Tuesday, 28 October, 2008

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.


....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?


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.



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