specialized products that are not well-known to consumers. Because of their low profile, these companies are often undervalued by Mr. Market, creating opportunities for savvy investors to buy into exceptional businesses at attractive prices.

Professor Bakshi advises investors to look beyond the popular names and explore smaller, lesser-known businesses that have strong competitive positions in their niche markets. These hidden champions may not make headlines, but they can deliver outsized returns over the long term.

3. Learning Machines:

One of the most valuable qualities in an entrepreneur is the ability to learn from mistakes and adapt to changing circumstances. Professor Bakshi refers to these individuals as ‘learning machines’—entrepreneurs who have made mistakes in the past but have demonstrated the ability to evolve, correct course, and build stronger businesses as a result.

Mr. Market often punishes companies that have stumbled, even if they have since corrected their mistakes and emerged stronger. Investors who can identify these learning machines before the market catches on can exploit the market’s temporary prejudice and profit from the eventual revaluation of the business.

Professor Bakshi recalls investing in a company that had previously gone bankrupt due to a series of mistakes made by its founder. However, the founder was candid about his mistakes and determined not to repeat them. He restructured the business, outsourced non-core operations, and made strategic acquisitions that transformed the company into one of the most profitable in its industry. Despite these positive changes, Mr. Market was slow to recognize the turnaround, giving Professor Bakshi the opportunity to invest at a favorable price.

4. Serial Acquirers:

Mr. Market tends to view acquisitions with skepticism, and for good reason—many acquisitions fail to create value for shareholders. However, there are exceptions to this rule. Some companies, led by disciplined and strategic managers, have a track record of successful acquisitions that create long-term value. Professor Bakshi refers to these companies as ‘serial acquirers’ and argues that the market’s blanket prejudice against them can create opportunities for value investors.

Serial acquirers like Warren Buffett’s Berkshire Hathaway or Prem Watsa’s Fairfax Financial have demonstrated the ability to create value through selective acquisitions. These companies have a disciplined approach to deal-making, only pursuing acquisitions that make economic sense and enhance the value of their existing businesses. By identifying these rare serial acquirers, investors can benefit from the market’s misjudgment and capitalize on the long-term value created through strategic acquisitions.

5. Freaks and Misfits

Some of the most successful entrepreneurs in history—Elon Musk, Steve Jobs, Jeff Bezos—are often described as ‘freaks’ or ‘misfits’ due to their unconventional personalities and behavior. Mr. Market tends to be overly critical of these individuals, focusing on their eccentricities rather than their visionary leadership and ability to build extraordinary businesses.

Professor Bakshi argues that the market’s prejudice against these so-called ‘freaks and misfits’ can create significant opportunities for investors. These entrepreneurs often see the world from a different perspective, allowing them to unlock new ideas and disrupt traditional industries. By recognizing the value of their unique vision and ignoring the market’s superficial judgments, investors can ride the coattails of these extraordinary individuals to long-term success.

Patience, Arrogance, and the Value of Independent Thinking

At the heart of Professor Bakshi’s investment philosophy is the need for patience and what he calls ‘necessary arrogance.’ In the world of value investing, patience is key to success. Investors must have the discipline to wait for Mr. Market’s prejudices to correct themselves, even when it seems like the market will never come around.

Professor Bakshi also emphasizes the importance of independent thinking. Value investors must have the confidence to go against the crowd and trust their own judgment, even when the market disagrees. This requires a certain level of ‘necessary arrogance’—the conviction that you know something the market doesn’t. However, this arrogance must be tempered with humility, caution, and a deep understanding of the risks involved.

Seth Klarman, another prominent value investor, describes this as the balance between confidence and caution. Investors must be confident enough in their own analysis to bet against the market, but cautious enough to respect the opinions of others and recognize when they might be wrong. This delicate balance is what allows value investors to capitalize on market inefficiencies while minimizing the risk of catastrophic losses.

Conclusion

Professor Sanjay Bakshi’s teachings offer a fresh and insightful approach to value investing, one that emphasizes the importance of empathy, behavioral psychology, and independent thinking. By understanding and exploiting Mr. Market’s temporary prejudices, investors can uncover hidden opportunities and profit from the eventual revaluation of high-quality businesses.

At its core, Professor Bakshi’s philosophy is about recognizing that the stock market is not always rational. Mr. Market is prone to emotional swings and biases, but he is also a learning machine. Over time, the market corrects its prejudices, and those who have the patience and conviction to wait for this correction can achieve significant rewards.

The key to success, according to Professor Bakshi, is empathy. By stepping into the shoes of the customer, the competitor, the entrepreneur, and Mr. Market, investors can gain a deeper understanding of the businesses they are evaluating and make more informed investment decisions. Ultimately, value investing is not just about numbers; it’s about understanding human behavior and capitalizing on the irrationality of others.

As Professor Bakshi’s teachings remind us, the stock market may be a voting machine in the short term, but in the long run, it is a weighing machine. By exploiting Mr. Market’s prejudices and focusing on the long-term fundamentals of a business, value investors can position themselves for lasting success.