Three Longs & Three Shorts

Illusion, Perception and Reality: Stock Splits and Index Inclusions

In his book ‘Conservative Investors Sleep Well’, Phillip Fisher said “The stock market is filled with individuals who know the price of everything, but the value of nothing”. As a corollary, the same can be said about the events that affect price and value. Professor Aswath Damodaran, in this blog, helps us with a framework to separate the two and therefore its repercussions for value investors and punters alike. The pretext for the blog was the crazy euphoria built around the stock splits of Apple and Tesla over the past month. The Professor obviously rubbishes stock split as a meaningless event for value investors but also helps with examples of how certain events could affect value or price or both or the gap between them. It is worth reading the whole piece with reference to the pictorial representations but here’s the crux:
“I have long argued that value and price, while used interchangeably by many, are different concepts, driven by different forces, and lead to different numbers.
If you are an investor, no matter what your philosophy, this picture should not surprise you, since every philosophy is built around beliefs about the value and price processes.
  • value-based investor, for instance, believes that value and price can diverge, often by large amounts and for long periods, but that the price will eventually converge on value, delivering profits to those with the patience to hold on to the investment.
  • trader, in contrast, has little interest in value and plays the pricing game, gauging momentum and mood shifts to make money, and using liquidity or the lack of it to magnify these gains.
  • An efficient marketer may agree that the price and value processes can diverge, creating gaps, but also believes that investors are incapable of finding and taking advantage of the gaps.
When an event occurs, whether precipitated by the company or an outside force, it can play out in one of three ways. A value event changes cash flows, alters expected growth and/or impacts the uncertainty/risk in these cash flows, and by doing so, change a company’s value. A gap event does not change value, but is designed to get markets to notice mistakes that cause price to diverge from value, and to correct those mistakes, closing the gap. A pricing event is one designed to either alter mood and momentum or to change the liquidity characteristics of a company, causing price to change, even if that price change widens the gap with value.
Without examples, these are abstractions, but before I cite examples for each, I want to emphasize that there are very few events that have only one effect, and that most have a dominant effect (on value, price or the gap) with secondary effects on the others.
  • Mostly value events: When a manufacturing company adds to its production capacity or a retailer opens new stores, the effects will almost entirely be on value. Since these actions are generally in the normal course of operations for these firms, they are unlikely to attract new market attention (which you need for gap events) or change market mood and momentum. Higher profile actions, though, almost always have spillover effects, and here are two examples. When Walmart recently announced its intent to partner with Microsoft to buy TikTok, there is clearly a value impact that this action will have, costing tens of billions in current cash flows, while promising to deliver higher growth and cash flows in the future. At the same time, though, this action, by attracting tech investors  to buy Walmart, may alter momentum and have a secondary impact on pricing. When a California court ruled against ride sharing companies a few weeks ago, on the issue of drivers being employees rather than independent contractors, that decision had consequences for cost structure and value for Uber and Lyft, but it may have induced some investors to look at the gap between price and value at these companies.
  • Mostly gap events: Gap events can be initiated either by the companies that are being mispriced (or at least perceive themselves to be mispriced) or by investors with the same perception. In academic finance, these events are termed signals, and while there is no guarantee that they will work, the motivation is to try to close the perceived gap between price and value. The cleanest example that I can offer for a gap event is a spin off or a split up, where a multi business company  spins off one or more of its businesses or splits itself up, with no consequential changes in how it is run as a company, but with two objectives. One is that the action will expose the disconnect between the underlying fundamentals and the pricing, by providing more transparency on cash flows, growth and risk of individual businesses. The other is that the action will draw investor attention to the company, and that the attention can lead to a repricing of the stock. Not all gap events originate with the company. When activist investors target a company either as a buy or a short sale, they are attempting to provide the catalysts for the pricing gap to close, though their end games may involve changing the way the company is run, thus affecting cash flows, risk and value.
  • Mostly pricing events: With mostly pricing events, the end game is altering mood and momentum or changing the liquidity in the stock, and by doing so, affecting the pricing of a stock. An emerging market company that lists its shares on a more liquid, developed market exchange, for instance, has clearly not altered its fundamentals through that action, but may benefit from higher liquidity pushing up price. There can be spillover effects from increased information disclosure, perhaps helping to close gaps between price and value, and perhaps even greater access to capital, allowing for a value effect.”