Tuesday, August 10, 2010

Market Inefficiencies Explained

There are many reasons why a particular stock's price might differ from its value, not the least of which is a motivated seller. A motivated seller will drop the price of any asset (e.g. real-estate, vehicles etc.) and stocks are no exception - particularly small-caps, where a lack of liquidity can result in dramatic price drops.

Consider KSW Inc. (KSW), a stock we have previously discussed as a potential value play. The company's CEO announced a plan to exercise 105,000 of his options, and then sell those shares in the market. The announcement was made several months ago at a time when he did not have inside information. Furthermore, the rest of his 750,000 shares will remain under his ownership, continuing to leave him a stake of over 10% in the entire company.

The plan was announced in March, and resulted in almost no change in the stock price. As the CEO has been selling the announced shares, however, the stock price has been dropping. The company only trades a few thousand shares per day; therefore, selling 100K+ shares over three or four months can result in significant price movements. In this case, shares have fallen some 20% since the share sales began. Now that the sales are practically complete, the share price can breathe again, as the supply and demand of the shares of KSW are free once again to find a more normal equilibrium.

Many financial experts regard stock prices as fully reflecting the values of the underlying businesses. This assertion must be thrown in doubt, however, in cases such as this one, where shareholders controlling large blocks of shares are dumping their stock over very short periods of time. The market is not efficient here; excess supply of shares is driving down the price, offering opportunities for those who don't believe the market is efficient.

Disclosure: Author has a long position in shares of KSW


Paul said...

Not that it matters too much, but I would feel a bit more confident if he held on to the shares. I know employees can do a "buy and hold" for stock options. With this method, the employee could buy the option at the exercise price and hold on to the shares without selling them. A variant of this is called "sell to cover" in which the individual will sell just enough shares to pay for as many shares as possible. For instance, if you have an option for 100 shares, you could sell 60 to pay for the taxes and an the 40 shares of stock. Essentially, it's a way for people without the available liquidity to still maintain ownership without coming up with funds out of pocket. I wished he would have utlized one of these methods to shore up confidence. Although, it's great to see he still owns about 10% of the shares outstanding.

Unknown said...

I agree with Paul. It seems he more concerned about his payday, rather than his company. Considering how 100,000 shares is worth about almost 1 weeks worth of trade volume for this company, I feel he has littler regard for the shareholders. Also I feel like the CEO's pay and compensation is too high. He earns around 1 million a year, yet his companies net profit last year was a little bit above 1 million.

Unknown said...

Barel -

I like the industry that the company is in (it'll be around for decades anyway), the strong reputation of the company in New York, and the fact that forced selling has been driving down the stock price. On the other hand, the fact that the company has been burning some cash in operations for the last two quarters makes me wary about jumping in. How do you feel comfortable owning a stock that is currently burning cash?

Saj Karsan said...

Hi Jeff,

I don't think it actually is "burning cash". I've written more about that here.

Unknown said...

Thanks for this Barel! Always great to learn something