David Einhorn — a top US fund manager — thinks the stock market is broken. And that means investors thinking about buying shares need to be extra careful.
It’s not that they need to stay away from stocks. But there’s more to consider than just finding shares that are trading below their intrinsic value.
What’s going on?
Traditionally value investing is about buying stocks for less than they’re worth. Over the long term, investors make money when the share price comes to reflect the intrinsic value of the company.
The trouble is, this relies on enough other investors looking for undervalued opportunities, which just doesn’t seem to be the case right now. And without it, undervalued stocks stay cheap indefinitely.
For instance, right now, I think DCC (LSE:DCC) shares look much better value than AstraZeneca. But Einhorn points out that it’s hard for share price movements to reflect this any time soon.
This is because the vast majority of cash entering the market right now is in funds that track things like the FTSE 100. As a result, the stocks getting bought are the ones that make up these indexes.
If someone invests £10,000 in a fund tracking the FTSE 100, £770 goes on AstraZeneca stock, but only £25 on DCC shares. If this is what mostly happens in the stock market, the gap can only widen.
I think Einhorn is dead right – and it gives value investors (like me) a problem. If buying undervalued stocks and waiting for the market to realise doesn’t work, how are we supposed to make money?
What to do
If value investors can’t rely on the stock market for returns, Einhorn thinks there are two places left to look. One is the world of private equity and the other is a company itself.
Private equity has been a powerful force for UK stocks, with the likes of Hargreaves Lansdown and Britvic being acquired. But buying a stock in the hope that the business will be taken over is extremely risky.
That’s why I like DCC and think it’s worth considering. I think the company’s component parts are worth more than the current market cap – but the key thing is that management is actively looking to do something about this.
The firm’s healthcare and technology subsidiaries contribute around 25% of overall operating income. But analysts think these are worth £1.3bn and £800m, respectively – around £2.1bn in total.
If they’re right, those two divisions are worth around half of DCC’s market cap despite only generating 25% of the operating income. In that situation, management might well be wise to try and sell them.
That would leave DCC shareholders with a more concentrated business, which can be riskier. The question is whether getting almost half the share price back as a cash dividend makes this worth it.
How to make money in the stock market
David Einhorn is a very sophisticated investor, who was once rumoured to be under consideration as a long-term successor to Warren Buffett at Berkshire Hathaway. What he says is worth listening to.
The stock market’s mechanism for getting shares to trade at the value of the underlying business might be broken. But stocks like DCC show there are still opportunities that are worth considering.
This post was originally published on Motley Fool
