VALUE INVESTING
Irrationality is Rational

By Stephen Bland (TMFPyad)
March 24, 2000

There was an interesting thread on the value board this week regarding the low share price of a company and why this should affect the company itself, if it does. Our reader suggested that one reason for a company being worried about low share prices is pride, a sort of macho factor. Companies like to see their shares rising and become concerned when the shares fall persistently, despite good results. It makes them appear to be weak, even though this is probably not the case at all for most of them.

I responded by agreeing that this "embarrassment in the shower" idea, as our reader put it, is probably the main reason why a company should be concerned about a falling share price, where there was no real underlying cause. It is true that in most cases the low price has little or no direct effect on the company. Exceptions would be where they wish to issue new shares for some reason, such as rights or a bid, but that would be rare. Other situations could be employee share and option schemes, which could be hit by a low share price, causing poor staff morale. But in general the low price has no direct impact on the day-to-day running of the business. It will be the same as when the price was higher.

The thread arose because of the massive falls over recent periods in the prices of traditional blue chip shares, even though the companies were not actually doing badly. Consequently there appeared to be no rational reason for the price falls, and one or two of them were suggesting that they might take themselves private if the situation did not change.

As it happens, by luck there has been some revival of interest in such shares very recently. This was inevitable as fashions change in the market, but nobody could know when it would turn.

People are strange. Very strange. A blue chip company "worth" a price to earnings (P/E) ratio of, say, 20 one day, a few months later might be rated at only 10, even though nothing has changed in the business. In fact it could well have actually improved earnings per share and despite this has been knocked back. This happens all the time. At the other end of the scale, some technet company – let's take one actually making EPS to make it easier – might be "worth" a P/E of 800. For no reason other than a change of fashion, the shares collapse and a few weeks later are on 80. A fall of 90%. The company is exactly the same. There has been no profits warning: on the contrary forecasts have been increased. It could have gone the other way; maybe it doubles to be "worth" a P/E of 1,600.

What is going on here?

It's just the market, which in other words is just the human nature of crowds. None of this is new. It is probably as old as since humans first started trading things in markets. Maybe the second or third oldest profession. It is new only to market newcomers.

It is this peculiar state of affairs that caused the likes of Whitbread (LSE: WTB) to announce their recent concern at the low rating given by the market to their shares. Just fashion, or lack of it, in their case. The extremes to which fashion can travel vary. Usually it trades between two more or less reasonable extremes. Every few years some sector grips the imagination and the heights to which the shares are pushed goes outside the more common norms, into super fashion.

And following Newton's law about every action requiring an equal and opposite reaction, we can apply financial physics to observe that when a sector goes into super fashion, other sectors will go into super unfashionability, super frump if you like.

Unfortunately for breweries, banks, utilities and all the rest of them, super frump was the rule over the last year or so for these sectors as the elegant and stylish fashion models of technet made the running until very recently. But it will change, perhaps going fairly normal for some time with only modest sector fashions exerting themselves but not to great extremes. Then at some point a particular sector will go mad again.

I have written before that the real value of a share is purely the price for which the market will sell it at that point. That's it. That is all it is worth at that moment. Even if the investor thinks it is worth much more, at that juncture it is purely in his head, he can do nothing about it. What he hopes for of course after buying is that other people, "the market" if you like, will come to agree with him and drive the price up. But that requires time. And if other people, "the market", never agree, then our value investor cannot make any money, however fervently he believes that the share is undervalued. We have mental value and we have real value. What the value investor desires is that these two will converge.

This applies both to the kind of fundamental view of value that I follow, and to the other type, net present value investors, who sometimes and confusingly also describe themselves as value players. Anyway, both of us work by believing we see a higher value in the share than the market is prepared to acknowledge at the moment. And both of us depend completely on hoping that the market will come to agree with us, in order to make our profit. And both of us know that all our shares are, in truth, worth at any moment, whatever we think, is the market price.

But as I comment above, the market is extremely fickle – desperately so – changing the P/Es given to shares quite radically for no underlying reason at all other than fashion. Learn and understand this, it is critical. It explains why some people never understand why value shares, especially pyad shares with their apparently incompatible ultra low ratings and good growth prospects, exist. They shouldn't, it is true. A share so cheaply rated must have something wrong with it, no? No! It is in this fickle behaviour, in the apparently irrational behaviour of the fashion following crowd who constitute a market, that the value player strikes gold. By going where they dare not tread, to follow you later: you hope, anyway. And when they do, you shun them, you bow out after a bit, after they have discovered what you knew was there all along. Crowds make you intensely nervous, after a decent interval during which they've done you a favour by bidding up your share.

If investors all acted entirely rationally, then value shares could not exist. Every share would be rated on a P/E according to its fundamentals, growth prospects and so on. There would be no anomalies. But human irrationality is the very sustenance of value. The fact that a share can halve its P/E over a few months whilst nothing has changed about it for the worse, is why value investors can make large profits.

Without market irrationality, I could never make what to me are entirely rational investment decisions.

And now I've got to the point where I have used the words rational/irrational here so much that they are starting to lose meaning. You know how if you keep repeating a word it becomes weird: that's happening to me now.

Comments on the value board please.

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