Friday, October 9, 2009

Negative Stubs

I've been catching up on some long overdue reading lately. In the Winter 2002 edition of Capital Ideas (University of Chicago) is an article entitled: Can the Market Add and Subtract?
Mispriced Stocks Break the Rules of Efficient Markets

It's a question that I've asked many times, but one that gets little attention from the efficient market academic crowd.

This particular article is a review of work done by Professor Owen A. Lamont and Professor Richard H. Thaler. And it included a review of the equity carve-out of Palm from 3Com. At the time of the distribution, the implied value of Palm was greater than all of 3Com. This despite the fact that 3Com retained a majority ownership stake in Palm and an operating business of its won. Thaler and Lamont showed that 3Com (by definition) was dramatically undervalued. The market was placing a negative value on 3Com if the Palm stake was subtracted. In other words, the "stub value" of 3Com was negative.

According to Thaler and Lamont, “in cases of equity carve-outs, a negative ‘stub value’ indicates an extreme case of mispricing. The stub value represents the implied stand-alone value of the parent company’s assets without the subsidiary, a projection of what the company will be worth after it distributes these shares.”

“Since stock prices can never fall below zero, a negative stub value is highly unusual.”

From their research, Lamont and Thaler found that: “While the number of negative subs is not significant, even a single case raises important questions about market efficiency.”

Hallelujah!

The result is that "stubs generally start negative, gradually get closer to zero, and eventually become positive. This implies that market forces act to correct the mispricing, but do so slowly, reflecting the sluggish functioning of the market for lending stocks.”

Nonetheless, examples like the Palm - 3Com case are so extreme that they should immediately be eliminated by arbitrage.

The professors ask an obvious question: “Why would anyone buy the overpriced security?”

The answer: “One plausible explanation is that the type of investor buying the overpriced stock is ignorant about the options market and unaware of the cheaper alternative.”

In short, they found “numerous patterns consistent with irrational investors.”

What? Irrational investors? No way!

The article explains that “while Lamont and Thaler do not generalize that these overpriced stocks reflect problems with all stock prices, their evidence casts doubt on the claim that market prices reflect fundamental values because these cases should have been easy for the market to get right.”

No kidding.

Again, not one to let the obvious go unsaid, Professor Lamont observes, “Regarding tech stocks in general, I don’t think that there were enough pessimists shorting the NASDAQ in March 2000.”

After all, there were no supply/demand constraints with this trade. For Lamont this illustrates that “sometimes the optimists go crazy, and things get overpriced.”

So true. I was one of the lonely few who wasn't tech crazy back then. But the bubble inflated so much for so long that anyone taking a contrary view was laughed out of the room. Nevermind we were resoundingly correct. In 2000, with Cisco Systems market value approaching $600 billion, I had the audacity to recommend selling CSCO shares in an investment committee meeting. The response: You've been wrong for years and you're wrong now.

Where was Lamont in 2000… or more specifically March 2000. Was this really an “insight” by late 2002? I don’t think so.

It was obvious then and now that the NASDAQ had grossly overvalued, but few at the time wanted to take the risk of betting against rampant stupidity that seemed to go on forever.

But Lamont wasn't done. He also said, “Whether you are an executive doing a takeover or buying the stock for your own account, if stocks can get overpriced, the key to success is identifying what’s overpriced and avoiding it.”

Time Warner wrote the book on this one when they bought AOL! And witness the recent jump in acquisitions. Executive or not, few want to buy when there is a real sale on Wall Street. But when prices are high (and certainly going higher), everybody piles in.

Where were these intelligent executives in March of this year? Only Warren Buffett and (perhaps Bruce Berkowitz) get credit for high profile buying.

It seems to me that Lamont only got half of the success formula right. The OTHER key to success is finding what is underpriced and NOT avoiding it. How about a current "negative stub" situation like Loews? But I digress.

Thaler and Lamont could have easily proposed that these examples do more than create the possibility that the market prices often do not reflect fundamental values. At least they proved that in some cases, the market is extremely inefficient. This merely confirms what value investors already know.

I’d like to suggest that these eminent scholars revisit their research with a more timely (if slightly more complicated) example: Loews (L). Behold a “negative stub” and all the liquidity one could want.

2 comments:

  1. I have gone back to the beginning of the blog and reread all the material. Excellent ideas! DPS and L still very interesting for conservative investors. Keep up the great analysis.

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  2. We at Seeking Alpha think your blog is great and would love to have you join our team. Please contact me at mholan@seekingalpha.com.

    Thanks,
    Mike

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