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Chapter 50: Discrepancies between Price and Value

Evidently the processes by which the securities market arrives at its appraisals are frequently7 illogical and erroneous. These processes are psychological, for they go on in the minds of people who buy and sell. The mistakes of the market are thus the mistakes of groups or masses of individuals. Most of them can be traced to one or more of the three basic causes: exaggeration, oversimplification or neglect.

General procedure to be followed by the analyst in uncovering mispriced stocks: Since analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst. He makes these discoveries mainly by hard and systematic work. Two broad methods of approach may be used:

1.    Comparative analysis of a series of industrial groups. Such studies will give him a fair idea of the standard or usual characteristics of each group and also point out those companies which deviate widely from the modal exhibit.

2.    Scrutinizing corporate reports and relating their showing to the market price. A quick glance at a hundred such reports (summary form like Valueline) may reveal between five and then that look interesting from the earnings or current asset standpoint to warrant more intensive study.

Exploiting Aberrations of the Securities Market

1.    Cyclical Swings of Prices: The best understood disparities between price and value are those which accompany the recurrent broad swings of the market through boom and depression. It is truism that stocks sell too high in a bull market and too low in a bear market, as this is simply equivalent to saying that any upward or downward movement of prices must finally reach a limit, and since prices do not remain at such limits (or at any other level) permanently, it must turn out in retrospect that prices will have advanced or declined too far.

Graham suggests an approach to exploit the repeated exaggerations of the general market. (a) Select a diversified list of leading common stocks (b) Determine a normal value for this group by applying a suitable multiplier to average earnings. Multiplier may be equivalent to capitalizing the earnings at say twice the current interest rate on highest grade industrial bonds. (c) Make composite purchase of the list when the shares can be bought at a substantial discount from normal value, say at 2/3 of such value. Or purchases may be made on a scale downwards, beginning say, at 80% of normal value. (d) Sell out such purchases when a price is reached substantially above normal value, say, 1/3 higher, or from 20% to 50% higher on a scale basis.

This simple idea should not be expected to catch the broad market swings with any high degree of accuracy. A program of this character would also have made far too heavy demands upon human fortitude. But for those who realize its inherent limitations it may have considerable utility, for at least it is likely on the average to result in purchases at intrinsically attractive levels – which is more than half the battle in common stock investment.

2.    Catching the Swings on Marginal basis Impractical: Graham warns that it would be impractical for a speculator to exploit the cyclical swings. Here the speculator is one using margin or short sales instead of purchasing the shares outright. The outright owner can afford to buy too soon and to sell too soon. In fact he must expect to do both and to see the market decline farther after he buys and advance farther after he sells out. But the margin trader is necessarily concerned with immediate results; he swims with the tide, hoping to gage the exact moment when the tide will turn and to reverse his stroke the moment before. In this he rarely succeeds, so that his typical experience is temporary success ending in complete disaster.

Bond prices tend to swing through cycles in somewhat the same way as stocks but it is doubtful if this can be done with satisfactory results. There are no well defined standards as to when high grade bond prices are cheap or dear corresponding to the earnings ratio test for common stocks. The loss of interest on funds between the time of sale and repurchase is a strong debit factor and in his opinion the net advantage is not sufficient to warrant incurring the psychological dangers that inhere in any placing of emphasis by the investor upon market movements.

3.    Opportunities in Secondary or Little known Issues: Leading common stocks are overvalued or undervalued only at certain points in the stock market cycle, the large field of “non-representative” or “secondary” issues is likely to yield instances of undervaluation at all times. When the market leaders are cheap, some of the less prominent common stocks are likely to be a good deal cheaper. It is probably a matter for individual preference whether the investor should purchase an outstanding issue like GM at about 50% of its conservative valuation or a less prominent stock at about 25% of such value.

There is indeed enough sound sense and selective judgment in the market’s activities to create on most occasions some degree of correspondence between market price and ascertainable or intrinsic value. When we are dealing with something as elusive and non-mathematical as the evaluation of future prospects, we are generally led to accept the market’s verdict as better than anything the analyst can arrive at. But on enough occasions to keep the analyst busy, the emotions of the stock market carry it in either direction beyond the limits of sound judgment.

During the intermediate period, when average prices show no definite signs of being either too low or too high, common stocks may usually be found that seem definitely undervalued on a statistical basis. These show a high current and average earnings in relation to market price or make a reasonable satisfactory exhibit of earnings and sell at a low price in relation to net current asset value. Obviously such companies will not be large and well known, or else the trend of earnings will not have been encouraging.

The main drawback of a typical smaller sized company is its vulnerability to a sudden and perhaps permanent loss of its earnings power. Such adverse developments occur in a larger proportion of cases in this group than among the larger enterprises. 

Most investors would try to locate the fast growing small company and will buy their shares at a fairly high price rather than make commitments in a diversified group of bargain issues with only ordinary prospects. Graham’s own experience suggests the later technique. One major caveat is that such commitments are avoided at times when the general market is statistically very high.

Market behavior of Standard and Nonstandard Issues – Standard or leading issues almost always respond rapidly to changes in their reported profits – so much so that they tend regularly to exaggerate marketwise the significance of year to year fluctuations in earnings. The action of less familiar issues depends largely upon what attitude is taken towards them by professional market operators. If interest is lacking, the price may lag far behind the statistical showing. If interest is attracted to the issue, the price will respond in extreme fashion to changes in the company’s exhibit.

When the general market appears dangerously high to the analyst, he must be hesitant about recommending unfamiliar common stocks, even though they may seem to be of the bargain type. A severe decline in the general market will affect all the stock prices adversely, and the less active issues may prove especially vulnerable to the effects of necessitous selling.

4.    Market Exaggerations Due to Factors Other than Changes in Earnings: The inveterate tendency of the stock market to exaggerate extends to factors other than changes in earnings. Overemphasis is laid upon such matters as dividend changes, stock split-ups, mergers and segregations.

5.    Undervalued Investment Issues: Undervalued bonds and preferred stocks of investment caliber may be discovered in any period by means of assiduous research. In many cases the low price of a bond or preferred stock is due to a poor market, which in turn results from the small size of the issue, but this very small size may make for greater inherent security. At times some specific development greatly strengthens the position of a senior issue, but the price is slow to reflect this improvement, and thus a bargain situation is created.

6.    Price-Value Discrepancies in Receiverships: In cases where substantial values are ultimately realized out of a receivership, the senior securities will be found to have sold at much too low a price. This has two consequences. The investor is strongly advised against buying at investment levels any securities of a company likely to fall into financial difficulties; it also suggests that after these difficulties have arisen they may produce attractive analytical opportunities. This holds most promise in cases where liquidation or a sale to outside interests results ultimately in a cash distribution or its equivalent.

Certain price patterns are likely to be followed during receivership or bankruptcy proceedings, especially if they are protracted. In the first place, there is often a tendency for stock issues to sell too high, not only in relation to the price of the bond issues but also absolutely i.e. in relation to the probable ultimate value. This is due to the incidence of speculative interest, which is attracted by a seemingly low price range. In the case of senior issues, popular interest steadily decreases, and the price tends to decline accordingly, as the proceedings wear on. Consequently, the lowest price levels are likely to be reached a short time before a reorganization plan is ready to be announced. A profitable field of analytical activity should be found therefore in keeping in close touch with such situations, endeavoring to discover securities that appear to be selling far under their intrinsic value and to determine approximately the best time for making a commitment in them.

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