With any subjective discipline the use of traditional mathematics is limited. How then, can we measure the market forces which govern price movement? Jeremy Bentham founded a discipline called felicific calculus, which affords the application of the principles of mathematics to unquantifiable paradigms such as morality. We can use a similar approach to gain insight on price movement. We will define the parameters, describe the methodology, and use it to uncover excellent opportunities currently and continuously available.
Defining the parameters
For the purposes of this discussion, we will exclude the random daily fluctuations in price and instead focus on sustainable price changes. Such movements of a stock are consequent to the sum of forces affecting it. A net positive force will cause a price gain of appropriate relative magnitude, and the opposite for a net negative force. Stagnant pricing results from either the absence of affecting forces, or an equilibrant condition in which the positive equal the negative.
Constant forces last so long as the underlying condition remains. The cleanest example of this would be valuation. A stock whose earnings multiple deviates from the norm will experience a constant pull in the direction of the normalized earnings multiple. Assuming a rational market, the force toward a normalized multiple would be proportional to the relative importance of the deviation. The magnitude of the force of the pull increases as the distance from the normalized multiple increases, but at varying rates. For multiples beneath the normalized value, the marginal difference as we go from a P/E of 10 to a P/E of 9 increases exponentially as we approach lower multiples. In contrast, as multiples above the normalized value increase, the marginal difference diminishes. This can be seen graphically when we compare returns on investment through earnings.
A stock trading at an earnings multiple of 5 will return 20% of your investment annually as earnings so long as it remains stable. This is already well known, but its relevance to this discussion becomes clear when we look at earnings of companies trading at various multiples relative to those trading what we will arbitrarily deem the normalized multiple, 15.
An investor entering in to a stock with a P/E of 7 will obtain 1.14X additional earnings, or 214% as much as compared to a stock with a P/E of 15. On the other end of the spectrum, a stock trading at a P/E of 33 nets additional earnings returns of negative 0.54X or 46% as much. To reiterate, the extra returns of low multiple stocks will constantly drive the price up and the opposite for the overvalued. Furthermore, the magnitude of the constant force increases the further earnings multiples deviate.
Other types of constant forces are related to the business structure and management: Specifically, a company's ability or lack thereof to outperform.
Universal forces are those which affect the entire stock market. As such, these have little effect on the relative strengths of securities. They can, however, be the source of great opportunity as will be explained further in the methodology section.
Transient forces are those which are inherently temporary or fragile in nature. Public perceptions and one-time events are the most common examples. False forces are a subdivision of transient forces that are either based on incorrect information or market emotion. The price movement is real, but the ideas it is based upon are wrong. A classic example of this was associated with the swine flu epidemic of 2009. The unfortunate name of the virus caused the price of Smithfield Foods (NYSE:SFD), a pork products company, to plummet. Of course, it was later revealed that the virus had absolutely no impact on the safety of pork products so the price quickly returned to normal. It is virtually impossible to predict the onset of a transient force, but the cessation of such a force often can be predicted. In the previous example, anyone who took the time to research the virus could see that it had nothing to do with food safety and buy the dip. It was only a matter of time before the investment community would realize the truth.
Capital appreciation is derived from positive changes to stock price, so we focus on buying the stocks that are most likely to go up. The aforementioned forces provide insight as to which securities are best positioned to do this. An Ideal stock is one that has strongly positive constant forces but the price is currently held down by transient and/or universal forces. Buying this type of security allows capture of the return to a normalized price as the transient or universal forces break. The opposite opportunity also exists in the shorting of a stock with strongly negative constants with a price held up by transient or universal forces. Opportunity is maximized when we can expect the transient force or forces to break very quickly and expedite the return to a normalized price. Chances to use this methodology occur with remarkable frequency. Following, are examples of such opportunities:
Recent Execution of methodology
On November 5th Strategic Hotels (NYSE:BEE) announced the unanticipated resignation of their CEO Laurence Geller. The stock price rose nearly 15% as a result of people expecting a takeover or other liquidity event. Having followed the company for a long time and being familiar with Geller, I felt the chances of such a takeover occurring were slim to none. As such, the market forces surrounding the $6.39 share-price were a strongly negative constant force from the earnings multiple around 23, and a strongly positive transient force due to the anticipated takeover. I shorted at this point with the assumption that the transient force would soon break. Once the filings associated with the resignation came out, investors saw the non-compete agreement, recognized that the takeover was not going to happen, and the price declined.
Current opportunities using methodology
The election and impending fiscal cliff put in place a negative universal force which is making nearly everything cheaper. This effect is furthered by the intentional selling off of positions for tax purposes. At the end of most years, investors will sell certain positions to realize the loss and save on taxes, but this year the opposite sort of sale is also occurring. Fears of increasing capital gains taxes lead many to realize any possible gains before the end of the year so as to get taxed at the current rate rather than the anticipated higher rates of next year. Normally, universal forces have an across the board affect so as to have little impact on relative opportunity, but the erratic nature of the tax selling has made certain securities irrationally cheap.
Whitestone REIT (NYSE:WSR)
WSR began November at $13.53 and has dropped to $12.58. The negative forces which created such a price dip are soon to end. Tax selling will clearly subside as the year closes, and it turns out 4 more years of Obama are in fact, not the end of the world. On the other side of the equation, the positive constant forces which I believe will drive WSR back above $13 remain strong and steady. At a price to FFO around 13, its valuation is not the driving force. Instead, it is WSR's ability to continuously outperform through accretive acquisitions. Time and time again it has acquired distressed properties massively below replacement cost and successfully leased them up. Its growing 87% occupancy drove revenue and AFFO increases of 32% and 39% respectively in 3Q12 as compared to the previous year. With no signs of the low interest rate environment ending, investors will flock to this 9% yielder and in my opinion, its share-price will soon return to over $13.
CapLease, like WSR, was simply a victim of the erratic market as it has dropped to $5 per share. Even in the event the fiscal cliff results in an economic slowdown, LSE has solid footing. With about 90% of its single tenant owned property portfolio being leased to investment grade tenants, there is a fairly large gap between the point of businesses hurting and them actually defaulting on their leases with CapLease. At an AFFO multiple around 7, investors get more than double the earnings return on investment as compared to the average REIT. The sheer value of LSE makes it a great investment, and the temporary negative forces make now a great entrance point.
There is no way to predict the onset of market forces, but once they are in place we can take advantage of their qualitative aspects. Trade with the constant forces on your side and benefit from the cessation of temporary effects. Opportunities of this nature occur with remarkable frequency. Taking advantage requires that we be aware of not only price fluctuations, but why they occur.
Disclosure: I am long WSR, LSE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. 2nd Market Capital and its affiliated accounts are long WSR and LSE. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.