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 MARKET REPORTS |
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Resident trader
The greater fool theory of trading shares
Will Kraa, March 5, 2007
There is a theory called the 'efficient market theory'. According to this idea the market efficiently prices in everything known about stocks so that everything is always correctly valued (which to anyone familiar with the stock market makes no sense at all). There is another investing theory called (tongue in cheek) 'the greater fool theory'.
This is the strategy whereby you are foolish enough to buy a stock in the hope that there will be a greater fool out there who is stupid enough to be willing to pay even more for the stock and so to allow you to make a profit out of the transaction. You may have realized by now that these two theories completely contradict each other. And for those of you with a scientific education I must also hasten to add that I am using the word 'theory' in the way it is popularly used since neither of these two ideas are strictly 'theories'. What I am going to write about today will show that the first theory is nonsense and that the second one can be made to work quite well to make good profits.
It is my trading of small companies that suddenly jump up in price with increased volume that has alerted me to an example which shows that there are cases where there may be no relation at all between market price and what the company is actually worth.
Up to now my strategy in trading price/volume breakouts has been to use the price action to alert me to companies where some recent news has caused the trading to change and then I buy only those companies where there was some news to justify the price action.
I am now beginning to wonder if I am wasting my time to some extent in looking at the company news before buying. It is obvious that the price of shares can rise dramatically when there is absolutely no justification for this and so it seems I might just as well simply buy and sell the price action and forget about the news.
I have written about both companies in the past, one I have traded, the other I have not. I did not think the second one was worth trading since there was just about no value in the stock. I was quite wrong. It would have been very profitable to trade it. Any trade where you increase your investment fourfold just has to be a great trade. Why allow some ‘funnymentals’ to stop me from taking such a trade? Just have a look at the chart below.
You might even recognize this stock as one I have written about when I was fascinated that something of so little value could trade at such a price. (See Of speculation, share placements and sophisticated investors ). As you can see the share, Richfield Group, came up on my scan in late October (red arrow) and I could have bought at 1 cent. In the article I mentioned that I was amazed that the price could have gone up to 3.1 cents but as you can now see it actually kept on going up to 5 cents!
If I had been content with a fourfold increase in price I could have exited in late November. But I did not do the trade since I could see no reason whatsoever for the price to do what it did. In spite of that, as you can see, it is still trading over the 4 cents and even the panic of the last few days has not done much damage.
The other company, the one I did trade, is D’Aguilar Gold, DGR, which also jumped in price and volume in early April last year. I bought at 14.5 cents and sold in late May at 27.1 cents (two red arrows on the chart). I decided to trade this one as there was good news to justify the price rise. Since then the price did move up again but has since drifted down back to the price where I originally bought it. The chart is a weekly one to accommodate the longer time frame.
What really intrigues me about these two companies is that they have a very similar market capitalization of just over $20,000,000 each. This means the market is saying that these two companies are of much the same worth.
In the case of RCH the Net Tangible Assets per share for the last financial report was 0.0013 cents per share. This is mostly cash and some money paid to another company and amounts to just over $600,000. Besides cash, companies usually have other assets such as goodwill, equipment, stock in trade etc. But this company does not have that since it does not presently own or conduct a business. It is endeavouring to purchase part of a company which owns the right to explore and exploit a molybdenum deposit in Indonesia. They actually don’t have the money to buy what they are looking at and would have to raise the funds by issuing more shares if the transaction goes ahead.
There are huge hurdles to overcome before there is any prospect of actually getting a worthwhile business (doing due diligence, getting government approval, raising funds to buy part of the company, exploring, raising funds for equipment, starting a mine, etc.). In the meantime all the company has is less money in the bank than the cost of a decent house in Sydney. But the market capitilization at the current share price is over $20,000,000. As well there are about half a billion options out there exercisable at 1 cent. Think of the dilution that would occur if these were exercised as well as the dilution when cash has to be raised to pay for the business and further expenses of getting a going concern off the ground.
The directors have pointed out to investors all these difficulties in the way of actually getting anything worthwhile going and still people have pushed up the share price to 4 cents and it is consistently trading there at good volume to give a market cap of over $23,000,000.
Now let's have a look at DGR. This company is actually valued in the market at slightly less than RCH and has a market cap of just over $20,000,000. Now this company has net assets of nearly $12,000,000 including cash in the bank of over $5,000,000. As well it actually owns a molybdenum project which shows a net present value of over $200,000,000. It also owns five other projects with proven and inferred resources in gold, silver, copper, zinc and nickel. It has a strategy of listing projects as separate entities once they are ready and so producing value for shareholders.
The shares of this company seem to be of little interest to the market, trading at only a fraction of the daily turnover of RCH and with a lower market cap. Maybe I am missing something here but to my mind there is absolutely no comparison between these two companies. I am not saying to rush out and buy DGR, I don’t actually own them at present but I’m certainly keeping an eye on it. But to any rational person it would seem to me that RCH is not worth even a tiny fraction of what DGR is worth and yet it is trading at a price which gives it a slightly greater value than DGR.
In other words, people are willing to pay a premium for a very,very remote chance of owning a tiny part of something that may perhaps one day create some value while at the same time showing no interest in a company that has tangible assets. This gives new meaning to the saying, 'Buy the rumour, sell the fact'.
In the words of a famous 'value' investor (I don’t want to name him, I'm sick of hearing his name bandied about), 'In the short term the market is a voting machine but in the long term it is a weighing machine'. Well, all I can say is that the 'weighing' is taking a long time and the 'voting' seems crazy.
Now, after all of this is there something of practical use to come out of all this? I think there is.
From now on I will trade these companies where the price goes up in such a ridiculous fashion for no good reason. If people are willing to waste their money throwing it at remote chances, I might as well collect some of it. But, I can almost hear you saying, what about risk management? Well, that is easy.
Let’s say I was about to buy RCH as it was going from its normal price of about 0.5 cents to 1 cent as it did late last October with a dramatic increase in volume. Also assume that using the 2% (or 1% or whatever suits) rule I am able to risk $5000. What is the worst case scenario? The risk is of course that the market suddenly suffers from a bout of rationality (I know, I know, it is only a very small possibility) and decides that seeing the company is actually worth 0.0013 cents per share (it was less at the time) then that is what should be paid for the shares. And seeing the least that can be paid for a share is 0.1 cent, let’s be generous and say it goes down to that price.
I am now about to lose just about all of the funds I used to buy the shares and so in this kind of situation I could buy $5000 worth of shares (seeing that is the amount I am willing to risk) at 1 cent each or 500,000 shares. Since the price went up to nearly 3 cents in the next few days and then retraces for a while I might have decided to get out at 2.5 cents.
Selling the 500,000 shares at this stage would have brought in $12,500 for a gross profit of $7,500. If I was willing to wait for the price to close below the 3.5ATR(10) line then I would have got out later at about 3 cents for a gross profit of $10,000.
So my new rule is that when a share trading at a few cents jumps up in price and volume and there appears to be no good reason for its doing so then I will assume all the money invested is at risk. So the risk per share will then be the same as the price of the share. I will calculate the percentage of my capital I am willing to risk per trade and simply divide that by the price of the share and buy that number.
Of course if I had formulated that rule a few weeks ago I could have bought 12,500 shares of Minemakers Limited (MAK) at 40 cents for $5,000. In the case of that stock I could have looked at the normal trading price which was around 20 cents and calculated that the risk per share was 40cents – 20 cents = 20 cents. Then I could have bought 25,000 of them at 40 cents. They came up on my scan at the time but there did not seem to any recent news so I did not buy them then. Today they closed at $1.845. Could someone please turn the clock back a few weeks?
It does not pay to be too risk averse when dealing in these trades. By taking positions that are of a size where the value of the whole trade is the amount risked then the trade has a risk that is known exactly as the trade is placed. No more can be lost than the value of the trade. Normally when trading shares this is not effective but when trading shares that can double or more in a matter of days or weeks it is possible to make good returns on relatively small sized trades. Using this risk management strategy makes it more comfortable to take these trades as they present.
It is in some respects similar to buying options. In this case too there is an exactly known risk when the trade is placed and the leverage of an option can mean a good return can be made from a modest sized trade. The difference is that with options it is said that 80% of options expire worthless, which means the trader loses the amount risked, a much bigger proportion of loss trades than with this trading strategy. Also lack of liquidity can be a big problem with options.
Even in this troublesome market there are still some of these trades coming up from time to time and profits can still be made. When I close more of these trades I can write about them in future issues.
More articles from this edition of CompareShares:
Rate rise: When and where will the rate hikes stop
Resident Trader: The greater fool theory of trading shares
Stocks: Good conditions for Newcrest Mining bodes well for its share price
Investing: Top places to stash your cash
Forex: Fundamental reasons for a record high Aussie dollar against the greenback
Expert Panel (CFDs): Capitalising on price movements in reporting season
Housing: A dozen reasons for housing stress
Rate rise: RBA on inflation 'red alert'
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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