Is The Market Fair? Yes Vs. No
Summary Yes. Mostly. But not entirely. 3 recent exploitable examples. Is the market fair and efficient? Yes. Well, almost always. The second best piece of news I have for you is that markets work quite well. Few activities allow for so much success for the people who don’t even try. If you sign up for a marathon and get to the starting line but don’t try to run, you lose to every other runner. If you don’t try to beat the market, you simply sign up for an index fund or buy a passive ETF in the S&P 500 (NYSEARCA: SPY ), you beat about three quarters of other investors. No. Not entirely. The best piece of news I have for you is that market prices fail sometimes – and do so in ways that are exploitable for profit. One of the best books to date on the subject has one of the worst titles: You Can Be A Stock Market Genius . It reveals the world of spinoffs, merger securities, bankruptcy, restructuring, recapitalizations, stubs, and warrants. It is in such investment opportunities where the price system often fails to accurately reflect underlying value. Today, there are three such investment opportunities where the price system continues to fail. These are not prices that are off a bit. They are prices that are wrong. They include share class trades such as CBS / CBS.A , parent/sub stubs such as Yahoo! (NASDAQ: YHOO ), and closed-end fund IPOs such as CCD . CBS There are two related opportunities in CBS. The first is that there are two share classes, each with the same economic value. According to the company, CBS Corporation has two classes of common stock: Class A, which is the voting stock, and Class B, which is the non-voting stock. There is no difference between the two classes except for voting rights. Shares of CBS Class A and Class B common stock generally trade within a close price range of each other. There are, however, more shares of Class B common stock outstanding, and most of the trading occurs in that class. The second is that it is unlikely that CBS remains a standalone company after a transition from its 92-year-old founder and executive chairman departs his role. (click to enlarge) So, it is reasonable to expect the price difference to converge. Given the likelihood that it will get a takeover premium, it is probable that the convergence is upward from the current market prices. What should one do with such situations? CBS Class B shares (NYSE: CBS ) are probably a bargain around $50 per share, even if it remains a standalone company. They are even better if Time Warner (NYSE: TWX ) or someone else buys CBS after Redstone’s tenure. But what is even more interesting is that the share class spread will probably go to zero in such a deal. One way to capture this spread is to buy the B shares ( CBS ) while writing calls on the Class A (NYSE: CBS.A ) shares. For example, you can write May 2016 CBS.A $50 calls, These have a $5.40 bid and a $7.50 ask. This is an attractive amount of premium to capture in addition to the share class spread. In an efficient market, this opportunity should not exist. But it is there for the taking. Yahoo! Net of cash, Yahoo Japan, and Alibaba (NYSE: BABA ), the public capital market valued Yahoo’s core business at $0.11 as of the beginning of this month. The structure can probably be resolved in a number of different tax-efficient ways according to this recent analysis. Reasonable people can differ on the value of the core business, but the stub is probably worth somewhere in the range of $4-$5 per share. $0.11 is just wrong. Net of cash and the exposure to BABA and Yahoo Japan, if the process goes badly and the company performs poorly, the stub should at least double. If the process goes well and the company performs well, the stub should at least double again. CEF IPOs The CEF IPO is an opportunity to lose 8% of your money quickly, then much the rest slowly. They are useful for investors because they are the financial world’s equivalent of a ski mask on a warm sunny day in that any broker caught with one has identified himself as a likely swindler. While I am a longtime skeptic of boom era IPOs generally, my skepticism is greatest when it comes to initial public offerings of closed-end funds. With industrial IPOs, there is some pre-existing corporate asset being supplied. With CEFs, the IPO is driven by the demand. What CEFs get IPOed? Whatever the retail mass market wants. Whatever is most in favor, priced-in, or trendy is what gets invented and then sold to the trusting public. At least industrial IPOs initially pop 16% or so on average on the first day and only later lose investors’ money. But with CEF IPOs, there is not even that initial pop. Then, average CEFs are down about 8% within three months, 13% within five months, and 19% within a year. While there is a market inefficiency in the repeated ability to sell such CEFs to the public for a 5-10% premium to NAV, the market is subsequently efficient at wrenching that premium out of the price. Over a billion dollars of value has been transferred from CEF investors to underwriters on day one. That is about 8% of the money that they invested. There is zero evidence of skill in the (typically expensive) management of the remaining 92% of their money. It is instructive that only about 4% of investors in new CEFs are institutional investors compared with the 22% of investors following similar industrial IPOs. One recent example is Calamos Dynamic Convertible and Income (NASDAQ: CCD ). This has been a smashing success… for its underwriters are brokers. These wealth transfers are useful tools for investors to identify brokers who are willing to do anything and say anything to take your money. So far, it is right on schedule. The market squeezed out massive underwriting fees, losing 11% of value in 100 days (slightly ahead of the -8% historical average) and 25% within five months, well ahead of the -13% pattern such funds have seen in the past. This was not a problem; this was the plan. These can be good opportunities to buy at deep discounts to NAV. Nobody sells shares for no good reason like an investor who bought them for no good reason. By the time they have sold off, the investors are probably in the market for a new broker while the broker is in the market for his next mark. Conclusion The market is good. It is good enough to trust in its general fairness and approximate efficiency. You can put all of your money in passive exposure to equities, debt, and cash with the confidence that – on average and over time – you will get what you pay for. But it is also imperfect. For diligent bargain hunters, some durable inefficiencies include occasional share class spreads, cheap parent-subsidiary stubs, and broken CEF IPOs. It is possible to beat the market over the long-term by judiciously selecting securities within such categories. Is the market efficient? I find much of the academic literature that indicates significant efficiency to be persuasive, yet in my direct experience, I keep finding lucrative exceptions. What do you think and what have you found? Please use the comment section below to weigh in with your findings.