How Many “Lemons” Do You Have In Your Portfolio ?
Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. It concludes that owners of high-quality used cars will not place their cars on the used car market. A car buyer should only be able to buy low-quality used cars, and will pay accordingly. The market for good used cars does not exist.
"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a well-known 1970 paper by economist George Akerlof which examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind. In American slang, a lemon is a car that is found to be defective only after it has been bought.
Suppose buyers cannot distinguish between a high-quality car (a "peach") and a "lemon". Then they are only willing to pay a fixed price for a car that averages the value of a "peach" and "lemon" together (pavg). But sellers know whether they hold a peach or a lemon. Given the fixed price at which buyers will buy, sellers will sell only when they hold "lemons" (since plemon < pavg) and they will leave the market when they hold "peaches" (since ppeach > pavg). Eventually, as enough sellers of "peaches" leave the market, the average willingness-to-pay of buyers will decrease (since the average quality of cars on the market decreased), leading to even more sellers of high-quality cars to leave the market through a positive feedback loop.
Thus the uninformed buyer's price creates an adverse selection problem that drives the high-quality cars from the market. Adverse selection is a market mechanism that can lead to a market collapse.
Akerlof's paper shows how prices can determine the quality of goods traded on the market. Low prices drive away sellers of high-quality goods, leaving only lemons behind. In 2001, Akerlof, along with Michael Spence, and Joseph Stiglitz, jointly received the Nobel Memorial Prize in Economic Sciences, for their research on issues related to asymmetric information.
What is the Lemons Problem
The lemons problem refers to issues that arise regarding the value of an investment or product due to asymmetric information possessed by the buyer and the seller.
The lemons problem exists in the marketplace for both consumer and business products, and also in the arena of investing, related to the disparity in the perceived value of an investment between buyers and sellers.
The lemons problem is also prevalent in financial sector areas, including insurance and credit markets. For example, in the realm of corporate finance, a lender has asymmetrical and less-than-ideal information regarding the actual creditworthiness of a borrower.
Causes and Consequences of the Lemons Problem
The problem of asymmetrical information arises because buyers and sellers don't have equal amounts of information required to make an informed decision regarding a transaction. The seller or holder of a product or service usually knows its true value, or at least knows whether it is above or below average in quality. Potential buyers, however, typically do not have this knowledge, since they are not privy to all the information the seller has.
I am sure we might have few “lemons” in our portfolio no matter how hard we do our due diligence, looking through all the detail of quarterly or annual reports, slice and dice all the reports/figures from financial reports or even attending the A.G.M , asking tough questions to B.O.D ,we will still have information “disadvantage “ from company’s owner or B.O.D.
From smokers trying to hide their health information when buying insurance to applicants trying to hide all their bad behavioural / experience during the interview, same may apply to companies who try to hide some important information from investors, especially those “small or mid “ CAP companies where there are just few or not much coverage from analyst.
Besides, in some privatization deal , company or owner may also have information advantage on company’s valuation or future grow prospect. This could be seen in some of the recent deal / propose of privatization where retail investors are lamenting the “low “ exit offer from owners.
Information asymmetry is more serious in some sector like “S-Chip “where by transparency is a big question mark ,be it in their management or accounting practice. Billions of cash can just disappear or vanish, even the Chairman of a company.
From starving pigs to disappearing chairmen: Chinese companies offer some bizarre excuses for plunging profits, missed deadlines amid worst earnings season on record
Of course not all “lemons” in your portfolio may due to “information asymmetry” , some is because of “regulatory risk” like Telco or disruptive technology which affecting the media industry ( SPH ).
Can we trust the “audit reports “ ?
There are countless of case where auditors had failed us internationally or locally. Obviously, who is paying auditors to do the job and if companies is having intentions to “hide” certain information , is also difficult for auditors to dig and verify, to be fair.
What the dickens is up with audit firms? <businesstimes.com>
No doubt , my biggest “lemon” was the “Hyflux 6%CPS” which cost me -$127K (blog link ) and throughout the years , without realize , I have also collected so many lemons like ( Design Studio -56% ) , (Sarine Tech -61%), (TREK2000 -40%), (TTJ Holding -29%) , (Avi-Tech -18%) , (Duty Free Intl -15%) ….. loss incurred (including dividend )amounting to -$103,594 if I would have to cut loss and sell all these counters by now.
I have to admit that I don’t have a good “ exit strategy “ after buying particular stocks , it might also due to behavioural bias ( Loss Aversion ) or hoping that business of these companies may recover eventually. Ultimately some will and some will not , I may need to cut loss at some point.
Volatility seems higher for “small cap” companies , although sometimes you can win big or finding gems that would give you a “multi-bagger” in your portfolio , but sometimes , you will just get the “lemons”. ?
But I think it's still OK as long as you have more “Peach “ than “Lemon” in your portfolio in the long run. :D