Most financial media and professional investors want us to believe that beating the market is becoming increasingly difficult.

Quicker access to information and the rise of passive investing, we are told, lead to stock prices reflecting new information faster than ever. That creates less room for mispricing, which is what active investors generally need to beat the indices. 

However, this type of thinking is flawed. In a recent interview on the Value Investing with Legends podcast, Ricky Sandler of Eminence Capital discusses how markets have changed over the three decades he has been actively investing. He argues that there are more opportunities for long-term investors today than ever before. There are two main reasons for this:

• The investor base has changed
• The gap in perceptions vs reality is increasing

As a result, the market structure is different than it has been before. Let’s dive into why that creates more opportunities:

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“What I realized post-GFC, markets began to shift away from being largely driven by bottom-up investors to being driven by passive flows, thematic investors and investors who were short-term oriented. What I began to notice was that the dislocation from value persisted for longer and wider amounts of time.”

According to Sandler, there are fewer active investors doing fundamental work. Because more capital comes from passive investors (which will continue as index funds get larger) and thematic investors, stock prices become less driven by fundamentals. 

As a result, some stocks get more overvalued and other stocks get more undervalued than ever before.

This is evidenced by the fact that momentum has become an important signal on a 6 or 12 month horizon. Wildly enough, buying what has gone up has actually worked as a strategy. This makes sense when considering that passive investors buys what is in an index, and as a stock goes up it becomes a larger part of that index and gets a bigger chunk of new flows as a result. 

The same thing happens as thematic investors look for stocks that fit current narratives, which today is anything related to AI or data centers. Again, these flows of capital are not concerned about fundamentals but rather what is likely to work in the next quarter or so as hedge funds are under pressure to deliver short-term alpha. 

When Sandler discusses investor perceptions, what he really refers to is how the market views a company. In other words, the narrative around a company.

The best way to understand the concept is probably to look at Sandler’s portfolio. Eminence Capital, which is run by Sandler, has Amazon (AMZN) as its top holdings followed by GitLab (GTLB) and Workiva (WK). 

Despite Amazon’s $2.5 trillion market cap, the stock regularly goes through phases where investors question its low-margin retail business and cash burn. Amazon has years in which it generates a bunch of free cash flow ($48 billion TTM at some point in 2024), but invests for growth when it sees an opportunity to do that (for example, to scale its logistics as it did during the pandemic). 

Because Amazon is trading at a price to operating cash flow multiple far below its long-term average (currently 18.9x compared to its 10-year average of 26.1x), the market is clearly not assigning a positive narrative to the stock. 

So what exactly is Sandler waiting for? Changes in investor perception is not about a catalyst, but rather what it would take for the market to assign a higher multiple to Amazon’s cash flows. In this case, the market could change its opinion on the stock if AWS proves that margins can continue to expand without much capex, or if management shows its ability to produce cash flows once again.

Sandler is willing to wait several years for these win-win situations where patient investors get multiple expansion on top of earnings growth.

Further, other aspects that could create positive perceptions around a company:

• Re-accelerating growth
• Positive earnings estimate revisions
• Removal of an overhang

To the last point, this happened with another mega-cap as recently as in the past few months. The market quickly changed from perceiving Alphabet (GOOG) as an AI loser to an AI winner and re-rated the stock from about 15x trailing earnings to the current 26x earnings. 

Again, there are fewer and fewer investors doing fundamental work. Stocks that do not fit into the current narratives fall faster and harder than before. 

Back in 2022, Ferguson (FERG) was in the process of moving its primary listing from the London Stock Exchange to New York. As it was de-listed in London, U.K. passive funds that were not allowed to U.S. stocks sold the stock. At the same time, U.S. funds could not buy Ferguson stock right away because the stock was not added to the index right away. 

This sent the stock in a 35% drawdown at some point that year for reasons that had nothing to do with the business. 

So there was an opportunity that came from a big investor base, index funds, mechanically selling a stock. Then, the opportunity for a perception change came as Ferguson was now a U.S.-listed company that should be trading at similar multiples to other distribution businesses in the index. Ferguson stock re-rated from below 15x to around 25x earnings and the stock has returned around 140% since the middle of 2022. 

Companies making less money than the market expected have always been punished. In many cases, this is completely fair. Cyclical companies going into a downturn typically sell off fast because earnings will be depressed for some time. Even though many opportunities can be found there, this is nothing new. 

What Sandler argues is different about this environment is that many good companies will sell off because of passive flows or because they take short-term hits to earnings, which creates negative momentum and more outflows. 

Software stocks have sold off significantly over the past year. The most notable name that comes to mind is Constellation Software (CSU.TO) because the narrative around the stock quickly changed due to the threat from AI. What investors have to remember is that many of these software stocks were trading at high multiples, so a 30-40% drawdown does not mean much. 

I think it is important to emphasize that Sandler is not simply saying to act contrarian and buy what the market is selling. 

To truly take advantage of this change in market structure, the selloff has to become deep enough to where the stock actually becomes undervalued. That is what leads to a re-rating on top of the earnings growth if the narrative was to change. 

A name like Adobe (ADBE) should be interesting to investors who can confidently say that the AI narrative has gone too far. At the current valuation of around 12x forward earnings, there is certainly room for a re-rating if perceptions change and the business proves more resilient than the market believes today. 

To that point, Salesforce (CRM) is a 2.9% position in Sandler’s fund.

A helpful way to think about this change in market structure is “Why are investors selling this stock?”

Selling pressure is increasingly coming from passive flows and thematic investors who sell for reasons not related to the individual businesses. That creates opportunities. 

At the same time, the business has to be good enough to actually deserve a re-rating when the narrative or momentum changes. The current market structure punishes to a larger degree companies that take short-term hits to earnings in exchange for long-term growth, and the drawdowns are more painful because they can be bigger and last longer.

At the same time, that creates more opportunities than what we have seen before for investors who have the patience and ability to stay with stocks that can emerge on the other side as stronger businesses. 

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