Irrational but arbitrage free

Last month I blogged about the Palm-3Com episode as an instance of prices being horribly wrong without there being an arbitrage opportunity (“free lunch”). Last week John Hempton of Bronte Capital had a blog post about Great Northern Iron Ore Properties (GNIOP) whose overpricing is extremely easy to establish. The post concludes by saying:

Because that is so well known the stock has a 20 percent borrow cost -- roughly offsetting the profit you will get from shorting it. In that sense there is a rational market. But that is the only sense there is a rational market. People own this. They will lose money.

Great Northern Iron Ore Properties is a trust set up in 1906 by the Great Northern Railway for regulatory reasons (apparently under the Hepburn Act of 1906, no railroad was permitted to haul commodities which they had produced themselves).

The 1906 agreement states that the Trust shall continue for twenty years after the death of the last survivor of eighteen persons named in the Trust Agreement. I would imagine that this provision has something to do with the rule against perpetuities. Anyway, the last survivor of these eighteen persons died on April 6, 1995 and the Trust terminates twenty years later or April 6, 2015.

All this is very clearly disclosed on the GNIOP website and in SEC filings. It is clear therefore that investors in GNIOP will get dividends for a couple of years and then a final dividend in 2015; these dividends can be estimated within reasonable bounds and discounting this short stream of dividends gives the fundamental value of GNIOP. But a careless investor who applies a PE multiple to GNIOP wrongly assuming a perpetual stream of dividends would arrive at an absurdly high valuation and would consider the stock hugely undervalued. Apparently some investors (humans and computers) who use simple stock screens based on PE ratios are eagerly buying the stock making it overvalued in relation to the true short stream of dividends.

Rational investors see a free lunch and step in to short the stock. Markets abhor free lunches, and the stock borrow rises to the point where it eliminates the free lunch. This is not enough to correct the distorted price.

Posted at 8:54 pm IST on Mon, 19 Nov 2012         permanent link

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