Opportunities exist when perception overpowers fundamentals

The following is a perfect example from Buttonwood, where sophisticated investors (such as pension funds) make irrational decisions. This particular one relates to their fear of bad optics, i.e. how they will be perceived by stakeholders if they had to report losses due to well known, long running problem.

A hedge fund manager told me at lunch today that meetings with clients often started with the question "What's your fund's exposure to peripheral European sovereign debt?"  The right answer to that question is, apparently, zero. If this attitude is common, hedge fund managers will avoid the asset class as an easy way of keeping their clients sweet. Nor do the clients want the managers to short the asset class, lest the Europeans come up with a deal at the last minute.

These clients are not sinister, top-hatted capitalists but ordinary pension funds afraid of some embarrassing loss in their portfolio. Their fear imposes a constraint on the people who look after their money. A similar process has happened at money market funds. Which fund manager wants to risk telling the clients they have lost money because of an exposure to Greek or Italian debt, stories that are all over the headlines?

Fear is often more powerful than greed.

 As a long term investor, you can take advantage of this fear, and carefully select businesses to add to your portfolio. These days, plenty of opportunities exist in European equities, Japanese equities and American financials and housing sectors.

Disclosure: None

Canam Group: Significantly inconsistent market pricing

What's wrong with this picture?

When a company is selling at low price-to-earnings ratio, it is usually safe to assume that the market has sufficiently discounted the future. Specifically, the market likely foresees significant decline in the earnings and earnings power.

If the same company is also selling for half the book value, then it can be assumed that market foresees future events to harm the balance sheet, either through major losses and/or significant negative cash flow.

If the market is right about the valuing the company at low price-to-book ratio, then the debt holders of the organization can also be expected to suffer a loss. Consequently, the debt holders should be expected to demand a higher premium from the company, in the event of a default.

However, that is not entirely the case in Canam Group's (TSE:CAM) situation-- the first two arguments are true, but not the third.

Canam is currently selling for under 5 times average earnings. This business is also available in the market at more than 50% discount to book value. However, the debentures (traded on the Toronto Exchange under the symbol CAM.DB) are hardly below par, while the stock has dropped significantly during the same time.

This can only mean that Mr. Market is overreacting to the recent bad news (i.e. dividend suspension) on the equities front, but is relatively calm on the fixed income front. The debt holders must not be actually worried about the balance sheet, otherwise they would have sold off the debentures to discount the expected future. Hence, the low price-to-book valuation on the common stock is likely due to short term irrationality rather than anything else.

As a value investor with a longer term horizon than the market, this sort of inconsistency can be an opportunity for significant gains in the near future.

Disclosure: I am an owner of Canam Group at the time of this writing.