Most investors have been taught stock prices are meticulously calibrated by the market. A stock’s price is said to reflect all current, significant information disseminated to investors. This idea, referred to as the Efficient Markets Hypothesis, originated at the University of Chicago in the sixties. Index investing is a real world pursuit of this premise. If a stock price perfectly reflects risk and reward, picking individual stocks shouldn’t work better than throwing darts.
There is a catch. Key building blocks of the Efficient Markets Hypothesis are liquidity and depth of market. Liquidity and depth refer to the amount of money and the number of independent actors participating in an asset. When there is liquidity and depth, many investors and legions of analysts carefully examine available information on a stock searching for an edge. It is this tremendous competition and expenditure of resource that leads to a “meticulous” public price. Without liquidity and depth, Efficient Markets break down. In periods of great uncertainty, liquidity and depth disappear, which is how even large cap stocks reach bargain levels during panics.
As the market capitalization of stocks gets smaller, there are fewer and fewer interested actors. Information doesn’t disseminate as quickly, or at all. Fewer investors and analysts participate in small cap stocks. Examining information becomes expensive as the scale is so much smaller. In smaller cap stocks the burden of disseminating information falls more heavily on the company itself.
This is why the Efficient Markets Hypothesis doesn’t always square with community bank stocks. A few hundred to a few thousand shares per day is normal volume for small bank stocks. Do these trades contain “all of the current, significant information”? It is an intriguing question because it implies a stock can be “mispriced”. What are the implications to the people who care most about a stock – investors, directors and management – if their company’s stock is mispriced in the marketplace?
Let’s throw in one more idea, framing, which is human psychology. When a person perceives a “low” stock price, it’s natural to look for all the reasons the price is low – maybe high risk or uninspiring management. When a person sees a “high” stock price, it’s natural to think about why – maybe high growth or good demographics.
The Efficient Markets Hypothesis makes framing worse for small cap stocks. Since most people think stock prices are efficient, they don’t consider whether the necessary building blocks of the theory are in place when considering a microcap stock. Investors look at a low relative stock price and generally think “there must be a good reason”. When investors see a high-priced stock, frequently they think “what a great company”. Making such snap decisions is a frequent human judgement error.
It’s common to hear from bank executives that its management’s job to run the company well and the valuation takes care of itself. In a large cap bank this is probably true. Large banks are primarily dependent on their employees, brand and market share to make gains and their performance is carefully dissected by analysts on the buy and sell sides. Community banks are a different model. Shareholders are customers and customers frequently become shareholders. Investment is a binding mechanism and a pillar of competitive advantage.
Because of this, a low relative stock price has a negative framing effect on a community bank. Shareholders, customers and employees are affected by a low price. It lowers morale and perception of the company. New hires, critical for growth, are less attracted to a company judged by the stock price to be low achieving. Stock incentives are less effective for recruitment and retention. These factors are critical to the many remaining independent banks serving low growth markets. Recruiting talent and expertise generally means relocating established professionals from urban centers. Stock incentives are a necessary inducement.
So how might a stock become persistently under priced? In a small cap stock, most of the experts in the stock are the people already invested in the stock. These people likely provided capital directly to the company when it was growing and are intimately familiar with the management and board of the company. If the confidence of this group of investors is shaken by a negative event at the company, then they become sellers. In banking, it’s usually an asset quality crisis, but it can be other things too. With all sellers and no buyers, the stock must drop precipitously. A very low price is the only thing that will attract buyers to an obscure stock.
The interesting thing is what happens after the panic selling is over and the immediate financial crisis at the company is mitigated. The price remains low. The “experts” in the company’s story are diminished and enthusiasm for the company is curtailed. Information doesn’t disseminate because no one is looking and crisis worn management is too busy or too heckled to make the effort. Time passes, even years, and modest selling keeps the price low. The transition from a price based on panic to a price based on illiquidity can pass unnoticed. Framing bias together with a misconstrued understanding of Efficient Markets combine to encourage this.
Not every low stock price is unwarranted or a sign of illiquidity. A valuation within 25% of a reasonable comparable list of similar companies is probably too close to suggest mispricing. This may seem like a wide band, but it’s not an atypical deviation for small cap stocks, particularly banks. More than a 25% discount to comparable companies on a sustained basis is a strong indicator of a persistent liquidity discount.
If the conditions exist for a mispriced, illiquid stock then it is the obligation of the board to take action. In many cases an illiquid, low priced stock represents greater value to shareholders than growth, and the best corporate strategy is share repurchases. Using the earnings strength of the company in buybacks creates a win-win-win scenario. Shareholders, who wish to exit, can do so more easily. Shareholders, who wish to stay invested, are accreted on a tax efficient basis. Bargain investors, who may be inclined for a quick buck, are kept out of the shares. Shareholders are calmed and encouraged by the firming price and a steady option for liquidity.
There are other financial and structural benefits to taking a constructive approach with a mispriced stock. A peer level stock price makes it easier and more palatable to raise capital to support growth. It is human nature for merger partners to be more willing to deal with companies with valuable stock currency. A valuable stock currency is essential for a buyer, but a seller benefits from a strong currency too. It is unlikely a seller will get full value in a merger if it starts with an illiquid, low priced stock. This is another impact of framing.
To enhance liquidity of a mispriced stock, there are more levers than buybacks. If a company has a dividend, shareholders should be given the option and encouraged to participate in a dividend reinvestment program. This creates a steady stream of purchase interest. Investors who reinvest can be offered an incentive such as a 5% discount to encourage participation. It is a win-win as loyal investors are encouraged to clear out sellers by purchasing their stock cheaply.
Dividend focused companies can calibrate payout to hit key investor screens. A 3% dividend yield, for instance, attracts attention from income investors screening for options. It is easier for a company with a low priced stock to have a high dividend yield and once income focused investors are “in” a stock at an attractive yield, they are likely to stay for the long run.
An illiquid stock devoid of “experts” benefits from new blood. New board members, particularly those who have a substantial business following, can be very effective in raising stock value. New board members with strong networks build confidence and are good for the operating business, future capital raising needs and rebuilding a committed, expert shareholder base.
Collectively these are more than individual, positive steps a board of directors can make with little cost. The nexus of customer, shareholder, employee and community is core to the competitive position of a community bank. Executives and the board of directors must understand and manage it with the same care and effort shown to the other key functions of the bank.