A vital notion all investors—especially speculators—should be crystal clear on is the difference between price and value.
In a perfect market with perfect information dealt with by perfect people, the two would be the same, on an aggregate basis. But none of these things are perfect in our world.
Consider what happens when a large, well-known company beats Wall Street estimates for profitability. Let’s imagine that the company is stable, with profit expected to come in 1% above the same quarter the year before—but it comes in 2% above that expectation. The “beat” doubles estimates. Enthusiastic investors in a frothy market pile in, pushing share prices up 10% that day. Then Wall Street gets news it wants to hear from the Fed and the market as a whole rallies, with this new winner rising another 25% by the end of the month.
Now, is this company, which produced a 2% increase in profit one quarter really worth 35% more than it was the day before the news came out?
Closer to home, when a junior exploration company releases exciting but early-stage exploration results, there is no measurable increase in the company’s value. None. But there’s often a huge increase in share price…
Manic and panicked moves are obvious, but more subtle waves of investor sentiment can have the same sort of effect. This is particularly dangerous when overwhelming market sentiment is so bullish or bearish, prices across the whole market rise or fall far above or below any rational valuation. Then it can come to seem normal for companies to trade at ridiculous price to earnings ratios. When the comparables are all crazy, a crazy valuation doesn’t look so bad. Important market warning signs and opportunity signals basically stop working. Investors make decisions based on false or misleading perceptions.
Speculators who bet on junior resource stocks must never forget this. These tiny companies have some of the most volatile stocks in the world. That’s why we like them; their extreme volatility can create fortunes, when it’s to the upside.
The knife cuts both ways, of course. When stocks I cover suffer drastic retreats with no bad news from the company, I often get messages along the lines of: “My stock is down 40%—what’s wrong with it?!?”
My answer is usually: “Nothing. Some fund is probably being forced to sell by redemptions or a major shareholder is facing bankruptcy.”
But sometimes it’s: “Nothing specific to the company. Copper (or whatever underlying commodity) is down 10% this month, so it’s not surprising that the stock is down 40%—that’s exactly the leverage we buy such stocks for when we expect prices to rise.” At that point, the question isn’t what’s wrong with the company, it’s whether we’re still confident of our outlook on copper (or whatever underlying commodity).
There are times when something really is wrong with the company; a falling price alerts us to this problem. You might think that if we’re paying attention, we shouldn’t have to be alerted by falling share prices. Generally, that’s true. But sometimes it takes a company a while to issue a press release when there’ s problem. Management may not even have time to assess a problem before the story runs in local press wherever operations are, and leaks back to the market.
So yes, I do pay attention to sudden price movements. When I see them, I look into the situation, to see if there’s a real threat or opportunity that requires action.
But the key point remains: a change in price does not always reflect a change in value.
When it comes to junior resource stocks, I’d say it almost never does. And the difference between price and value can set up terrific speculative trades.
Monday, November 19, 12:01pm, EST, 2018