In logic problem, we noted the determination of some companies to continue paying dividends even when it is clearly not in their long-term interests to do so. Even if the most value-enhancing thing a particular company could do in reality is cut its dividend, its management team will often convince itself such a course of action will be punished by investors with a falling share price.
This sort of attempt to second-guess the market is of course by no means the only way psychology can undermine rational decision-making in business and investment. Another example, this time involving share buybacks, has been cropping up in an area we have been taking an interest in recently – the US education sector.
The number of students enrolled in for-profit companies offering university-level education in the US has mushroomed over the last decade on the back of a huge programme of government grants and loans. Some companies have been accused of charging students extortionate sums and leaving them with a lot of debt – and possibly worthless degrees – but that is not the only potential bad behaviour in the sector.
Over the last five or six years, a significant proportion of US education companies have been buying back stock very aggressively and yet, after seeing their shares prices fall 60% or 70%, several have simply stopped because they are worried about the current environment. Once again, we would argue this is perverse psychology because, if you thought your company’s shares were worth buying back at £1, say, then surely at 30p or 40p they are even better value.
For our part, as value investors, we are looking for businesses where we have reasonable security about the value of the company so that, should the share price fall, we do not worry the business is worth less – we think it is worth the same as it was before but priced at an even more attractive level.
So, here on The Value Perspective, we believe the confidence of those education companies in their businesses ought to be rising because suddenly they look so much cheaper and yet in reality their confidence looks to be dropping as fast as the share price. This happens with mergers and acquisitions as well as share buybacks – as the price of their or a competitor’s business rises, management teams often feel more confident about buying and, as the price comes down, they are more inclined to sell.
Rationally, if you loved your – or someone else’s – stock at £1, you should be falling over yourself to buy it at 50p. What you often find, however, is management frequently love the stock at £1 but are less keen on it at 50p because they fret about the possible reasons it has fallen in price.
A further perverse angle relates to a business’s capital expenditure in such situations. If a company’s share price has halved, how are management feeling about the millions of pounds they are currently committing to, for example, a new factory? Should one thing really affect a judgement on the other? The answer is possibly yes, but more often no.
The dangers of allowing short-term factors – either positive or negative – to affect long-term decision-making are something we recently talked about here in relation to the mining sector. These dangers apply as much to capital expenditure as to buybacks and acquisitions. Finding management teams that understand this is a crucial part of any successful value investment process.