Investment Central

Perennial Value’s investment process is about finding cheap stocks that are good businesses. The thinking behind this is that investors are more likely to re-rate a good business and boost its share price.

But why would a good business be cheap? The answer traces to the central belief of active share management; that share markets are imperfect.

Listed here are seven - sometimes interrelated - reasons why good businesses can be undervalued. In no particular order, they are:

1. Delay in spotting a business has improved

The fortunes of most companies wax and wane. When things get bad enough, steps are often taken to fix the problems.

Whatever the remedies, businesses often turn around well before their stock prices do. The fund managers that first pick that a business has improved stand to benefit if, as most likely, its shares subsequently rise.

Boral Ltd. is one business that was revamped. New management arrived with the demerger from Origin Energy in 2000 when the shares were around $2.

Costs were cut, non-core businesses sold and a culture of rewarding profitable growth installed. The building-materials company was well placed when concrete and other key product prices rose. Boral shares topped $7 in 2004.

2. Effect of big institutions selling

Large institutions can move the share prices of companies when they go overweight or underweight – sometimes so much that the stock price strays from “fair value”.

Harvey Norman Holdings Ltd. provides an example. In early March 2003, when doubts existed about the retailer’s exposure to property, a big institution lowered its 20% stake when the shares were just under $2.30. The selling drove down the shares towards $1.90 within weeks. Eight months later, Harvey Norman shares had rebounded to as high as $3.40.

3. Forced sales

Whatever the item, when people must sell they often accept a lower price than otherwise. It happens on share markets all the time.

One forced sale was the listing of insurer Promina Group Ltd. in May last year. Its owner, Royal Sun Alliance of the UK, was financially stretched by the woes plaguing British insurers.

Promina was listed cheaply at $1.80. The shares had jumped to $4.53 by 30 September this year.

4. Industry out of favour

For various reasons, share markets can turn against industries.

Bad news might just mount up. The coal industry was shunned for a long time because coal prices stagnated.

Emotional overreactions to a disaster can turn investors off an industry. Airlines were untouchable after September 11 because of concerns about repeat incidents and insurance coverage.

Or the share market might get hyped up about one industry and overlook others. Recall the unpopularity of “old-economy” industries such as basic materials during the recent technology bubble.

5. Reliance on earnings revisions

Many share investors run processes where earnings revisions play a major role in buy-and-sell decisions. Accordingly, stock prices tend to overreact to earnings upgrades or downgrades.

In 2003, the successful diversified company Wesfarmers Ltd. said the drought would hamper profit growth. Downward earnings revisions saw the stock price fall about 30% within weeks, a rate Perennial Value viewed as too steep for such a good business. It was no surprise that Wesfarmers shares quickly recovered.

6. Role emotion plays

Share prices are set by more than rational analysis. The irrational element of emotion – read fear and greed – plays a big role too.

Emotional reactions often explain why markets deviate from “fair value”. Markets often react more emotionally to bad news than they do to good. This asymmetric reaction can leave stocks undervalued.

A case of fear undermining a stock is when Qantas Airways Ltd. shares fell about 25% in 2003 as the SARS virus spread around Asia. Qantas’ earnings were healthy and there was no evidence SARS would be a catastrophe.

7. Market knowledge gaps

Markets sometimes misjudge companies for a variety of reasons, underrating some and overrating others.

One that was under-appreciated was Metcash Trading Ltd., a distributor for independent supermarkets in the eastern states.

Most fund managers are Sydney-based and many think independent supermarkets are corner stores. Yet in Victoria and South Australia, there are independent supermarkets of the highest standard.

Without visiting independent supermarkets outside New South Wales, Sydney-based analysts and fund managers wrongly assumed Metcash would struggle. In conclusion, there are many reasons why good businesses can be cheap and this list doesn’t claim to be exhaustive.

Perennial Value believes value managers are often best placed to spot that a good business is undervalued because they are the most focussed on cheap stocks.