Investors learn the parable of Mr. Market early in their education. The lesson that Benjamin Graham tried to teach is that investors shouldn’t value a company based on what the – possibly irrational – market is telling them, but on their own merit. Taking the teachings of Benjamin Graham to heart many value investors more or less ignore market prices. While this is roughly right in a lot of cases it misses the reflexivity between intrinsic value and price. A business with a higher price is often worth more than an otherwise identical business with a lower price.
Stock as currency (in deals)
One reason for this phenomenon is that overvalued companies can use their stock as a cheap currency. This allows a company to do acquisitions that really add to the intrinsic value/share. Let’s say a hypothetical company is worth $10 million, but it is trading at $20 million with one million shares outstanding. It could double its share count and acquire a second business worth $20 million. The result would be an increase in intrinsic value/share from $10/share to $15/share while the overvaluation shrinks from 100% to just 33%.
And a fair question to ask in this case: is the stock really trading above intrinsic value if the company is able to do deals like this? And if it’s trading above intrinsic value, by how much? I would argue that the true intrinsic value – taking into account reflexivity – is higher than $10/share. But how much it is worth exactly depends on how long the music keeps playing. The company could in fact be worth a lot more than $20/share if it is able to do a bunch of favorable acquisitions. I would never be long a stock based on this idea, but it is worth thinking about when you are shorting!
Share based compensation
Closely related to the example above is the use of stock as a currency to pay management and employees. A higher stock price is better for investors because share based compensation is usually based on the monetary value of the underlying. If you invest in nano-caps (like I do) you might be significantly diluted because of the option package that is granted to insiders. It might not be an insane bonus in absolute terms, but when a companies market cap is minuscule a share based payment could be a quick way to see your stake shrink.
When a company is overvalued and you consider shorting a stock the share based compensation is also an issue to think about. Many web 2.0 stocks have a sky-high valuation and pay employees using their (according to some) overpriced stock. If they are able to continue that practice it makes the business better than it otherwise would be.
If you own a stock that you think is extremely undervalued there is a very real risk that you are unable to benefit fully from that insight. A stock that is worth $50/share but is trading at $10/share is a great target for a management buyout or an acquisition from some other party. If you are, as the acquiring party, able to offer a significant premium above the latest trading price there is a very high probability that you will be able to close the deal. If shareholders wouldn’t be happy to sell a $10-stock at $20 it wouldn’t be trading at $10.
This is one of the many reasons that I’m happy to share my investment idea’s on this blog. Once I have bought a stock I don’t think a dropping share price is just a great opportunity to double down. Doubling down might still be a great idea, but it is a double-edged sword since you also run an increased risk of a take-over at an unfavorable price.
A higher share price does not always translate to a higher intrinsic value: the reverse is also a common occurrence. Some companies buy back stock irrespective of the current market price. When the market price is below intrinsic value this is great for remaining shareholders, but when the stock is overvalued this is not good news. In that case value is transferred from remaining stockholders to selling stockholders. A company with a smarter share repurchase policy is also more valuable when its stock is undervalued: it cannot create value if it doesn’t have the opportunity to repurchase undervalued shares.
While the reflexivity between price and value is an interesting phenomenon I don’t think you can do a whole lot with this knowledge. You still want to buy undervalued companies and short overvalued companies. But it should have a place in your process when you think about the risks and rewards of various investments. Both short and long investments offer less upside than you would have thought when taking reflexivity into account. How much? I don’t know.