Undervalued Assets

by breeve 7. August 2011 15:55

For all the theories explaining the stock market not one has gained more traction than the Efficient Market Hypothesis. Coming to prominence in the 1960s the theory states that given many intelligent individuals with equal access to information, stocks that are underpriced will be bought and stocks that are overpriced will be sold thus creating accurately priced stocks.

Nothing sums up the theory better than a conversation between a professor and his student. Upon the student noticing a ten dollar bill on the ground the professor quickly denied it stating it was impossible because if it were really a ten dollar bill someone would have picked it up already.

But if the group philosophy helps the theory it also hurts it. The thing with groups is they sometimes behave like herds and go trampling off in the weeds. No one can say that markets had assets priced correctly during the end of the 1920s or during the top of the dot com boom. Yahoo, for example, was priced at $237 on January 2000 but only $11 dollars a little over a year later.

And it wasn’t like Yahoo’s earnings changed drastically during that time. Instead, the herd mentality took over and a bubble formed. Eventually someone noticed they couldn’t see out of the head tall weeds and the sell off began. If markets were run by robots, the Efficient Market Hypothesis would be well efficient.

But markets are not run by machines but humans complete with greed, pride, and the competitiveness to beat their neighbor into submission. It can be shown that markets are rarely priced perfectly but instead follow a pattern similar to a clock pendulum in that most of the time they are either to the left or right of the correct price. It is like listening to your sister recall her last date. Either things are going really well or they are going terribly. People tend to think the same way about stocks.

Boone T. Pickens was never one to follow the crowd. Having successfully created Mesa Petroleum and then taking it public, he became fascinated with the relationship between oil company’s stock prices and the underlying values of the oil and gas reserves it owned. In 1969, his mind perked when he noticed that Hugoton Production—a larger company with extensive gas reserves in southwestern Kansas—had a stock price much lower than what the gas reserves it owned would fetch if sold. He launched a hostile takeover of Hugoton and merged it into Mesa creating an even more powerful independent oil company.

Pickens didn’t forget about Hugoton. In the early 1980s, he again noticed that oil company validations were not priced correctly. He moved quickly targeting Cities Services which was three times the size of his company but its stock was priced at only a third of what its oil and gas reserves where worth. Mesa acquired blocks of stock in Cities Services and though it lost the battle for the company it made a 30 million dollar profit on its shares. Further profits of 500 million were made in much the same way with Gulf Oil in 1983 when their stock went from $41 a share to $80 a share.

If there is one thing Pickens proved it’s that real money can be made by those who take undervalued assets and make them valuable. And like undervalued companies, big money can be made by employees who take undervalued projects and make them successful.

In sports, for example, coaches rise to fame not because they took a winning team and kept them winning but because they took a bad team and changed them into a winning team. There is very little prestige initially coaching for a bad team but turn it around and people notice. Make no mistake, the quickest career advancements happen because of the ability to turn undervalued assets into valued ones.

People in their career tend to make the same mistakes as people who buy stocks that are pitched by CNBC. They buy the stocks expecting big returns but by the time the market has realized the true value of the company the big returns have already materialized. The people who invested before CNBC made the stock newsworthy are the ones truly rewarded.

Likewise, joining a company that has already hit it big greatly decreases your potential to hit it big. People who join these companies expecting to make big gains will be disappointed. The hard work of turning the undervalued products into valued products has already been done and the employees who did the work have already been rewarded.

Let’s be clear, there is nothing wrong with joining a successful company. It is just like investing in index funds. With index funds, you are guaranteed to get an average return. Just don’t expect to beat the market.

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I am a Principal Engineer with 13 years experience developing and releasing software products. I started developing in C/C++ then moved into .NET and C# and have tech lead multiple projects. I have developed products in Windows Forms, ASP.NET/MVC, Silverlight, and WPF. I currently reside in Austin, Texas.

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