Price and Value Arbitrage

Price and Value Arbitrage

Source: The World wide web. I was doing a search on value investing in these troubled times and came across this piece. Since it appeared on many different web sites, I've not attributed the same to any specific web site. The copyright, if any, continues to belong to the original copyright holder.

Read on:

One day in March 1955, Benjamin Graham appeared before the Senate Committee on Banking and Commerce after being invited to give his views on the state of the financial markets and the principles of value investing. The Committee chairman was Senator William Fulbright and what follows is an excerpt from the transcripts of the hearing.

Chairman:

....One other question and I will desist. When you find a special situation and you decide , just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realise it until a lot of other people decide it is worth 30, how is that process brought about - by advertising, or what happens? (Rephrasing) What causes a cheap stock to find its value?

Graham:

That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. But we know from experience that eventually the market catches up with value.

I have to admit that I have also spent a considerable amount of time thinking about why undervalued stocks eventually rise to their intrinsic value and more importantly, why they should do so. After all there is the distinct possibility that they could remain undervalued forever. However the more I thought about it, the more I began to realise that the same principle is also at work in the natural world. Here, it takes the form of reversion to the mean whereby plant and animal sizes and their numbers eventually revert to their long term average from extremes. It is also why vacuums do not exist in nature because as soon as they do, air immediately flows towards the vacuum, to bring atmospheric pressure back into equilibrium.

More specifically, I believe that the same principle is at work in value investing whenever there is a discrepancy between the price of a stock and its intrinsic value. The wider the discrepancy, the more things get out of whack and this eventually creates an arbitrage opportunity for discerning investors. When you come to think of it, it is the basis for the so called Yen carry trade, which involves hedge funds borrowing Japanese Yen at ultra low interest rates in Japan , and then using the cheap yen to buy higher yielding currencies such as the Swiss Franc and the Australian dollar. It is also the reason why value investing works because as soon as the price of a stock falls below its intrinsic value, value investors can immediately lock in on a potentially profitable arbitrage opportunity. It then takes no stretch of imagination to realise that as soon as other investors notice that the price has stopped falling and has even begun to rise, they take a closer look and once they too spot the opportunity and act on it, the discrepancy between price and value narrows until eventually price meets value and equilibrium is reached in the same way as in all free markets when supply moves to match demand and vice versa.

Not surprisingly, the same phenomenon also works on the downside when the price of a stock rises far above intrinsic value. This time, the reverse gear is engaged and there is initial selling by some holders of the stock who suddenly realise that they are not getting good value for their money and that there are better investment opportunities elsewhere. This causes the price of the stock to begin to fall, and after some time a negative feedback loop is created as the selling begets more selling until equilibrium is again reached between price and value and the discrepancy is ironed out. There is little doubt that it is this same scenario which is now being played out in the US housing market where prices are beginning to fall from their inflated levels to their long term average relative to rents and median income, as well as returns from other investments such as Treasury bonds.

In conclusion, playing the price and value arbitrage is a relatively simple, safe and profitable way to make money in the markets. However, that is not to say it is easy, as it sometimes requires the patience of Job, and the ability to overcome the super contagious emotions which swirl around the markets everyday. As such while you have a very high prospect of beating the market as a value investor, you will need to perform a major task at the outset: Beat yourself.

Regards,

N

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Power of Compound Interest!

Power of Compound Interest!

Did you know Rs. 500 contributed yearly compounded at 25% for 27 years = over Rs. 1 million!

Think about it! I wish that I had grandparents who did precisely that for my sake!

Regards,

N

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Hope you are not thirsty enough for a glass of water right now!!!

Hope you are not thirsty enough for a glass of water right now!!!

"Today those who are desperate for cash because they fear redemption or have redemptions are forced to sell. Those who do not have any reason to raise cash should not try and value their stocks based on the prices that they are seeing today. This is very important because someone who is desperate for a glass of water will take off his diamond ring and exchange it for water. Those who do not have to should not look at that as any establishment of price either of that water or for that drink." - Vallabh Bhansali, Chairman, Enam Financial.

Makes a lot of sense.

Regards,

N

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Thank God for small mercies

Thank God for small mercies

Indeed!

Considering the prevailing atmosphere of extreme fear, it is indeed heartening to note that Warren Buffett appears to have started buying equity again for his personal portfolio. Read on to get reassured:

• http://epaper.timesofindia.com/Repository/ml.asp?Ref=VE9JQ0gvMjAwOC8xMC8yNSNBcjAxNDAx&Mode=HTML&Locale=english-skin-custom

Regards,

N

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Fear & Greed - 2008 Version

Fear & Greed - 2008 Version

Self-explanatory (Original source unknown - got it through email from a friend):

Regards,

N

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Warren Buffett on Leverage

Warren Buffett on Leverage

Here goes a gem from Warren Buffett:

"Leverage," he said, "is the only way a smart guy can go broke … You do smart things, you eventually get very rich. If you do smart things and use leverage and you do one wrong thing along the way, it could wipe you out, because anything times zero is zero. But it's reinforcing when the people around you are doing it successfully, you're doing it successfully, and it's a lot like Cinderella at the ball. The guys look better all the time, the music sounds better, it's more and more fun, you think, 'Why the hell should I leave at a quarter to 12? I'll leave at two minutes to 12.' But the trouble is, there are no clocks on the wall. And everybody thinks they're going to leave at two minutes to 12."

Many of us would wish that we read this (and followed the implied advice) in January 2008!

Regards,

N

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Financial Bubbles - A simple illustration for the financial dummy!

Financial Bubbles - A simple illustration for the financial dummy!

Here's a gem that I got from a friend. Didn't know whether it deserves mention on this blog or my "Something to Smile" blog. Hence I'm posting it on both!

* * * * * * * * * * * * * * *

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.

* The net asset of the country now = 3 dollars.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.

*A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
* Thus, the net asset of the country = 4 dollars.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.

* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.
* The net asset of the country = 5 dollars. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.

* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.

* The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blew, and an evil thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more."

(8) A also thought the same way.

(9) Nobody wanted to buy land anymore.

* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.
* The net asset of the country = 3 dollars again.

(10) So, who has stolen the 3 dollars from the country? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B's net asset is still 2 dollars, his heart is palpitating.

(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.

* A owns the 2 coins; his net asset is 2 dollars.
* B is bankrupt; his net asset is 0 dollar. (He lost everything)
* C got no choice but end up with a land worth only 1 dollar

* the net asset of the country = 3 dollars.

************ **End of the story; BUT ************ ********* ******

There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting -

(1) when a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depends largely on psychology (or speculation)

* * * * * * * * * * * * * * *

Regards,

N

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Need for Retirement Planning

Need for Retirement Planning

Hear out the lament of a retired pensioner - not a rather impoverished, uneducated retired clerk from the back of beyond, but a senior management pro from a PSU giant:

• http://money.outlookindia.com/article.aspx?sid=10&cid=71&articleid=7762

Many of us tend to postpone financial planning for our post-retirement years till it is way too late. Just listen to Einstein's sermons on the "Power of Compounding" being the "Eighth wonder of the world".

The link referred to above is just one more reminder to those of you who are over the ripe old age of 25!

Regards,

N

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Tata Motors, Singur, Transparency, etc.

Tata Motors, Singur, Transparency, etc.

Recently I happened to read an article in Economic Times:

• http://economictimes.indiatimes.com/articleshow/msid-3523973,flstry-1.cms

Normally, I expect ET folks to write stuff that is reasonable and fair. This article half-accuses the Tatas of

• not being transparent
• almost exploiting the WB government by getting land on terms which are supposedly very favourable to the Tatas, and at a great cost to the general public

Before I express my views on the matter, let me add a disclaimer - I've not invested in shares of Tata Motors & do not have any personal stake if Tata Motors were to gain something significant from their business dealings at Singur.

Now that the disclaimer is done away, here goes:

1. Whenever any business house proposes new investments in a state, it asks for a basket of concessions in lieu of its commitments in terms of investments, employment generation, etc. There's no reason why details of a purely business agreement should be available in the public domain. It will certainly go against the business interest of the investor(s) vis-a-vis their business rivals. At the maximum, the details can be made available to the plethora of Audit teams that are bound to scrutinise all such deals at various levels, including any review committees of state / central governments, which can obviously include members from the opposition if appropriate. Why should the details be available to the general public??? Is it to enable the TV channels to gain TRPs or to improve the circulation of business journals?
2. To claim that the concessions given by the WB government are unwarranted is perhaps within the bounds of tolerable limits - one can always argue for and against such concessions on behalf of the Government; But to blame the Tatas for the same is certainly laughable. Certainly, Tata Motors was not negotiating with a small scale industrial unit with 45 employees from Ambattur or Adityapur Industrial Estates. They were negotiating with powerful and highly educated officials of a State Government. Surely, one doesn't expect them to be bull-dozed or bribed into an agreement to the detriment of the state.
3. If any reviewing authority finds that the terms are unduly and unfairly favouring the Tatas, it can be only due to inefficient negotiations or corrupt practices on the part of the negotiators. In either case, the negotiating team must be taken to task in accordance with the rules and norms for the same, instead of blaming the Tatas. After all, when one goes even to the vegetable market, if we try to bargain beyond a point, the "choota boy" at the shop asks us to take a walk!

Regards,

N

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