Icahn Exits, Buffett Enters, Whither Apple? Value And Price Effects Of Big Name Investing by Aswath Damodaran, Musings on Markets
In my last post, I looked at Apple, arguing, with a Monte Carlo simulation, that the stock was a good investment at the prevailing market price ($93 at the time of the analysis). I appreciate the many comments that I got on the analysis, some taking issue with the distributions that I used for profit margins and revenue growth and some taking me to task for ignoring the fact that big name investors were either entering and exiting the stock. Those who felt that my valuation was optimistic pointed out that Carl Icahn, a long time and very vocal investor in Apple, had decided to sell his stake in the company on April 28. Some who concurred with my value judgment on Apple pointed out that Berkshire Hathaway (and by extension, Warren Buffett or his proxies) had invested in the company on May 16. Should Carl Icahn’s decision to sell Apple or Berkshire Hathaway’s choice to buy it change my assessments of value or views on its price? More generally, should the decisions by “big name” investors to buy or sell a specific company affect your investment judgments about that company?
Price versus Value: The Set Up
To set up the discussion of whether, and if so how, the actions of other investors, especially those with big names and reputations to match, affect your investing choices, I will fall back on a device that I have used before, where I contrast the value and pricing processes.
Put simply, the value process is driven by a company’s fundamentals (cash flows, growth and risk) or at least your perception of those fundamentals, whereas the pricing process is driven by demand and supply, with mood, momentum and liquidity all playing big roles in determining price. In an earlier post, I argued that it these processes that separate investors from traders, with investors focused on the drivers of value and traders on the pricing process, and that the skills and tools that you need to be a successful trader are different from those that you need to be a successful investor. To understand how and why the entry of a big name investor may alter your assessments of value and price, I would suggest categorizing that investor into one of four types.
- An Insider, who is either part of management or has privileged access to management.
- An Activist, who plans to change the way the firm is run or financed.
- A Trader, whose skill lies in playing the pricing game, with the power to either reinforce or reverse price momentum
- A Value Investor, who has valued the company and is willing to take a position based upon that value, on the expectation that the pricing gap will close.
[drizzle]Each type of big name investor has the potential to change how you view the dynamics of price and value, though the place where the change occurs will depend on the investor type.
The entry (or exit) of a big name insider or big name activist can alter your estimate of value for a company, by either changing your perceptions of cash flows, growth and risk or by having the potential to change the company’s operating and financing characteristics. As a trader, the entry or exit of a big name trader may cause you to move from one side of the pricing game to the other, i.e., shift you from being a buyer to a seller. Finally, as a long term value investor who believes that a stock is mis-priced but has little or no power to cause the pricing gap to close, the entry of a big name value investor can provide a catalyst for the correction.
The Value Effect
If you asked a value purist whether the actions of other investors affect his or her value, the answer will almost always be “of course not”. After all, the essence of intrinsic value is that it is determined not by what others think about the company but the company’s capacity to generate cash flows over time. That said, there are two ways that the investment action (to buy or sell) of a big name investor can change your assessment of value.
- The first is if the big name investor has private information or is perceived as knowing more about the firm than you do. While that may walk awfully close to the insider trading line in the United States, it is entirely possible that the investor’s information is diffuse enough to not be in violation of the law. In this case, it is entirely rational for you, as an investor, to reassess your cash flows and risk, based upon the insiders’ actions. That is perhaps why we are so fascinated by insider trading, where the perception is that insider buying is value increasing and insider selling is value selling. In some emerging markets, where possessing proprietary information is neither illegal nor unusual, and the decision by an investor who is perceived as having this information (an insider, manager or family member) to buy (or sell) is an indicator that your value should be increased (decreased).
- The other scenario is where the big name investor is an activist who plans to push for changes in the way the company operates, how it is financed or how much and how it returns cash to investors. The potential effects of these changes can be most easily seen using a financial balance sheet:
To the extent that you believe that the company will have to respond to activist pressure, your assessment of value will change. An asset restructuring can alter he cash flows and risk characteristics of a business, changing your estimate of value, though the direction of the value change and its magnitude will depend on how you see these operating changes playing out in cash flows and growth. Adding debt to your financing mix can add value to a firm (because of the tilt in the tax code towards debt) or destroy value (because it exposes companies to bankruptcy risk). If you are valuing a company, the entry of a big name activist investor in the ranks with a history of pushing for more debt could lead you to reassess your value estimate as well. Returning more cash to stockholders in special dividends or buybacks can change value either upwards (if the market is discounting the cash on the presumption that the company would waste the cash on bad investments/acquisitions) or downwards (if returning the cash will expose the firm to default risk or substantial financing costs in the future).
The Pricing Effect
In some cases, the big name investing in the stock is a trader, doing so on the expectation that momentum will either continue, sustaining the pricing trend, or that momentum will reverse, causing the trend to reverse as well. Since this trade is not motivated by either new information or the desire to change how the company is run, there is no value effect, but there can be a price effect for two reasons.