The Art of Finding Market Inefficiencies

My strategic framework to find multibaggers.

I think it was time to write a post about my investment philosophy and my objectives with this Substack. I will start with the second, as I should have talked about it some time ago. I started this Substack 9 months ago with the only objective of holding myself accountable in my investing and writing. However, pretty quickly I started to receive messages from other writers, investors, and fund managers who were very interested in my work, and I decided to take it a little bit more seriously and write at least one post a week. Fast forward to now, I have almost 1,500 subscribers and 2,500 followers on this platform, for all of which I am very grateful. Additionally, I have formed incredible connections with investors from all around the world that have made me even better.

With no further introduction, I will just introduce myself and then go straight into what you want to read: my investment philosophy.

Who am I?

My name is Hugo Navarro, and I am the Co-director of Twelve and Eight Capital Management, an investing firm based in Spain that manages and advises its clients, from funds to individuals, in real estate and equity investing. I am really passionate about investing, as I find it to be a very rewarding job where every day I learn something new. I think that instead of talking more about myself, I will just post here the interview Benjamin from the ROI Club did with me, so you can judge for yourself.

My strategy to outperformance.

My investment philosophy is based on looking for niches with low competition and then looking for opportunities through different lenses. I apply a contrarian view from different angles. Instead of thinking about why I should invest in a business, I think about why others are not investing in the business. I apply different qualitative and quantitative filters that allow me to quickly identify interesting companies or sectors to look at.

This might seem counterintuitive, but let me explain. Stock market outperformance is a simple game, but one that most people do not understand. The key is not to invest in exceptional businesses or to find stocks that are cheap on paper, all of these are important factors, but what the game is really about is identifying a gap between perception and reality. A good business will lead to outperformance if the market thinks it is just a decent business. When you invest in a great business, you have to make sure the market prices in a ROIC of 12%, but you think the business is able to do 15% ROIC. There is a gap of perception there.

What most people who invest in growth fail to understand is that if everyone knows the company is great, you assume 15% and the market assumes the same, you will probably not get good returns. The same happens with “net-nets” or deep value, however you might like to call it, the market expects a company to go bankrupt, but you realize that it still has some more years of cash flows left or some assets that could be sold.

It is that simple, find a gap between market perception and reality. However, when it comes to doing so, most people will tell you that it is not that simple, that the market is almost always efficient, and there, my friends, lies the key to everything. Most of the time the market is efficient, so why would I invest in markets or sectors that are largely efficient? There is no reason, this is why I choose small caps as my playing field.

I don’t want to compete with the best. Most hedge fund managers are really good, I’d rather not go up against them. So I take the easy path. As the manager of a small fund where I’ve got my own money on the line, I just aim for small and undercovered companies. For most institutions, it is just not worth it to go through all the due diligence just to make a 0.1% position in a company. Additionally, these small companies are usually outside indexes, and therefore passive money does not flow into them. This creates much more inefficient pricing, creating opportunities for people like me and you.

However, I might add that despite the lower efficiency of these markets, they also tend to be more or less efficient, as there are a good amount of people trying to go for these companies. Here is where I start thinking as a business owner, my role in the market is to capitalize on these gaps and then sell once they have closed. Forget about time for now, basically, what I am doing as an investor is buying a company, waiting for some things to happen, and then selling it for a better price with more data supporting the now higher valuation.

So, which are these things that I can capitalize on that offer asymmetry in my investments? I have built these over the years through different principles from different crafts, most of them come from psychology, where I am an avid reader.

The four things I capitalize on are the following:

• Uncertainty perceived as risk,

• Linear extrapolation,

• Time,

• Size.

I can capitalize on these thanks to my competitive advantages as a small investor. I do not have to meet any quarterly metrics, I do not have problems buying small or illiquid companies, and I can sit on my ass for years.

So let’s look at these 4 in detail.

Uncertainty perceived as risk:

I think this one is self-explanatory. Most times there are a lot of possible catalysts in a company, but we do not know for sure if any of these will happen. This usually leads to a situation where the company trades at a valuation as if these catalysts did not exist, or they even weigh negatively in the valuation of the stock, which leads to the classic situation: heads, I win, tails, I do not lose much. I like to have some of these bets, which I call special situations, in my portfolio, as they are great ways to get some uncorrelated results to the market. These opportunities usually offer great protection to the downside and a lot of upside potential from catalysts uncorrelated to market movements.

Linear extrapolation:

This one comes from psychology also. As humans, we assume that trends continue forever, and we are comfortable thinking so because most people in our surroundings think the same. This means that in a professional or personal setup, it will be safer for us to agree with the herd, as it is the safest option and the least likely to get us into any problems. In the financial world, this means that most analysts and investors make financial models assuming that what happened in recent years will continue to happen in the future. It is a way of not risking their career and reputation with a valuation that diverges from the mean. It is easier to just forecast linear growth. This is why when a stock goes up, the price targets always go up, and the opposite happens when a stock goes down.

The trick here is that this extrapolation usually leads to huge mispricings from the market, and even when there are already some signs that the trend is reversing, valuations do not change to reflect that. This is what happens with commodities and turnarounds. While it is difficult to catch them at the bottom of the cycle or just before the turnaround, there are moments where there are signs of it but they are largely ignored, offering a good gap between perception and reality.

These two things I capitalize on mainly when I look for special situations, turnarounds, and other classic Graham opportunities. Right now, a big part of my portfolio is based on these opportunities: companies like Seaport, Kohl’s Corporation, or PGMs and coal in commodities. My investing horizon on these is usually 1 to 4 years, depending on each opportunity, but they are great ways of looking for alpha even when the market is overvalued and has hefty valuations like now.

Now we go to the last two. I use these two to find multibaggers and compounders: time and size, both related. These ones are not related to psychology; here, I try to capitalize on the big funds' and investors' weaknesses and apply my competitive advantages.

Time:

Most hedge funds and investment entities have to report quarterly results, where they face the risk of withdrawals from investors if they do not like these short-term results or if they diverge to the downside compared to the market. This means that most funds value companies in terms of what they will look like in 2 to 5 years, specifically if they are small and more volatile. This creates a huge window of misvaluation if you value companies in a longer time frame. Companies that are going through a big CAPEX investment program will be largely undervalued, as if these programs last some years, the short-term valuation will be largely affected.

Size:

As I mentioned in the beginning of the article, most funds cannot buy small companies, and therefore their valuations and long-term returns are greater than the overall market. This means that if you buy a small but growing company, the multiple will expand without anything changing, just because the business is available now for larger investors, which drives up demand and price. This means that I can buy high-quality businesses at a bigger discount just because they are small, and that this discount will close as they get bigger. Here is where I look for compounders, because even if people know they are good businesses, they still trade at good discounts and present amazing buying opportunities. What is key is to find companies and sectors that fit one or more of these. Small companies that are going through a big capex investment project and with some uncertainty regards the margins of some new contracts, and different combinations like these.

Now, let's look at some past and present examples of how I apply these principles to find multibaggers. We will take a look at Intellego, a company that I covered 6 months ago and has been a 3x since, and then we will cover the PGM sector through this framework.

Intellego:
When I covered Intellego, it traded at a market cap of around 60 million dollars. Right now, it trades over 200 million dollars, in a span of just 6 months. Intellego was a combination of the principles of size and uncertainty perceived as risk. Let me explain. The first one, in terms of size, is self-explanatory, but the second one is more interesting.

At the moment I wrote about the company, Intellego was going through some problems that the market perceived as major risks. However, for me, they were just a matter of time. The company had grown from a small startup into a big corporation, and there were some major issues: the CEO was flagged as unprofessional and they did not have a formal CFO, which caused delays in some filings. The company was already addressing those problems and had also issued guidance for some very big contract wins expected by the end of 2024 and the beginning of 2025. However, the market did not assign any value to them. Even though the company was doubling revenues year after year, it was trading at 7 times EBIT. This meant that the company was cheap even without assuming any further growth, and all guidance pointed to 40% growth in 2025.

A few months later, the contracts were announced, a 360-million-dollar contract over the span of 5 years with China. 2025 guidance has already been met, as the company now guides for 160 million in EBIT, and more and more contracts are beginning to appear. A 3x in 6 months, an IRR of 600% not bad.

PGM market sector:
Now we move on to one of the sectors I think has it all: time, uncertainty, linear extrapolation, and size and illiquidity in some companies. I am talking about the PGM sector. Here, the thesis is simple: the EV revolution is happening slower than predicted, hybrid vehicles (which need more PGMs than combustion vehicles) are growing faster than expected, prices are well below production costs, supply cuts are increasing very fast, and inventories are at record lows.

The thesis has everything I like:

• Time, as it will probably take some time for car manufacturers to replenish their inventories. With their current problems, they want to reduce short-term costs, but eventually, they will have to buy.

• Uncertainty, because no one knows exactly when the demand pressure will reflect on prices.

• Linear extrapolation, because the market assumes that EV adoption trends will continue exactly as expected without bumps.

• Size and illiquidity, because some of the best opportunities are small producers ignored by the big players.

All of this will eventually create a huge upswing in prices. When? I do not know, but it is a matter of time for this to happen.

Additionally, I apply the size factor by purchasing Sylvania Platinum, a 130-million-pound PGM producer that has low production costs, a huge amount of cash, and is trading at 1x EV/EBITDA based on their forecasted 2026 EBITDA — which assumes current depressed prices, leaving lots of room for growth.

Conclusion:
Overall, I am just looking for an edge in the market, looking for a gap in the narrative that reflects on valuations and leads to alpha. If you like my way of investing, maybe you should consider my paid subscription option, where you will receive weekly theses on undervalued and undercovered companies and access to a paid subscriber portfolio where I invest into the best opportunities I cover, all of this for less than a dollar a day.