| By Susan C. Walker, Elliott Wave International August 28, 2007 Remember that catchy love song that Frank Sinatra made popular in the 1960s, "The Best Is Yet To Come"?
At the risk of mixing musical metaphors and styles, it looks more like the sun has deserted us right now in the financial markets, and we're about to see "The Dark Side of the Moon," the title of Pink Floyd's 1973 smash album. With the subprime mortgage problems reaching farther and farther out to touch hedge funds, U.S. and European banks, mortgage companies and money-market funds, what we're going to experience sounds more like "The Worst is Yet To Come." That's because the financial markets must contend not only with the credit crunch brought on by rising foreclosures now; they must also deal with the repercussions from more foreclosures over the next 18 months as more adjustable-rate mortgages (whether subprime or not) reset from low teaser rates to higher interest-rate levels. How bad can it get? Investment adviser John Mauldin recently published a month-by-month account of the dollar amount of mortgages that will be reset through 2008, and the largest reset amounts pop up in the first six months of next year. In fact, as he points out, the $197 billion of mortgage resets so far this year is "less than we will see in two months (February and March) of next year. The first six months of next year will see more than the total for 2007, or $521 billion." So, we haven't even begun to feel the pain yet. It's bad enough for the folks who will find that they can't keep up with the higher mortgage payments and will have to move out of their homes. But the financial markets won't be catching a break either. The antiseptic phrase used to describe the situation is "repricing risk." That means that investors have woken up to the fact that the AAA-rated mortgage-backed securities and derivatives they invested in look more like junk bonds now. This eye-opener causes them to want higher yields from what they now see as riskier vehicles. That new investor caution plays out this way: investment banks, hedge funds and any other entity that bought securities backed by subprime loans now find it hard to sell the darn things. It's almost the same as homeowners trying to find buyers for their homes – nearly impossible in a market where home prices are falling. In the financial markets, it's nearly The Fed can try to calm such fears all it wants by lowering the discount rate and giving banks more time to pay back loans (from overnight to 30 days), but the real problem can't be fixed with more access to credit. The fact is nobody wants any more of that. What they really want is cash to pay off their debts, be it a mortgage or an unwinding of a securities bet. Wall Street's denizens are in the dark about how much their schemes depend on the ocean of liquidity created by the bull market, say Elliott Wave International's analysts, Steve Hochberg and Pete Kendall. They are particularly struck by the image of the Grim Reaper that Business Week magazine put on its cover recently with the headline, "Death Bonds:"
And the bad news just keeps accumulating: * Housing prices dropped 3.2% percent in the second quarter compared with last year, the largest drop since Standard & Poor's started tracking home prices in 1987. *CIT Group closed its mortgage unit this week, while Lehman Brothers closed its own last week. Mortgage companies that specialize in low-quality mortgages are either going out of business (London-based HSBC) or struggling (California-based *The Wall Street Journal lists the number of fired employees at seven mortgage companies, including First Magnus (6,000), Capitol One's Greenpoint (1,900), Associated Home Lenders (1,600) and Lehman (1,200), which totals more To top it off, Bloomberg reports that the subprime mess may lead to lower bonuses for the first time in five years on Wall Street, according to Options Group, a company that's been tracking this kind of information for a decade. Susan C. Walker writes for Elliott Wave International, a market forecasting and technical analysis company. She has been an associate editor with Inc. magazine, a newspaper writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. Her columns also appear regularly on FoxNews.com. For more information on the housing market and the credit crisis, access the free report, “The Real State of Real Estate,” from Elliott Wave International. |
Friday, August 31, 2007
Subprime's New Song: The Worst Is Yet To Come
Thursday, August 30, 2007
Sharekhan Investor's Eye dated August 30, 2007
Ashok Leyland
Cluster: Ugly Duckling
Recommendation: Hold
Price target: Rs42
Current market price: Rs38
In tie up with Nissan
Key points
- Ashok Leyland and Nissan Motor Company, Japan have agreed to form three joint venture companies in India to develop, manufacture and market light commercial vehicle (LCV) products.
- Both companies are also examining ways to tap each other's dealer networks in India and elsewhere. A final agreement would be signed after the feasibility study concludes by October 2007.
- The tie up should aid Ashok Leyland to expand its product offerings and introduce products in the sub-6 tonne category, where it currently lacks presence. However, the setting up of the plant would take at least 18-24 months and hence the first roll out of the new products is expected only in FY2010.
- The commercial vehicle segment is currently witnessing a slowdown, which is impacting Ashok Leyland as well. We continue to watch keenly the commercial vehicle segment in India to determine any signs of revival. We expect things to improve in the second half of the fiscal with the advent of the festive season.
- For FY2008 we expect the company to report a sales volume growth of 3.2%.
- At current levels, the stock discounts its FY2009E earnings by 9.7x and is available at an enterprise value (EV)/earnings before interest, depreciation, tax and amortisation (EBIDTA) of 6.2x. We maintain our Hold on the stock.
SECTOR UPDATE
Telecommunications
TRAI recommendations on licensing policy and spectrum
The Telecom Regulatory Authority of India (TRAI) has recommended certain measures in the licensing policy ranging from issues like the entry limit and spectrum allocation, merger & acquisition (M&A) guidelines, usage of technologies and rollout obligations. The recent policy initiatives are favourable for Reliance Communication as it sets the framework for its proposed rollout of services under the GSM technology. On the other hand, the large GSM operators would be adversely impacted due to the enhanced subscriber criteria for additional spectrum (as it would result in higher capital expenditure [capex] requirement) and increased cost of services (due to the increase in the annual usage charges and the levy of one-time charge on additional spectrum). However, it should be noted that these are only recommendations and have not been notified by the concerned government department yet. We expect the GSM operators to strongly oppose some of the recommendations.
Cement
Two companies from Pakistan get BIS approval
Two cement companies from Pakistan namely Pakistan Lucky Cement and Maple Leaf Cement have received the Bureau of Indian Standards (BIS) approval for exporting cement to India. Six other firms from Pakistan are awaiting final approval from the BIS. The approval allows these companies to directly export cement to private players in India. But we understand that the logistical bottlenecks at the ports as well as constraints in exporting cement through road will limit the total cement imports from Pakistan to about 2 million metric tonne (MMT). We also learn that the local cement prices in northern Pakistan (a potential region of exports) have gone up by Rs20 per bag to Rs215 per bag. Though we agree that the cement imports via the ports should impact the players in the western region namely Ambuja Cements, Sanghi Cement et al, but by and large the impact on the industry would not be significant. We maintain our positive outlook on the sector with Grasim and Jaiprakash as our top picks.
Wednesday, August 29, 2007
Pritish Nandy Communications : The Adlabs of the Future
- Kaante
- Jhankar Beats
- Pyar Ke side effects
- Sur
The film is being made by the Company as a tribute to the genius of Shakti Samanta, one of Bollywood's legendary film makers, and the animation work will be done by Florida-based Motion Pixel Corporation, who are already partnering the Company on five animation film projects.
Following Howrah Bridge, the Company has also acquired the rights to make animation versions of two other Shakti Samanta films; Amar Prem, starring Rajesh Khanna and Sharmila Tagore, and Barsaat Ki Ek Raat, starring Amitabh Bachchan and Raakhee. "This is our way of reviving some of the grand old classics of Indian cinema and introducing them to the new generation of movie goers", says Pritish Nandy, Chairman, the Company.
Written and directed by Anjan Dutt, the film has already won acclaim on the international film festival circuit and will be the second PNC film under the PNC Classics banner. The first film under this banner was Hazaaron Khaishein Aisi, which was also internationally acclaimed and won the first Ramnath Goenka Award for the Best Film of 2005 at the Star Screen Awards.
It stars Victor Banerjee, Lilette Dubey, Rupa Ganguly, Neha Dubey and Moon Moon Sen. The music has been released by Times Music and is already on the Top 20 Hit List.
Allied Film Services, an associate Company of UFO Moviez, has licensed the theatrical distribution rights of the movie for Mumbai, Delhi, Punjab, Mysore and Tamil Nadu. Kapurchand has licensed the rights for West Bengal. Eros Multimedia has licensed the overseas rights while Star TV has licensed world satellite rights.
The deal will see the Company handle the scripting, sound track and marketing of these animated films, which will feature voice-overs by some of Bollywood's top stars, while MPC will do all the animation work.
These animated films will provide a new extension to the Indian film industry, which is one of the fastest growing film industries in the world today, and could multiply its turnover by creating many Indian and international language versions of what are essentially successful Bollywood movies. Manny Bains, Chairman of MPC, comments "We are extremely excited to be working with a creative Company of the stature of PNC. We will work exclusively together to take ahead both the multi-billion dollar animation sector and the ever growing global Bollywood market."
Pritish Nandy shares the same vision. "We have seen MPC's animation work and they will totally redefine what we know as animation movies in India. These are not kid flicks. These are movies of every genre that everyone of every age will watch in their own language. They will surprise world audiences with the ingenuity and magic of Bollywood."
The first of these joint venture animation movies is expected to be ready for release in the first half of 2008.
Tuesday, August 28, 2007
Sharekhan Post-Market Report dated August 28, 2007
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For ideas on reducing your carbon footprint visit Yahoo! For Good this month.
Monday, August 27, 2007
Sharekhan Investor's Eye dated August 27, 2007
NIIT Technologies
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs690
Current market price: Rs442
Stake sale to unlock value
According to media reports, the promoters of NIIT Group are looking to sell the 25% stake in NIIT Technologies (NIIT Tech) that is currently held by NIIT Limited. This much-awaited trigger in the stock is likely to unlock value for the shareholders, as the transaction is expected to be negotiated at a significant premium to the prevailing valuations.
State Bank of India
Cluster: Apple Green
Recommendation: Buy
Price target: Rs1,780
Current market price: Rs1,556
Taking steps in the right direction
Key points
- SBI has decided to merge State Bank of Saurashtra: The State Bank of India (SBI), the country's largest commercial bank, has kicked off the consolidation process with its associate banks. It has decided to merge the State Bank of Saurashtra (SBS), an unlisted wholly owned associate bank, with itself. The boards of both the banks have given an in-principle approval to the merger proposal. The SBI will now have to get approvals from the Government (which holds 59.7% stake in SBI) and the Reserve Bank of India. We feel the SBI chose the SBS to begin the consolidation process, as the SBS is the smallest among the SBI's subsidiary banks and due to the ease of getting the regulatory approvals as the SBS is completely owned by the SBI.
- First signs that SBI is serious in restructuring its subsidiaries: The SBI-SBS merger has been lingering around for many years without any concrete action on the ground. The merger process was slowed down mainly due to political hindrances and regulatory hurdles. However this time things are really looking bright as the formation of a holding company is in the pipeline and the merger process is already initiated.
VIEWPOINT
Cipla
Highlights of AGM
We attended the annual general meeting (AGM) of Cipla held in Mumbai on August 24, 2007, where the management discussed the company's FY2007 performance and the strategic plans for the future. The highlights of the meeting are presented .
Sharekhan's daily newsletter Dated August 27, 2007
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Sunday, August 26, 2007
Sharekhan Investor's Eye dated August 23, 2007
STOCK UPDATE
Esab India
Cluster: Vulture's Pick
Recommendation: Buy
Price target: Rs575
Current market price: Rs484
Results ahead of expectations
Result highlights
- ESAB India's revenues grew by 35% to Rs87.3 crore in the Q2CY2007, which is ahead of our expectation.
- The operating profit grew by 36.8% to Rs21.7 crore in Q2CY2007 as against Rs15.8 crore in Q2CY2006. Consequently, the operating profit margin (OPM) also expanded by 30 basis points year on year (yoy) to 24.8%. The raw materials cost-to-sales increased by 130 basis points, while the staff cost-to-sales ratio increased by 290 basis points.
- The commissioning of a new plant at Chennai and capacity additions in its existing plants lead to an increased top line in Q2CY2007. The equipment division registered a whopping 65.5% growth in its revenues and the revenues from the consumables increased by 25.6%.
- The depreciation cost for the quarter increased by 26.7% as the company has commissioned its new plant.
- Elexvia group India B.V. along with Charter plc and ESAB Holding Ltd have made an open offer to the shareholder of ESAB India to acquire 30.78 lac shares (Fully paid up equity share of Rs10 each) at Rs426 per share. These represent 20% of the total fully paid up capital.
- For the first half of CY2007 the net sales grew by 32.1% to Rs168.5 crore and the bottom line grew by 36.4% to Rs26.4 crore, subsequently generating an earnings per share (EPS) of Rs17.2 per share.
SECTOR UPDATE
Banking
Q1FY2008 earnings review
In this sector update we have analysed the banks under our coverage based on certain parameters that we feel are important for the overall banking sector's performance going forward. We have also taken cognisance of the risks and positive triggers that the banking sector could face in the near to medium term. Based on our analysis we feel the risk/return ratio for banking stocks appears favourable for investors. We say so because we expect the USA to reduce rates in the near future and if that happens, the Reserve Bank of India (RBI) would not be able to sit on the sidelines for too long. A stable to falling interest rate scenario is generally best suited for the banking sector's performance. Hence, although we remain cautions in the near term, yet we feel the banking sector provides good investment opportunities after the recent correction. Our top picks in the banking sector remain State Bank of India in the public sector, and ICICI Bank and HDFC Bank in the private sector.
Information Technology
Concerns overdone
The tech sector has grossly underperformed the benchmark indices over the past few months. Going by the historic trend, the tech stocks tend to lag behind the overall markets in Q1. However, the underperformance has been much more pronounced this year, due to the added concerns related to the steep appreciation in the rupee, subprime issue and its possible fallout on the overall demand environment, and the slowdown in the earnings growth momentum (compounded annual growth rate [CAGR] over the next three years) on the back of technical issues such as higher tax rate in FY2010.
These issues are largely related to external environment and consequently, not in the control of the domestic tech companies. However, the concerns appear to be overblown and more than priced in the current valuations.
In fact, the premium commanded by the tech stocks over the Sensex valuations (on one year forward basis excluding tech stocks) have reduced from a high of around 120% in the mid of 2004 to a historic low of 20%. This appears to be an overdoing given the fact that one of the key concerns of rupee appreciation is under control now and the performance of the tech sector is not likely to impacted by the rising political risk in the country.
VIEWPOINT
Ambuja Cement
Holcim picks up 3.94% in Ambuja Cements
Continuing with the creeping acquisition of Ambuja Cements' shares, Holcim Mauritius has announced the acquisition of 6 crore equity shares of the company from its promoter and promoter companies (Narotam Sekhsaria, and Radha Madhav Investments and RKBK Fiscal Services). The acquisition has been carried out at a price of Rs154 per share and amounts to 3.94% of the equity capital of Ambuja Cements.
Pondy Oxides & Chemicals : A Spike expected any moment
Business Profile
Pondy Oxides & Chemicals (PONOXICH), incorporated in 1995, is engaged in the manufacture of metallic oxides and plastic additives. The company has three business divisions; metallic oxides, PVC stabilizers and energy. The metallic oxide division manufactures products like zinc oxide, lead sub oxide, litharge and red lead. Its PVC stabilizers division manufactures lead-based stabilizers, liquid stabilizers, paint driers, plasticisers and lubricants. The energy division of the company manufactures high-power batteries which finds application in UPS, domestic inverters, emergency lighting, and automobiles. PONOXICH has four manufacturing units, two at Pondicherry and two at Tamil Nadu. Baschem Pharma is its subsidiary company based in Maraimali Nagar, Tamil Nadu. It is engaged in the manufacture of liquid stabilizers epoxy oil and paint driers. 
As can be seen in the chart, the bollinger bands have converged, giving an indiaction of a spike any moment.This could give a return of 20-30% in a short span of time.
What to Do While the Market Tanks
Why do market corrections upset us so much? We all know -- at some level -- that the market is bound to hit bumps on its march upward, and some of those bumps will be big ones. But even so, those selloffs tend to be white-knuckle heartburn-inducing rides. I think there are two big reasons why that's the case.
- Corrections tend to be fast and big. The market might spend a year going up 20% only to give up three quarters of that gain in a few trading days. The downward spikes happen so quickly that it's hard to avoid the fear that they'll keep going all the way to the bottom, even if we "know" that that's incredibly unlikely.
- We hate losses more than we like gains. This principle, which the pros call "loss aversion," is a cornerstone of behavioral finance and was demonstrated by Nobel laureate Daniel Kahneman and Amos Tversky in a famous (among finance geeks, anyway) 1979 paper. Research has shown that losses may have as much as twice the psychological power of equivalent gains -- in other words, the upset we'd get after losing half our portfolio is twice as big as the joy we'd get if our portfolio doubled. I don't quite understand how they measure it, but that sounds about right to me.
Put these two together, and what you get is this: When the market goes down hard, investors panic and sell, hoping to avoid further losses. Even if you know better, it's still tempting to sell -- I've done it, many pros have done it, and if you've been investing for any length of time, you've probably felt the urge to sell on dips like last week's -- even if you haven't actually sold.
Of course, selling on market dips is usually a bad idea, even if it is human nature. Not only do you lock in a loss, but you also pass up good buying opportunities. I probably have a dozen books on my shelves that quote Warren Buffett's famous dictum : "Be fearful when others are greedy, and be greedy only when others are fearful."
One reason Buffett's a multibillionaire while most of us aren't is that he has been able to hold on to his hat, swallow his emotions, and approach market dips rationally. He's one of many savvy value investors who buy up those good stocks that we've rushed to sell -- and then make a bundle during the recoveries that follow.
How might we join them?
Grab an umbrella
It's best to think of a correction as a passing storm. You don't abandon your beach holiday and go home when a thunderstorm hits, do you?
Here are some things to keep in mind when squalls hit the market.
- Don't panic. The market has always recovered. Odds are high that it'll recover this time, too. Remember that your investment horizon is years away, and corrections are often over and gone in a few weeks -- and remember that you're wired to panic when you see losses, even "paper" losses. Unless your reason for owning a stock has fundamentally changed, there's no good reason to sell -- even if the dip drags on for several months.
- Remember that corrections often bounce. Sometimes, recoveries happen more quickly than the correction did -- and even during the correction, prices will bounce up and down. Selling might increase your distress when you see prices recover a few days or weeks later. Some folks sold BHEL (NSE ) Rs.1550 last Friday 17/8/2007 -- it closed near 1750 just Four days later. Oops.
- Look for buying opportunities. It goes against our natures to plow more money into the market when things are looking bad, but ... well, see that Warren Buffett quote above. For a buyer, a correction means that stocks are on a storewide sale. So take a look at your favorite stocks and see whether you can grab some bargains. Sure, they might go lower -- but even if you don't get the lowest price, you can still set yourself up for good long-term gains.
If all else fails, just go to the beach. Or the lake, or the mountains, or the ice cream shop, or the library, or wherever you go when you're taking some time for yourself. Seriously: If you're fully invested in good stocks, there's really no need to do anything. Turn off your computer, skip your nightly date with CNBC, and use the business section of the Sunday paper to line the bird cage this week. If you built your portfolio using sound investment principles, those principles are still sound, even if Mr. Market is having a tough month. Have the confidence to walk away from it, and let Mr. Market work out his indigestion on his own.
Monday, August 20, 2007
Do fundamentals—or emotions—drive the stock market?
There's never been a better time to be a behaviorist. During four decades, the academic theory that financial markets accurately reflect a stock's underlying value was all but unassailable. But lately, the view that investors can fundamentally change a market's course through irrational decisions has been moving into the mainstream.
With the exuberance of the high-tech stock bubble and the crash of the late 1990s still fresh in investors' memories, adherents of the behaviorist school are finding it easier than ever to spread the belief that markets can be something less than efficient in immediately distilling new information and that investors, driven by emotion, can indeed lead markets awry. Some behaviorists would even assert that stock markets lead lives of their own, detached from economic growth and business profitability. A number of finance scholars and practitioners have argued that stock markets are not efficient—that is, that they don't necessarily reflect economic fundamentals.1 According to this point of view, significant and lasting deviations from the intrinsic value of a company's share price occur in market valuations.
The argument is more than academic. In the 1980s the rise of stock market index funds, which now hold some $1 trillion in assets, was caused in large part by the conviction among investors that efficient-market theories were valuable. And current debates in the United States and elsewhere about privatizing Social Security and other retirement systems may hinge on assumptions about how investors are likely to handle their retirement options.
We agree that behavioral finance offers some valuable insights—chief among them the idea that markets are not always right, since rational investors can't always correct for mispricing by irrational ones. But for managers, the critical question is how often these deviations arise and whether they are so frequent and significant that they should affect the process of financial decision making. In fact, significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. Therefore, managers should continue to use the tried-and-true analysis of a company's discounted cash flow to make their valuation decisions.
When markets deviate
Behavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions. When all three apply, the theory predicts that pricing biases in financial markets can be both significant and persistent.
Irrational behavior. Investors behave irrationally when they don't correctly process all the available information while forming their expectations of a company's future performance. Some investors, for example, attach too much importance to recent events and results, an error that leads them to overprice companies with strong recent performance. Others are excessively conservative and underprice stocks of companies that have released positive news.
Systematic patterns of behavior. Even if individual investors decided to buy or sell without consulting economic fundamentals, the impact on share prices would still be limited. Only when their irrational behavior is also systematic (that is, when large groups of investors share particular patterns of behavior) should persistent price deviations occur. Hence behavioral-finance theory argues that patterns of overconfidence, overreaction, and overrepresentation are common to many investors and that such groups can be large enough to prevent a company's share price from reflecting underlying economic fundamentals—at least for some stocks, some of the time.
Limits to arbitrage in financial markets. When investors assume that a company's recent strong performance alone is an indication of future performance, they may start bidding for shares and drive up the price. Some investors might expect a company that surprises the market in one quarter to go on exceeding expectations. As long as enough other investors notice this myopic overpricing and respond by taking short positions, the share price will fall in line with its underlying indicators.
This sort of arbitrage doesn't always occur, however. In practice, the costs, complexity, and risks involved in setting up a short position can be too high for individual investors. If, for example, the share price doesn't return to its fundamental value while they can still hold on to a short position—the so-called noise-trader risk—they may have to sell their holdings at a loss.
Momentum and other matters
Two well-known patterns of stock market deviations have received considerable attention in academic studies during the past decade: long-term reversals in share prices and short-term momentum.
First, consider the phenomenon of reversal—high-performing stocks of the past few years typically become low-performing stocks of the next few. Behavioral finance argues that this effect is caused by an overreaction on the part of investors: when they put too much weight on a company's recent performance, the share price becomes inflated. As additional information becomes available, investors adjust their expectations and a reversal occurs. The same behavior could explain low returns after an initial public offering (IPO), seasoned offerings, a new listing, and so on. Presumably, such companies had a history of strong performance, which was why they went public in the first place.
Momentum, on the other hand, occurs when positive returns for stocks over the past few months are followed by several more months of positive returns. Behavioral-finance theory suggests that this trend results from systematic underreaction: overconservative investors underestimate the true impact of earnings, divestitures, and share repurchases, for example, so stock prices don't instantaneously react to good or bad news.
But academics are still debating whether irrational investors alone can be blamed for the long-term-reversal and short-term-momentum patterns in returns. Some believe that long-term reversals result merely from incorrect measurements of a stock's risk premium, because investors ignore the risks associated with a company's size and market-to-capital ratio.2 These statistics could be a proxy for liquidity and distress risk.
Similarly, irrational investors don't necessarily drive short-term momentum in share price returns. Profits from these patterns are relatively limited after transaction costs have been deducted. Thus, small momentum biases could exist even if all investors were rational.
Furthermore, behavioral finance still cannot explain why investors overreact under some conditions (such as IPOs) and underreact in others (such as earnings announcements). Since there is no systematic way to predict how markets will respond, some have concluded that this is a further indication of their accuracy.3
Persistent mispricing in carve-outs and dual-listed companies
Two well-documented types of market deviation—the mispricing of carve-outs and of dual-listed companies—are used to support behavioral-finance theory. The classic example is the pricing of 3Com and Palm after the latter's carve-out in March 2000.
Two types of market deviation—the mispricing of carve-outs and of dual-listed companies—are used to support behavioral-finance theory
In anticipation of a full spin-off within nine months, 3Com floated 5 percent of its Palm subsidiary. Almost immediately, Palm's market capitalization was higher than the entire market value of 3Com, implying that 3Com's other businesses had a negative value. Given the size and profitability of the rest of 3Com's businesses, this result would clearly indicate mispricing. Why did rational investors fail to exploit the anomaly by going short on Palm's shares and long on 3Com's? The reason was that the number of available Palm shares was extremely small after the carve-out: 3Com still held 95 percent of them. As a result, it was extremely difficult to establish a short position, which would have required borrowing shares from a Palm shareholder.
During the months following the carve-out, the mispricing gradually became less pronounced as the supply of shares through short sales increased steadily. Yet while many investors and analysts knew about the price difference, it persisted for two months—until the Internal Revenue Service formally approved the carve-out's tax-free status in early May 2002. At that point, a significant part of the uncertainty around the spin-off was removed and the price discrepancy disappeared. This correction suggests that at least part of the mispricing was caused by the risk that the spin-off wouldn't occur.
Additional cases of mispricing between parent companies and their carved-out subsidiaries are well documented.4 In general, these cases involve difficulties setting up short positions to exploit the price differences, which persist until the spin-off takes place or is abandoned. In all cases, the mispricing was corrected within several months.
A second classic example of investors deviating from fundamentals is the price disparity between the shares of the same company traded on two different exchanges. Consider the case of Royal Dutch Petroleum and "Shell" Transport and Trading, which are traded on the Amsterdam and London stock markets, respectively. Since these twin shares are entitled to a fixed 60-40 portion of the dividends of Royal Dutch/Shell, you would expect their share prices to remain in this fixed ratio.
Over long periods, however, they have not. In fact, prolonged periods of mispricing can be found for several similar twin-share structures, such as Unilever (Exhibit 1). This phenomenon occurs because large groups of investors prefer (and are prepared to pay a premium for) one of the twin shares
Thus in the case of Royal Dutch/Shell, a price differential of as much as 30 percent has persisted at times. Why? The opportunity to arbitrage dual-listed stocks is actually quite unpredictable and potentially costly. Because of noise-trader risk, even a large gap between share prices is no guarantee that those prices will converge in the near term.
Does this indict the market for mispricing? We don't think so. In recent years, the price differences for Royal Dutch/Shell and other twin-share stocks have all become smaller. Furthermore, some of these share structures (and price differences) disappeared because the corporations formally merged, a development that underlines the significance of noise-trader risk: as soon as a formal date was set for definitive price convergence, arbitrageurs stepped in to correct any discrepancy. This pattern provides additional evidence that mispricing occurs only under special circumstances—and is by no means a common or long-lasting phenomenon.
Markets and fundamentals: The bubble of the 1990s
Do markets reflect economic fundamentals? We believe so. Long-term returns on capital and growth have been remarkably consistent for the past 35 years, in spite of some deep recessions and periods of very strong economic growth. The median return on equity for all US companies has been a very stable 12 to 15 percent, and long-term GDP growth for the US economy in real terms has been about 3 percent a year since 1945.5 We also estimate that the inflation-adjusted cost of equity since 1965 has been fairly stable, at about 7 percent.6
We used this information to estimate the intrinsic P/E ratios for the US and UK stock markets and then compared them with the actual values.7 This analysis has led us to three important conclusions. The first is that US and UK stock markets, by and large, have been fairly priced, hovering near their intrinsic P/E ratios. This figure was typically around 15, with the exception of the high-inflation years of the late 1970s and early 1980s, when it was closer to 10 (Exhibit 2).
Second, the late 1970s and late 1990s produced significant deviations from intrinsic valuations. In the late 1970s, when investors were obsessed with high short-term inflation rates, the market was probably undervalued; long-term real GDP growth and returns on equity indicate that it shouldn't have bottomed out at P/E levels of around 7. The other well-known deviation occurred in the late 1990s, when the market reached a P/E ratio of around 30—a level that couldn't be justified by 3 percent long-term real GDP growth or by 13 percent returns on book equity.
Third, when such deviations occurred, the stock market returned to its intrinsic-valuation level within about three years. Thus, although valuations have been wrong from time to time—even for the stock market as a whole—eventually they have fallen back in line with economic fundamentals.
Focus on intrinsic value
What are the implications for corporate managers? Paradoxically, we believe that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations.
•Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value
•Repurchasing shares when the market under-prices them relative to their intrinsic value
•Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value
•Divesting particular businesses at times when trading and transaction multiples are higher than can be justified by underlying fundamentals
Bear two things in mind. First, we don't recommend that companies base decisions to issue or repurchase their shares, to divest or acquire businesses, or to settle transactions with cash or shares solely on an assumed difference between the market and intrinsic value of their shares. Instead, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value. Market deviations are more relevant as tactical considerations when companies time and execute such decisions—for example, when to issue additional capital or how to pay for a particular transaction.
Second, managers should be wary of analyses claiming to highlight market deviations. Most of the alleged cases that we have come across in our client experience proved to be insignificant or even nonexistent, so the evidence should be compelling. Furthermore, the deviations should be significant in both size and duration, given the capital and time needed to take advantage of the types of opportunities listed previously.
Source: Mckinsey
