Value Investing During Economic Downturns

Jun 28th, 2007 | By Penny Sleuth Contributor | Category: Investing Strategies

OK. There were three groups of investors in a room — company executives, graduate-level economists students and econ undergrads. And while this isn’t a joke, what happened was definitely funny.

Researchers Caginalp, Porter and Smith showed in a study back in 2000 that stock prices could stray from their fundamental values for long stretches of time. Much of their study was based on experimental markets — where just about every variable was under their full control. But what the study displayed was that investor ignorance and ineptitude gives the rest of us some great moneymaking opportunities…

The study, as described in James Montier’s Behavioural Finance, included two-hour “trading sessions” in which each participant was given play money to invest in fictitious stocks. The trading session was divided into 15 separate periods where simulated buying and selling could take place.

In one of the most telling experiments conducted during these sessions, the players were told that one of the stocks would pay a dividend. They were given a table of what it would likely payout, and they were told that the stock would be worthless at the end of the game:

Given the data in the table, it could be determined that the stock would likely pay $0.24 per each share held for each of the 15 periods it was owned in the game. Multiply them together and the stock is at least worth $3.60 per share, and would be worth $0.24 less as each of the 15 periods passed. Present values don’t even come into play in the game. Simple, right?

The post-grad economists were the most rational of the bunch. They got it right. They were willing to pay $3.60 a share and valued the stock $0.24 less each period. The other groups’ behavior, frankly, was bizarre…

The undergrads traded in such a way as to create a price bubble. They were not willing to pay full value for the shares — that is, $3.60 — in the beginning of the game. But then in the middle of the action they bid the stock up 270% more than its fundamental value.

The company execs reportedly were even less rational. They started their bids a little closer to the true fundamental value of $3.60, then bid shares up 530% past it!

Bare in mind these were experimental market conditions where you could buy and sell without real world concerns. There were no liquidity problems, commissions, taxes or anything else to worry about. If you wanted to buy the shares at $3.60, then you could. There was no trickery here.

The experiment displayed that stock market bubbles can occur when you have more neophyte investors involved than rational, educated participants.

Many sets of experiments conducted by Caginalp, Porter and Smith under a host of different conditions have shown that security prices typically start lower than the $3.60 fundamental value during the first period, then rise drastically higher than the fundamental value during the middle to late periods. Sometime late in the game — around the eleventh and fifteenth periods — the asset prices begin to crash. They usually drop below their fundamental value.

Follow up studies have shown that market bubbles dissipate over time primarily because of one thing: experience. The groups who ignorantly inflated the price they’d pay for shares learned rapidly what not to do in their second and third go-rounds. In fact, in the third round each group played, the bubbles were gone completely.

Apply this to something like the U.S. real estate bubble of recent years. There were a lot of inexperienced people wielding a lot of cheap credit buying up real estate assets at sky-high prices. Many made outrageous claims like “prices would never come down again.”

Many of us knew then, as well as now, that such sentiment was nonsense. So, where is the bubble today? To answer that, we have to determine what the fundamental value is for a home. If it’s a rental property, we might call its basic fundamental value the accumulated rent checks you receive from it. If it’s a home you’ll reside in, its most basic fundamental value might be the cost of the materials used to build it. In that case, there have been reports of homes being auctioned in Michigan for prices less than the cost of the wood they contain…

Until next time,
Craig
June 28, 2007

P.S.: In Small-Cap Strategy Report, there are tons of studies and research ideas that lead to many of my blockbuster gains like 221% on Coeur d’Alene Mines and 146% on China Yuchai Intl. These gains are no accident.

Penny Sleuth Contributor

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