£1 coffee, stock overhangs and conglomerate discounts

There’s a coffee shop opposite Legal & General’s London office which last year served coffee for £1. Given that this is the City, a latte for a pound is a long way below the market rate and an extremely tempting offer. 

Surely this bargain would be swooped upon by hordes of deal-hungry (thirsty?) traders, asset managers and indeed anyone with an interest in saving more than two-thirds on their mid-morning macchiato?

Apparently not. The large sign that advertised this deal was largely ignored, and when a colleague drew my attention to it, I was surprised to find that traffic levels were much the same as normal.

There are all sorts of potential reasons why people were not queuing around the block:

• Force of habit (bias)
• They didn’t care because they were billing someone else (agency risk)
• They didn’t notice (lack of price discovery)
• They simply didn’t care

Stock overhangs

Given that this is an active equities blog, astute readers will have guessed that I’m going to draw parallels between the morning coffee market and equity capital markets: here in the City, glaring market inefficiencies can and do exist.

One recurring market inefficiency is the ‘stock overhang’, where a large shareholder is viewed as likely to sell their holding. For a short-term investor, this can provide a strong reason not to hold the stock. If sold as a block, the seller’s shares are likely to be offered at a discount to the current price, therefore the stock is likely to go down when the large shareholder sells.

For a long-term investor, however, this is potentially an opportunity. Often market participants with short-term investment horizons will sell out of a position in anticipation of further decline: a price driven by trading rather than by fundamentals. Therefore, it can allow the long-term investor to acquire a stock for less than its fundamental value.

But why not just pick up the stock when it’s being sold off, when it’s at its cheapest? This would be ideal, but there are two flies in the mocha:

• Allocation: Often the book builds¹ will be restrictive on allocations: you may well not get as much as you ask for. Generally, the more popular a book build is (and therefore the stronger the performance after it) the less allocation you will receive
• Time: Accelerated book builds (ABBs) are announced at short notice. If a stock is not under direct coverage at the time, this necessitates an extremely rushed valuation process, making it hard to gain conviction in the stock

Both factors detract from the ideal of buying right at the bottom – your chance of buying a dud is increased, and you may well not get a material quantity of the stock. In my view, it is better to do the research thoroughly and at your leisure, then consider buying an initial holding, and adding to it when you have the opportunity (potentially caused by heavy selling). This is a strategy that is open to long-term investors with diversified holdings.

Conglomerate discounts

Another frequent mispricing is the ‘conglomerate discount’. Companies with diverse operations will often be valued by the market as less than the sum of their parts. Put another way, there is a ‘pure play premium’.

For investors specifically seeking (for example) a copper miner, clearly a miner that focuses on copper is worth more to them. But to an investor who is focused on value, a miner that has been ‘discounted’ for the diversity of metals it mines could be a much better deal, as you may get more earnings for your investment.

Lifting the conglomerate discount is difficult for a company, but it is sometimes possible by separating out the segments of the company through spin-offs or other corporate actions, sometimes called ‘value crystalisation’. This can provide a very welcome upside for an investor. 

While the idea of a catalyst for value appeals universally to investors, especially those with a short time horizon, predicting when the value will be realised is often difficult and far from guaranteed – more factors that play in the favour of a long-term investor.

Sadly, the era of the cheap cappuccino on Coleman Street is long gone, but there are still potential bargains to be had in capital markets. Stocks trade at the wrong price for a whole host of reasons, with trading pressure and conglomerate discounts being just two examples.

In Active Equities and specifically in the value space, we spend a lot of our time seeking out these bargains – and there are worse places to start than searching for conglomerate discounts and share overhangs.

 

1. A ‘book build’ is the process by which underwriters find buyers to determine prices for large volumes of stock. The term is most often used in relation to initial public offerings (IPOs), but also applies to the unwinding of a stock overhang.