search strategies for value investor - the anomaly of value (2)
In Hong Kong, and other securities trading countries, the fund pool size in the market is expanding. As the pool size increases, their influence on the price movement becomes greater. However, these institutions are run by human and they are always subject to stringent rules & regulations. These various constraints might give us answers to why the value anomaly might persist in the face of intelligent and energetic investors who are always eager to outperform the market average.
Institutions, as stipulated in their policy, are sometimes not allowed to purchase certain types of stock (e.g. socially irresponsible companies like tobacco companies). If there are a number of institutional investment funds prevented from owning certain kinds of stock, the demand for their shares will be reduced. So as measured by current earnings or growth prospects, these stocks are usually undervalued. However if the policy restriction is not lifted, they could be undervalued permanently.
Greenward et al. further contended that funds cannot purchase small valued stocks because their mandates do not allow it. Or in compliance with the regulation, small companies cannot be a worthwhile investment for funds. Greenward et al. explained that fund does not want or is not allowed to own more than 10 percent of any company's stock*. So, if the fund has $ 5 billion ($ 5,000 million) to invest in say 100 companies. On average, it needs to buy $50 million in each. But if the small company market capitalization is only $50 million. Constrained by the rules of owning less than 10% of the stocks, the fund can only invest $5 million at maximum, which is just 0.1 % of the total fund size. So, funds are usually not interested in buying small company shares.
Greenward et al. also discuss how corporate spin-offs result in some stocks being undervalued. It is interesting as the new spin-off company is usually small, especially when compared with the giant from which it has just been separated. Funds holding these the giant companies are eager to sell or dump the new spin-off shares as their size is too small. This type of reasons unrelated to the company's prospects creates a good opportunity for investors. Greenward et. al. has of course covered more details in their book. These details should not be missed so I highly recommend the readers to go check the book out.
In the next part in this series I will explore the equally interesting factor of money manager psychologies.
Notes: *This issue might be slightly different in HK. According to the SFC takeovers code, mandatory general offer will be triggered if a person or group persons acting together buys 30% or more of voting shares in the company. Funds are likely to comply with more stringent regulation stipulated by their own, no more related information is available here though. But, the general rule in a takeover requires the offer to be announced. Though not a prohibition, this rule is already trouble enough to decrease the fund appetite to own too much of just one stock in my opinion.
Reference:
Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.
InvestEd Intelligence. Retrieved from http://www.invested.hk/invested/en/html/section/products/stocks/privatizations/trigger.html
