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.

There is no price low enough to make a poor quality company a good investment.

If you're in doubt about the quality of a company as an investment, abandon the study and look for another candidate.

When in doubt, throw it out.

Abandon your study and go on to another.  There is no price low enough to make a poor quality company a good investment.


The worse a company performs, the better value its stock will appear to be.

Because declining fundamentals will prompt a company's shareholders to sell, the price will decline.  This will cause all the value indicators to show that the price has become a bargain.  It's not!

When the stock is selling at a price below that for which it has customarily sold, you will want to check to see why - what current investors know that you don't.

Margin of Safety Concept in Undervalued or Bargain Securities

The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. 

• We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. 
• That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. 
• The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. 
• For in most such cases he has no real enthusiasm about the company’s prospects.

True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price. 

But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. 

• If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. 
• The margin of safety will then have served its proper purpose.

Ref:  The Intelligent Investors by Benjamin Graham

CHAPTER 20  “Margin of Safety” as the Central Concept of Investment





Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stocks
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

Price-Earning Ratio 101

What actually is PER?

It's often said that the PER is an estimate of the number of years it'll take investors to recoup their money. Unless all profits are paid out as dividends, something that rarely persists in real life, this is incorrect.

So ignore what you might read in simplistic articles and note this down: a PER is a reflection not of what you earn from a stock, but “what investors as a group are prepared to pay for the earnings of a company”.

All things being equal, the lower the PER, the better. 


But the list of caveats is long and vital to understand if you're to make full use of this metric.

PER:  Historical versus Forward or Forecast PER

The PER compares the current price of a stock with the prior year's (historical) or the current year's (forecast) earnings per share (EPS). Usually the prior year's EPS is used, but be sure to check first.

For example:

Last financial year, XYZ Ltd made $8 million in net profit (or earnings). 

The company has 1 million shares outstanding.

So it achieved earnings per share (EPS) of $8.00 ($8 million profit divided by 1 million shares). 

In the current year, XYZ is expected to earn $10 million; a forecast EPS of $10.00.

• At the current share price of $100, the stock is therefore trading on a historic PER of 12.5 ($100/$8). 
• Using the forecast for current year's earnings, the forward or “forecast PER” is 10 ($100/$10).

Quality has a price to match

Quality usually comes with a price to match. 


It costs more, for example, to buy handcrafted leather goods from France than it does a cheap substitute from China. Stocks are no different: high quality businesses generally, and rightfully, trade on higher PERs than poorer quality businesses.





Low PER doesn't alone guarantee quality business

• Value investors love a bargain. Indeed, they're defined by this quality. 
• But whilst a low PER for a quality business can indicate value, it doesn't alone guarantee it. 
• Because PERs are only a shortcut for valuation, further research is mandatory.
• 
  

High PER with strong future earnings growth maybe a bargain

• Likewise, a high PER doesn't ensure that a stock is expensive. 
• A company with strong future earnings growth may justify a high PER, and may even be a bargain. 
• A stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high PER. 
• But for a poor quality business with little prospects for growth, a high PER is likely to be undeserved.

Avoid a Common trap: Use underlying or normalised earnings in PER


There's another trap: PERs are often calculated using reported profit, especially in newspapers or on financial websites. 


But one-off events often distort headline profit numbers and therefore the PER. 


Using underlying, or “normalised”, earnings in your PER calculation is likely to give a truer picture of a stock's value.





What is a normalised level of earnings?

That begs the question; what is a normal level of earnings? That's the $64 million dollar question.


 If you don't know how to calculate these figures for the stocks in your portfolio, now is the time to establish whether it's skill or luck that's driving your returns. And if you don't know that, history may well make a monkey of you.




An old encounter with low PE stock: Hai-O


It is nostalgic to re-read an old post on Hai-O by ze Moola. 

http://whereiszemoola.blogspot.com/2008/04/more-on-haio.html

Sunday, April 13, 2008
MORE ON HAIO

My dearest BullBear,

A low PE stock means only one thing and that is the stock is trading on a lower valuation compared to what it is currently earning.

Some simply consider that what is happening is the stock is being ignored in the market despite its impressive earnings.

Why?

The market could be wrong and that perhaps this is a stock that's an ignored gem. Yeah, the classical hidden gem and if this is the case, investors who invests in the stock could be rewarded for their stock selection.

However, on the other hand, sometimes the market could be right and that they do sense something is not right within the stock.

And because of this reasoning, I have always realised that a low PE stock does not make a stock a QUALITY stock.

It just means the stock is trading 'cheaply'.

It could be a bargain but it could also be a trap.

Bargain Conundrum - another cognitive error

A stock has done tremendously well for a period of time. Investors tend to extrapolate linearly, assuming that a company which has done well in the last few years is expected to continue to do so.

Then came the correction. For many buyers, it was an opportunity to get in.

Here lies the bargain conundrum - another cognitive error that consistently lead us to make irrational decisions. The belief is that the price uptrend would resume. That this correction could be a reversal may not feature in the thinking or radar of most.

One risk in the investment world that is often overlooked is behavioural risk. Recognising such flaws which the field of behavioural finance has uncovered is the first step towards being more rational in one's investing.


Also read:
Evaluating Changing Fundamentals (Part 3 of 5)
· Don't automatically buy because a stock falls in price; re-evaluate as if new.
Ask ourselves:
Is the correction a true bargain?
Maybe the price uptrend would resume?
Or, maybe not, this being a reversal of the uptrend?
Obviously, having an idea of where the "fair value" of the stock is, helps.