This is a challenging time for those who are invested in cheap stocks. By “cheap,” I mean well below what a rational businessperson would pay for the business -- not to be confused with just a stock whose price has gone down. Historically, even cheap stocks have stretches where their share prices perform poorly. How can we account for this and does it present an opportunity?
Over the last hundred years, there were times when U.S. stocks became meaningfully detached from the underlying values of their respective businesses. Most notably, the periods of 1932-1933 and 1973-1974 come to mind. In both instances, many different factors led to a gloomy market outlook – deflation, high unemployment and thousands of bank failures in the former period and high oil prices and high interest rates in the latter period just to name a few. In fact, at the market lows in 1932, the Dow Jones Industrial Average traded at half of book value. The market was only willing to pay $0.50 for each $1.00 of the aggregate net asset value of some of the largest and most valuable U.S. companies. As priced, the market was implying that these companies were worth a fraction of their net assets as going-concerns. If they were indeed priced correctly, the rational course of action would have been to liquidate these companies. Why keep an asset worth $0.50 when $1.00 is available (assuming assets and liabilities liquidate at book value)? Should Proctor & Gamble, IBM, Standard Oil (Exxon Mobil), and the other companies, which comprised the Dow Jones Industrial Average, have been liquidated in 1932? Were they worth more dead than alive as the market suggested? This is exactly the absurdity the market was implying at the time. Why did the market sell at these ridiculous levels? It was extraordinary fear and panic that drove market prices to levels well beyond the realm of rationality.
At the other extreme, human behavior rooted in euphoria can drive stock prices to obscenely high valuations as happened during the technology bubble of 1999-2000. Justified by a “new era” mentality, market prices of technology stocks rose to levels far detached from underlying business values. There were many companies that did not earn money and had no prospects of doing so, within a reasonable period of time, which sold for multiples of stable earning “brick and mortar” businesses.
Human emotions are a major reason why markets sometimes behave irrationally and can cause even cheap stocks to perform poorly, at least for a time. Logically, if stocks can be severely undervalued, they can also be grossly overvalued. But the “efficient-market hypothesis” (EMH) -- which essentially states that the price of a stock reflects all available information and consequently cannot be mispriced – still has its devotees. This is somewhat surprising, considering the preponderance of historical evidence, which would help refute the notion of EMH.
But some rational-thinking non-academics, who have repeatedly recognized inconsistencies between market behavior and academic theory, know better. After all, to debunk a theory, at least heuristically, it is only necessary to show one instance in which it is wrong. Inarguably, there is a plethora of such examples, the aforementioned among others.
Emotions that factor into stock prices can create great opportunities for the rational investor. In a declining market such as the current one, a cheap stock that sold at half its intrinsic value last week can sell at one-third its intrinsic value this week. This is not a reason to worry, assuming the position is not on margin. Instead, taking advantage of this situation by accumulating additional shares is usually the most logical course of action because the expected rate of return on the investment has increased.
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Guest columnist William Pappas is managing partner of Pappas Management LLC, a New York City-based money management firm. Mr. Pappas appreciates your feedback at [email protected].
Over the last hundred years, there were times when U.S. stocks became meaningfully detached from the underlying values of their respective businesses. Most notably, the periods of 1932-1933 and 1973-1974 come to mind. In both instances, many different factors led to a gloomy market outlook – deflation, high unemployment and thousands of bank failures in the former period and high oil prices and high interest rates in the latter period just to name a few. In fact, at the market lows in 1932, the Dow Jones Industrial Average traded at half of book value. The market was only willing to pay $0.50 for each $1.00 of the aggregate net asset value of some of the largest and most valuable U.S. companies. As priced, the market was implying that these companies were worth a fraction of their net assets as going-concerns. If they were indeed priced correctly, the rational course of action would have been to liquidate these companies. Why keep an asset worth $0.50 when $1.00 is available (assuming assets and liabilities liquidate at book value)? Should Proctor & Gamble, IBM, Standard Oil (Exxon Mobil), and the other companies, which comprised the Dow Jones Industrial Average, have been liquidated in 1932? Were they worth more dead than alive as the market suggested? This is exactly the absurdity the market was implying at the time. Why did the market sell at these ridiculous levels? It was extraordinary fear and panic that drove market prices to levels well beyond the realm of rationality.
At the other extreme, human behavior rooted in euphoria can drive stock prices to obscenely high valuations as happened during the technology bubble of 1999-2000. Justified by a “new era” mentality, market prices of technology stocks rose to levels far detached from underlying business values. There were many companies that did not earn money and had no prospects of doing so, within a reasonable period of time, which sold for multiples of stable earning “brick and mortar” businesses.
Human emotions are a major reason why markets sometimes behave irrationally and can cause even cheap stocks to perform poorly, at least for a time. Logically, if stocks can be severely undervalued, they can also be grossly overvalued. But the “efficient-market hypothesis” (EMH) -- which essentially states that the price of a stock reflects all available information and consequently cannot be mispriced – still has its devotees. This is somewhat surprising, considering the preponderance of historical evidence, which would help refute the notion of EMH.
But some rational-thinking non-academics, who have repeatedly recognized inconsistencies between market behavior and academic theory, know better. After all, to debunk a theory, at least heuristically, it is only necessary to show one instance in which it is wrong. Inarguably, there is a plethora of such examples, the aforementioned among others.
Emotions that factor into stock prices can create great opportunities for the rational investor. In a declining market such as the current one, a cheap stock that sold at half its intrinsic value last week can sell at one-third its intrinsic value this week. This is not a reason to worry, assuming the position is not on margin. Instead, taking advantage of this situation by accumulating additional shares is usually the most logical course of action because the expected rate of return on the investment has increased.
______________
Guest columnist William Pappas is managing partner of Pappas Management LLC, a New York City-based money management firm. Mr. Pappas appreciates your feedback at [email protected].
