The “newbie” premium and discount
I know a lot of people who have bought a stock because it was “cheap” and when I have asked WHY they think it’s cheap they literally quote the share price. I have had this kind of conversation with both “blue collar” people and “white collar” people. I would actually argue that the majority of people have a hard time accepting the simple concept of multiplying share price with shares outstanding in order to even begin finding out if a company could be considered cheap. Don’t get me wrong, the actual share price affects me as well, but that irrational impulse usually gets subdued pretty quickly and most of the time I don’t think it affects my investing that much. With that said, I bet the actual share price is able to affect some decisions some of the time, which obviously should lead to slightly worse decision quality and thus decreased returns. This human “impulse” should affect the appetite for penny stocks. Thus two identical companies but with slightly different share structures, should favor the company with more shares outstanding and lower share price, in terms of an increased buying pressure. In short, there should be a higher risk of this “cheaper” company being overvalued and the more “expensive” company being undervalued, all else equal.
With the above said, there is a flip side to this concept. It’s not uncommon for “savvy” investors can be very obsessed by a tight share structure and thus low share count due to expectations of amplified price movement in case a company puts out favorable news releases. This could result in an increased appetite for companies with low share count which often goes along with a higher price per share. This preference for tight and more volatile stocks could mean that there is an “irrationally” high buying pressure in said stocks. In other words, there could be an “irrational” premium which simply means overvaluation relative to intrinsic value, all else equal. In turn, this should then also mean that some “savvy” investors are not even willing to buy an intrinsically undervalued stock, if the company is perceived to have a “poor” share structure.
… These are obviously two opposing forces from two different groups of investors. The question whether a stock is potentially irrationally undervalued or overvalued at any point in time would thus depend on what force/group is currently dominant. With that said, there is obviously more preferences at work at any given time than just these two so it’s hard to say if a stock is overvalued or undervalued even though one might know which one of the previously mentioned groups are in control.
It still leads to an interesting questions:
- Are there periods when these forces are very prevalent and there are broad valuation differences just based on companies share structures?
- Are perhaps companies with tight share structures increasingly overvalued relative to their peers during the bottom of a bear market when the amount of “generalist” investors are at cyclical lows?
I think the common wisdom is that penny stocks can outperform in a full blown gold bull because the “newbie premium” is overwhelming the “savvy” investor “tight structure premium” and increasingly so the more popular the gold bull becomes.
“I don’t want to chase” vs. FOMO
I think these opposing forces is quite interesting. Most of us don’t want to feel like we are chasing a stock for multiple reasons such as; a) Thinking that because a stock has run the buying opportunity must be gone, b) Afraid to be called a newbie “bagholder” and/or having experienced a lot of short lived “pumps”, and c) Remembering the ancient mantra of “buy low, sell high” etc.
The “I don’t want to chase” group of investors is probably mostly made up of a higher degree of veteran investors who got the scares to prove it. These will probably be the first to take profits and the least likely to buy after a run up, on average.
Opposite of the “I don’t want to chase” group is the group that is infused with FOMO. This group might get larger and more determined the higher the stock price runs. If the former group is stronger then the rally should be short-lived. If the more generalist FOMO group is stronger then the stock will probably keep on running.
Combining These Factors
So given the different forces mentioned in this article, what might one expect to see during different scenarios(ALL ELSE EQUAL)?
When “savvy veterans” are in control:
- Shorter lived rallies?
- Lots of small starts and stops / “Sell the news” / Constant dip buying
- Companies with tight share structures (relatively high price per share) outperforming?
When “newbies” with FOMO are in control:
- Longer lived (possibly exponential) rallies followed by severe corrections?
- Not many small starts and stops / Sporadic dip buying / flush outs
- Companies with loose share structures (relatively low price per share) outperforming?
- Should companies with a tighter share structure do better during bear markets due to there being a higher proportion of “savvy” investors?
- Should companies with low share prices underperform when the proportion of generalists is low?
- Should a steady walk up of price be the best sign that “smart money” is in control of the buying?
- “Savvy” investors buying calmly
- More dip buying and less chasing
- Less volatile since there is less FOMO and flush outs of impulsive “weak hands”
- Stock keeps trending up even though the higher price should/could increasingly scare off the group of people who can’t help to let share price dictate their views of a company being cheap or expensive
- Should stocks with a low share price have more violent rallies off a bear bottom because they were overly punished (undervalued?) during the bear market and the newbie/FOMO group will be the ones buying?
- Should stocks with a high share price have the shortest rallies off a bear bottom because they saw a higher proportion of buying from the “savvy” veterans during the bear market and will be quicker to take profits?
The best gauge of what forces might currently be in control could be to watch what stocks do after a split or a reverse split. If the stock starts to under perform after a split it might mean that the selling from the group of people who suddenly find the share structure less appealing while there is not enough buying pressure from the group that equates a low share price with a stock being cheap. In other words it might signal that the generalists are not yet a force to be reckoned with and vice versa. Under performance after a reverse split might mean the opposite.
stock split/reverse split
Majority considers Novo to be very expensive