Understanding value is vital to making informed decisions

Arne Alsin: Understanding value is vital to making informed decisions

By Arne Alsin
Published: March 29 2008 03:09 | Last updated: March 29 2008 03:09
In 2020, when the pundits are asked to reflect on the market panic of early 2008, they will sniff and roll their eyes.They
will criticise investors for panicking and selling their stocks too
cheaply. They will say that the buying opportunity in the market was
obvious, that the economy would obviously make a cyclical turn back to
positive territory by 2009.It is easy to rail from on high
several years after the fact. But when you’re in the middle of a
maelstrom of negativity, when the headlines scream disaster, when big
market players suddenly disappear (E.F. Hutton in the Crash of 1987,
Bear Stearns in 2008), then it is not so easy.Negativity will be
around for a while longer, while recession and credit contraction
issues stay front and centre. While everybody is talking about these
issues, there are other important investor considerations that no one
is talking about.No one is discussing how stocks decouple from
the economy during a recession. There is no exception to this rule over
the past 100 years. Look at stock prices during recessionary phases and
you will see the same dynamic recur with clocklike regularity. Stock
prices fall at the beginning of an economic decline. Then they decouple
from the economy and launch a sustained surge, which usually begins
around the mid-point of a recession. Investors are caught flat-footed
because, in part, the decoupling doesn’t make sense. It’s
counter-intuitive: “How can the market go up? This rally can’t last.
The economy is awful.”Recessions start just after economic
activity peaks and ends when activity troughs. Normally, it is not
evident in gross domestic product data. But there is a significant
correlation between the inception of past recessions and an increase in
the unemployment rate. Most prior recessions start at the same time
that the unemployment rate begins to trend higher. Because of a big
move in the unemployment rate late last year, combined with big
deterioration in retail data, the current recession probably started in
November or December. If the recession lasts from six to nine months,
we are at or near the mid-point.Another investor issue that
nobody talks about in the media is value. Savvy investing requires a
comparison of price to value, yet the media talk about price and price
alone. When the Nasdaq broached the 3,000, 4,000 and 5,000 levels
during the technology bubble, it was met with celebration and fanfare,
and nary a discussion about value. In early 2008, when stock prices
fell like a brick, the discussion focused only on price, not on the
widening gap between price and value.Here’s an example of why a
careful comparison of price and value is all-important. I gave readers
a “holiday gift” in a November column, recommending a stock that is up
more than 60 per cent since: Tecumseh Products, my largest position.
The stockmarket has woefully mispriced this cash-rich company. Per my
calculations, a profitable acquirer of this company could realise a
$500m cash return by next year, by accessing the excess cash buildup
that will soon reach $394m and by using its substantial net operating
loss. In addition, an acquirer would own a $1.1bn (annual sales)
compressor business worth about $500m. Even after a 60 per cent
increase in the stock price, the market price of this company is still
too low, at $580m. I should note that the financials are unusually
complex, given that the company sold two of three divisions late last
year.In spite of the media’s obsession with price, investors
should resist assigning too much importance to it. The market tells me
how much cash I can get for my shares of Tecumseh Products on any given
day. It does not tell me the value. It is up to me, as an investor, to
know and understand the value of my asset.Since the media
ignores value, you will never hear a proper discussion of risk. An
understanding of value is required before risk can be evaluated. If the
stock quote for XYZ drops from $40 to $20, what does that tell me about
risk? Nothing. By itself, the fall is meaningless. Is XYZ worth $5 a
share? Is it worth $100 a share? I need a frame of reference before I
can attach meaning to the price quote. The frame of reference is value.
If I know that XYZ is worth $50 a share, for example, buy and sell
decisions are easy.Unfortunately, many investors in the
stockmarket do not make an effort to understand value. They make
critical buy and sell decisions without knowing value. They are, in
effect, flying blind – and they are competing against other investors
that can see, who are skilled in calculating value.The writer is a portfolio manager for Alsin Capitalarne@alsincapital.com

Copyright The Financial Times Limited 2008


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