Chapter 51—Discrepancies between Price and Value (Continued)

One Minute Summary:

This chapter gave additional reasons for discrepancies between price and value of a security, such as seasoned and unseasoned issues, contractual and non-contractual comparables, and special supply and demand circumstances.

Chapter in Detail:

Seasoned issue—an issue of a company has a high reputation among investors due to its long and successful operating history. The price of a seasoned issue may exhibit price inertia even when its financial statements or future prospects have been weakened.

Unseasoned issue—an issue that usually belongs to the industrial field. Unseasoned issues are very sensitive to adverse developments of any nature. Therefore, during a business storm, a group of unseasoned issues is likely to suffer more than a group of seasoned issues, which speculative opportunities may arise for a security buyer.

Misuse of comparables—an issue is quantitative preferable to others in a similar industry does not imply that issue is a sound purchase. The issue must be considered as attractive on a stand-alone basis.

Contractual related comparables—when a senior issue is more preferable than its junior securities based on quantitative factors, one should consider switching to the senior issue as a sound investment. Any improvement in the business should reflect a better return than one made in the common stock.

Special supply and demand factors—short-term speculative purchases due to temporary excitement in an issue, or its related industry.

Practical Application:

1. Washington Mutual (WaMu) as a seasoned issue—an analyst may examine WaMu’s financial statements and reveal significant information about its financial position. At the peak of WaMu’s operation, the option ARMs and subprime mortgage represent over 50% of its loan portfolio.
2. Buy an issue that you can fully understand its business fundamentals, unless a significant, demonstrable discrepancy exists between its current price and value.

Three Quotes:

1. “We have warned against an overready acceptance of a purely quantitative superiority. The future is often no respecter of statistical data.” Pp. 691
2. “He buys by reputation rather than by analysis and he holds tenaciously to what he has bought. Hence holders of long-established issues do not sell them readily, and even a small decline in price attracts buyers long familiar with the security.” Pp. 688
3. “These disparities [of prices between senior and junior securities] arise from the frequent failure of the general market to recognize the effect of contractual provisions and often also from a tendency for speculative markets to concentrate attention on the common stocks and to neglect the senior securities.” Pp. 693

Three questions to the group to test understanding:

1. Why price inertia exists?
2. In valuing comparables between companies in the same industry but with different capital structure, how would the analyst account for the differences?
3. When an industrial issue appears to be undervalued from its comparables, what would be the best course of action?

Clarifications & Group Discussion:

1. Would you consider expanding your investment horizon to include more senior securities?
2. What other additional factors may contribute to discrepancy between price and value?
3. Do we have more “seasoned” industrial issues today?
4. Technical analysis is a form of special supply and demand?