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Not fair – Investors should think carefully before concluding a share price constitutes ‘fair value’

21/06/2013

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

The Value Perspective is on the whole a happy family but like any family there is the occasional disagreement. One occurred last week as we discussed the share price of a well-known mining stock that had dropped 5% on the day and indeed, having fallen continuously for the previous fortnight, was more than 50% down from its peak.

A colleague casually remarked the shares were now roughly “fair value”, which technically means at that point in time they stood at precisely their correct long-term price. I replied the chances of that being true were zero although I concede that, in my irritation, I might have been unfair. The chances of it being true were merely statistically insignificant – so a tiny fraction of 1%.

To be even fairer to my colleague, all he really meant was the company was trading at a price that was in the neighbourhood of what we could ever hope to identify as fair value within a tolerance of statistical significance – so let’s call it 20% either way. And while the chances of that being true are clearly higher than a tiny fraction of 1%, they are still pretty low.

Were my colleague not an extremely experienced member of the value investing community, I might have accused him of the behavioural finance bias known as ‘anchoring’ – in this instance, looking at a share’s current price and then reversing out the arguments for what a business might be worth. Do that and, more often than not, you will end up with a price that is very close to the current share price.

At its essence, anchoring involves making a decision based on the first piece of information available, with the classic experiment to prove this being to ask one group to guess the answer to 1 x 2 x 3 x 4 x 5 x 6 x 7 and another to guess the answer to 7 x 6 x 5 x 4 x 3 x 2 x 1. The latter group will invariably come up with a much higher number because it has referenced or ‘anchored’ off the 7 rather than the 1.

The market is often described as a good ‘discounting mechanism’ in that it very quickly processes new developments and pieces of information and then ‘discounts’ them. Human interpretation can get in the way, however, leading to huge share-price mis-valuations. As such, it can be argued with a high degree of confidence the mining company in question – Anglo-American, since you ask – is at present not fair value. It is either cheaper or more expensive than it should be and time will tell which.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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