Market Inefficiencies and Institutional Constraints cause stocks to sell at depressed prices

Ask:  Why the bargain has become available?

The research task does not end with the discovery of an apparent bargain. It is incumbent on investors to try to find out why the bargain has become available. 

• If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. 
• If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?” 

A bargain should be inspected and re-inspected for possible flaws.

The same healthy skepticism applies to the stock market. A bargain should be inspected and re-inspected for possible flaws. 

• Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price. 
• Perhaps there are contingent liabilities or pending litigation that you are unaware of. 
• Maybe a competitor is preparing to introduce a superior product. 

When reason for undervaluation can be clearly identified, the outcome is more predictable

When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable. 

• By way of example, the legal constraint that prevents some institutional investors from purchasing low-priced spinoffs is one possible explanation for undervaluation. Such reasons give investors some comfort that the price is not depressed for an undisclosed fundamental business reason. 
• Other institutional constraints can also create opportunities for value investors. For example, many institutional investors become major sellers of securities involved in risk-arbitrage transactions on the grounds that their mission is to invest in ongoing businesses, not speculate on takeovers. The resultant selling pressure can depress prices, increasing the returns available to arbitrage investors. 
• Institutional investors are commonly unwilling to buy or hold low-priced securities. Since any company can exercise a degree of control over its share price through splitting or reverse splitting its outstanding shares, the financial rationale for this constraint is hard to understand. Why would a company’s shares be a good buy at $15 a share but not at $3 after a five for-one stock split or vice versa? 

Market inefficiencies cause stocks to sell at depressed levels

1.  Obscurity and a very thin market can cause stocks to sell at depressed levels. 

Many attractive investment opportunities result from market inefficiencies, that is, areas of the security markets in which information is not fully disseminated or in which supply and demand are temporarily out of balance. 

Almost no one on Wall Street, for example, follows, let alone recommends, small companies whose shares are closely held and infrequently traded; there are at most a handful of market makers in such stocks. Depending on the number of shareholders, such companies may not even be required by the SEC to file quarterly or annual reports. 

2.  Year-end tax selling also creates market inefficiencies. 

• The Internal Revenue Code makes it attractive for investors to realize capital losses before the end of each year. 
• Selling driven by the calendar rather than by investment fundamentals frequently causes stocks that declined significantly during the year to decline still further. 
• This generates opportunities for value investors.