Fischer Black, one of the most creative financial economists of his generation and co-developer of the Black-Scholes option pricing model, offered what I use as a guide to value investing. In his Presidential Address to the American Finance Association, Black stated that “we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value. The factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value.” Following Black’s tip, when I do a fundamental valuation, I check to see if the fundamental value I calculate is within a factor of 2 of the market price. If it is, then I am reluctant to take a position.
To some Black’s band of fair pricing may seem too large, but a word of warning. When you, and by you I mean a prototypical value investor, find that your estimate value differs significantly from the market price there are two possibilities. First, the market price is irrational. A great deal of research in behavioral finance has uncovered evidence in support of this possibility. The second possibility is that your analysis is faulty. The simple fact is that even if the market can be irrational, as behaviorists suggest, individuals are likely to be a whole lot more irrational. Thus, the most reasonable conclusion to draw when your estimate of value differs from the market is that you are the irrational one. But what if it differs by more than a factor of 2? In that case, either you or the market are really wrong. You have passed outside Black’s limits. Under such circumstances, the “mispricing” is worth a second look and may warrant taking a speculative position.
Over the course of the last couple of years, only three companies discussed in this blog have fallen outside the Black bounds – Tesla, GoPro and FitBit (in every case in the direction of overvaluation.) In those three cases, taking a short position (or writing options to take simultaneous advantage of the high implied volatilities that accompanied the high valuation) turned out to be very profitable. Unfortunately, a sample of three is too small to draw any reliable conclusion so be aware that the next example that may be discussed in this blog may not work out so well. Nonetheless, Black’s bounds can serve a practical guide for any value investor. Before you put your money at risk it should not be enough that you conclude that the market price is wrong, you should think it really wrong.