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.

‘Low-ball’ offers

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.

Share repurchases

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.

Closing thoughts

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.

How I generate my ideas is probably the question I get asked the most. So I figured I should do a blog post to answer this once and for all. The honest answer is that I usually don’t really generate any idea’s: I simply wait for someone else to write-up a convincing thesis. I thought that this was pretty obvious because a lot of my write-ups start with something along the lines of “Previous week blogger X took a look at company Y…”. The handful of blogs that are displayed at the right-hand side of this post are a major source of inspiration, and I follow another 50 blogs or so as well using Feedly.

Blogs are of course not my only source of ideas. I also follow a bunch of authors on Seeking Alpha and I follow even more people on Twitter. There are also a couple of funds that I follow (again using Feedly) and the great thing about running a blog yourself is that people often e-mail interesting idea’s as well. Like minded investors are in my opinion a great screen for potential idea’s.

Buffett is known for advising people to simply start with the A’s and look at everything while a stock screener is also a popular method to find potential interesting companies. I rarely do this. I have no doubt that this can be successful as well, but I doubt that it is a time effective method. When you look at everything you also spend a lot of time looking at stuff that isn’t even remotely attractive. When you use a screener you often run in data quality issues for micro caps and foreign stocks, and another problem is that usually the cheapest stocks don’t show up on a screener. I’ll happily let my fellow investors do the heavy lifting.

The number of ideas that I can research is limited, and by mostly looking at stocks that like minded investors find interesting I think I’m significantly increasing the odds that I’m looking at a company worth investing in. You don’t get points for originality as an investor. The only score that matters is the risk-adjusted return that you are able to achieve.

I also think that a lot of investors have a bit of a misplaced believe that they need to buy something that is truly undiscovered, and that going through all stocks or using a screener is a way to accomplish that. But the reality is that a stock is almost never undiscovered. Unless you are buying in an IPO there is always a group of people that already know the stock and own the stock. Doesn’t matter how obscure a company is: there is probably someone out there that has owned it for years and knows everything there is to know about it.

What should be noted is that while I almost always borrow my ideas from someone else I never invest without doing my own research 100%. When I find a potential interesting company I always start my research from scratch. If you don’t read the annual reports yourself you don’t know what someone else might have missed, and when you don’t built your own valuation model you don’t know what kind of assumption were exactly used. It’s in my opinion critically important to fully understand the investment thesis. If you don’t it will be hard to interpreted news releases and to decide what to do when the price changes. Do you have the conviction to buy more when the price drops but intrinsic value remains constant? Is it even possible to know what happened to intrinsic value without fully understanding your investment? Seems like a though task to me.

The biggest common factor that connects the stocks in my portfolio is that they are all (relative) illiquid. If you have two almost identical assets, one liquid and one illiquid, the most attractive asset is obviously the liquid one because illiquidity is a real risk:

1. You can never be totally certain that you don’t need money on short notice.
2. An illiquid stock also makes it hard to profit from superior insight. For example: you can’t turn on a dime and exit when you change your mind.

The question of course if how much you want to be paid for illiquidity risk, and how much the market is willing to pay you for that risk. In my opinion you shouldn’t be paid a whole lot to take on illiquidity risk. The main reason is that stocks are only a suitable investment if you have a long-term horizon. But why would you need intraday liquidity if you are holding an asset for a multi-year period? The answer is simple: you don’t! The value of being able to trade out of your position in a few microseconds is negligible when your intention is to hold it for years or even decades.

So if the market is willing to pay you a significant premium for holding an illiquid asset it’s a deal you should take, and there is a lot of academic research that suggests that the illiquidity premium is sizable. The paper “Liquidity as an Investment Style” contains to following table that shows that low liquidity stocks outperform irrespective of size:

As is visible the difference in performance is huge. Especially when we look at the microcap segment where it is a whopping 14% per annum while taking less risk at the same time (if we accept the standard deviation as a risk measure). I don’t know if I’m able to add alpha to my portfolio. I of course think that I do, but by structuring my portfolio in a such a way that I have exposure to factors that have outperformed in the past I’m hedging my bets. Besides a bet on illiquidity my portfolio is of course also a bet on small-sized firms and value stocks.

And the big question is of course: can we expect that the illiquidity premium persists in the future? I think that it will because of how the financial services industry is structured. Most individual investors don’t really need very liquid assets because they do have a long-term horizon. But they do park their money in ETF’s, mutual funds and hedge funds, and the managers of those funds can’t afford to buy illiquid assets. They never know when their investors want to withdraw, so they always have to plan for the worst.

As an individual investor you don’t face this risk, and because of that illiquid assets are a great match if you want to generate high returns over a long-term horizon. I think that is (or should be) the goal of most investors, but as long as they don’t realize what they are implicitly paying for the liquidity they don’t use they will be at a disadvantage.

Disclosure

Author is long a lot of (relative) illiquid stuff