Famed value investor David Einhorn recently suggested, “I view the market as fundamentally broken. As algorithmic and passive traders chase after price, overvalued portions of the market are disproportionately bought. Instead of stocks reverting toward value, they actually diverge from value. It’s a structure that means that almost the best way to get your stock to go up is to start by being overvalued.”
What does this mean for fundamentally discounted value stocks? As passive funds flows continue to grow, these value stocks get left further behind, and the discount continues to grow. It is incredibly frustrating for disciplined value investors and for CEOs who remain at a loss as to why their shares are fundamentally undervalued. For small and mid-cap stocks, it is even worse.
In my view, there are four potential outcomes. First, investors will press hard for share buybacks to help reduce the discount to fair value. Capital allocation becomes more challenging as companies must balance shareholder remuneration driven by stock buybacks vs M&A, Capex, leverage, etc. This can lead to misguided short term capital allocation. Second, as share price and valuation discounts extend for a period of time, a company can become a takeover target. This attracts special situation, short term traders interested in a successful takeover to capture M&A premiums. The board can end up in the unenviable position of accepting a discounted offer or declining to engage in the hope future results based on the current strategy will ultimately drive enhanced valuation, often frustrating existing minority shareholders.. Third, the perception of a value trap occurs. Cheap valuations over time lead investors to assume there are fundamental issues that can or will not be addressed and the stock becomes orphaned. It is a downward spiral from there. Lastly, a company can “re-IPO” the company through an enhanced / rebuild / remake of the investment thesis, aligning the board, c-suite and investors with an effective, compelling and credible strategy combined with a new investor engagement plan to drive renewed interest in the company. It is not easy and takes commitment and resource. However, the alternatives to standing still will only get worse over time.
I agree with Mr. Einhorn. The markets are fundamentally broken and the traditional process of investor relations requires a re-think. Companies have to take greater control and earn and own their place in the capital markets.
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