Things are seldom what they seem, skim milk masquerades as cream

iangunn Dec 18th, 2020

Investors would do well to bear in mind these words from Gilbert & Sullivan’s HMS Pinafore, since things are seldom what they seem in financial markets.

Exhibit 1.

The basic premise of owning shares in a limited company is that the owner is protected from liability beyond the capital subscribed for the shares. That capital could be wiped out entirely but, if the company’s liabilities exceed its assets, the owner is protected, i.e. the lowest possible value for a share is zero.

Those who are old enough will remember their portable digital assistant (PDA) which Palm Inc, a US tech company, launched in 1996. These were the first handheld computing devices, which paved the way for smart phones. Palm Inc was owned by 3Com, another tech company.

On 2nd March 2000, 3Com sold 5% of its stake in Palm via a public offering of shares, with the intent of selling the remainder before the end of the year. 3Com shareholders were entitled to 1.525 shares in Palm for every 3Com share they owned.

This gave investors two routes to own Palm shares. They could buy them directly in the public offering or indirectly by purchasing 3Com shares.

Therefore, taking a simple view, even if the non-Palm part of 3Com was worthless, its shares should have been valued at 1.525 times the value of Palm shares.

The day before the public offering, 3Com shares closed at $104.13. After the first day of trading, Palm shares closed at $95. Other things being equal, 3Com shares should have closed at a minimum of $145 ($95 x 1.525); they actually closed at $82.

In other words, the implied value of 3Com’s non-Palm assets was negative, at minus $63.

But that can’t happen!

The market attached a negative value of minus $22 billion to 3Com. This was widely discussed on the second day of trading in Palm shares: but the market continued the mispricing for months.

This is a stark example of market misbehaviour. As a reminder, it happened during the tech bubble which burst the same year. That may or may not be relevant to why it happened, but it has some relevance to this blog.

Exhibit 2.

In 2019, twelve global carmakers (Ford, GM, Fiat Chrysler, Honda, Nissan, Subaru, Mazda, Mitsubishi, BMW, Porsche, Mercedes and Hyundai) sold around 43.6 million vehicles between them. Tesla made global sales of 0.4 million electric cars.

As at 30th September 2020, the market capitalisation of Tesla (then $400bn) was more than the twelve other carmakers combined (roughly $330bn). As of now (December 2020) Tesla is worth around $620bn.

For the first time in its short history, Tesla posted a profit for the fourth successive quarter in the second quarter of 2020. However, its profits do not come directly from making and selling cars: they derive from the sales of ‘regulatory credits’ – taxpayer dollars given to Tesla for making and selling electric vehicles thereby contributing ‘zero pollution’ to the environment.

Is this another example of markets misbehaving, or perhaps the herd instinct of investors?

President Trump has of course taken personal credit for propelling the US stock market to record highs: the S&P 500 is higher today than it was pre Covid-19, which is also a sign of misbehaviour in the face of a shrunken economy and the mind-boggling level of uncertainty over the path to recovery – and indeed what the world will look like when we get there.

Some commentators are drawing parallels between today’s market conditions and those of 1999/2000: history may not repeat itself, but echoes can be heard.Perhaps now is precisely the wrong time to dump active investment managers in favour of cheap and efficient passives: but that too would require not following the herd.

These are challenging times indeed, for all of us.