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  • Irrational behavior in US-listed China stocks 1 comment
    Feb 24, 2011 6:30 PM | about stocks: CHBT, CCME, YONG, CMFO, CNOA
    The US-listed China sector has undergone a horrible climate where volatility is high and irrational behavior sweeps the markets. Accusations of fraud (CHBT, CMME, YONG, CGAM, CMFO), fears over the Chinese economy (inflation, real estate bubble.) have killed the appetite for Chinese stocks.

    We are in a deep depression and have forgotten the true value of US-listed Chinese companies.

    Sometimes I receive the question: What do I have to do now with my Chinese stocks?  
    "Stocks are falling so hard, do I have to sell and put my money somewhere else?".

    Frankly that is what short sellers want you to do, sell at these prices and never come back again. 
     
    In this article I will proof that there is still hope and that irrational behavior will be replaced by rational behavior in the future.

    There's never been a better time to be a behaviorist. Already more than four decades, the academic theory that financial markets accurately reflect a stock's underlying value was all but unassailable. But lately, the view that investors can fundamentally change a market's course through irrational decisions has been moving into the mainstream.

    With the exuberance of the high-tech stock bubble and the crash of 2007 still fresh in investors' memories, we see the same happening in the US-listed China space. Adherents of the behaviorist school are finding it easier than ever to spread the belief that markets can be something less than efficient in immediately distilling new information and that investors, driven by emotion, can indeed lead markets awry. Some behaviorists would even assert that stock markets lead lives of their own, detached from economic growth and business profitability.

    A number of finance scholars and practitioners have argued that stock markets are not efficient — that is, that they don't necessarily reflect economic fundamentals. According to this point of view, significant and lasting deviations from the intrinsic value of a company's share price occur in market valuations.
    The argument is more than academic. The rise of stock market index funds, was caused in large part by the conviction among investors that efficient-market theories were valuable.

    I agree that behavioral finance offers some valuable insights — chief among them the idea that markets are not always right, since rational investors can't always correct for mispricing by irrational ones. But for investors, the critical question is how often these deviations arise and whether they are so frequent and significant that they should affect the process of financial decision making.

    In fact, significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. Therefore, investors  should continue to use the tried-and-true analysis of a company's discounted cash flow to make their valuation decisions.

    Behavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions. When all three apply, the theory predicts that pricing biases in financial markets can be both significant and persistent.

    Irrational
    behavior
    Investors behave irrationally when they don't correctly process all the available information while forming their expectations of a company's future performance. Some investors, for example, attach too much importance to recent events and results, an error that leads them to underprice stocks with strong fundamentals.
     
    Systematic patterns of behavior
    Even if individual investors decided to buy or sell without consulting economic fundamentals, the impact on share prices would still be limited. Only when their irrational behavior is also systematic (that is, when large groups of investors share particular patterns of behavior) should persistent price deviations occur.

    Hence behavioral-finance theory argues that patterns of overconfidence, overreaction, and overrepresentation are common to many investors and that such groups can be large enough to prevent a company's share price from reflecting underlying economic fundamentals — at least for some stocks, some of the time.

    When investors assume that a company's recent weak performance alone is an indication of future performance, they may start selling shares and drive down the price.

    Momentum
    A well-known pattern of stock market deviation has received considerable attention in academic studies during the past decade: short-term momentum.
    In the case of our China space, negative returns for stocks over the past few months are followed by several more months of negative returns. Behavioral-finance theory suggests that this trend results from systematic overreaction.

    But academics are still debating whether irrational investors alone can be blamed for the short-term-momentum pattern in returns.

    Similarly, irrational investors don't necessarily drive short-term momentum in share price returns. Profits from these patterns are relatively limited after transaction costs have been deducted. Thus, small momentum biases could exist even if all investors were rational.

    Furthermore, behavioral finance still cannot explain why investors overreact under some conditions (such as IPOs) and underreact in others (such as earnings announcements). Since there is no systematic way to predict how markets will respond, some have concluded that this is a further indication of their accuracy. (Eugene F. Fama, "Market Efficiency, Long-term Returns, and Behavioral Finance," Journal of Financial Economics, 1998, Volume 49, Number 3, pp. 283–306.)

    Persistent Mispricing in US-listed China stocks
    A classic example is the pricing of most of the US-listed China stocks. A lot of them trade under intrinsic value or even under net cash per share (OTC:CNOA).

    Focus on Intrinsic Value
    What are the implications for managers of US-listed China companies?
    The market  deviations that we have now makes it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully.

    Here are some examples of how corporate managers can take advantage of market deviations.
    •Repurchasing shares when the market under-prices them relative to their intrinsic value
    •Paying for acquisitions with cash instead of shares when the market underprices them relative to their intrinsic value
    •Paying dividends at times when trading and transaction multiples are lower than can be justified by underlying fundamentals

    Bear in mind. I don't recommend that companies base decisions on an assumed difference between the market and intrinsic value of their shares. Instead, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value. Market deviations are more relevant as tactical considerations when companies time and execute such decisions.

    Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions. What should matter is the long-term behavior of the share price of a company, not whether it is undervalued by 30 or 40 percent at any given time.
     
    For strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.

    What we learn from all this is that our China depression will fade away, only time will tell us when US-listed China stocks are valued at reasonable prices again.  


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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  • bobobobabbins
    , contributor
    Comments (135) | Send Message
     
    Good article.
    2 Mar 2011, 11:53 AM Reply Like
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