3Com-Palm Market Anomaly: Can the Market Do Simple Arithmetic?

A $22 Billion Question Sparks a Fundamental Inquiry into Financial Market Rationality.

• Understand how market prices can defy logic through the 3Com-Palm case.
• Learn the principles behind market failures caused by ’limits to arbitrage’ and ‘irrational exuberance.’
• Reassess financial market rationality and gain insights for better investment perspectives.

The $22 Billion Question

On March 2, 2000, financial markets witnessed a market anomaly that blatantly contradicted their own logic. When tech company 3Com spun off 5% of its subsidiary Palm via an IPO, the market valuation completely defied common sense.

On the first trading day, the value of 3Com’s remaining 95% stake in Palm, implied by the publicly traded 5% stake, was about $50 billion. Yet, 3Com’s total market capitalization was only $28 billion. This meant the market was effectively assigning a negative $22 billion value to 3Com’s core business (its profitable networking operations and substantial cash reserves). This was not a simple miscalculation but a mathematical absurdity shaking the foundations of market logic.

This event was a clear challenge to the Efficient Market Hypothesis (EMH) and its fundamental principle, the Law of One Price. Starting from this “negative $22 billion question,” this article delves deeply into why and when markets seem unable to perform even the most basic addition and subtraction.

Dissecting the Anomaly: 3Com-Palm Equity Carve-Out

How did this absurd market anomaly occur? Let’s analyze the transaction step-by-step.

• Background: 3Com was a solid computer networking company, and its subsidiary Palm was a leader in the rapidly growing personal digital assistant (PDA) market.
• Equity Carve-Out: At the peak of the dot-com bubble on March 2, 2000, 3Com sold 5% of Palm to the public through an IPO.
• Spin-Off Commitment: Simultaneously, 3Com announced it would distribute the remaining 95% of Palm shares to 3Com shareholders by year-end, with each 3Com share expected to receive about 1.5 Palm shares.
• Logical Implication: This plan set a clear lower bound: the 3Com share price ((P_{3Com})) should be at least the value of the Palm shares it implied owning ((1.5 \times P_{Palm})). In other words, (P_{3Com} \geq 1.5 \times P_{Palm}). In reality, 3Com’s other profitable businesses should have pushed this value even higher.

But the reality was the opposite. On Palm’s IPO day, Palm’s stock closed at $95.06, implying 3Com’s share price should be at least $142.59. Instead, 3Com’s stock price dropped to $81.81.

Absurdity in Numbers

Calculating the intrinsic value of 3Com’s non-Palm assets (the “stub”):

[\text{Stub Value} = P_{3Com} - (1.5 \times P_{Palm})]

[= 81.81 - (1.5 \times 95.06) = -60.78]

Translated to total market value, this implied a negative $22 billion valuation for 3Com’s core profitable business. This price discrepancy persisted for months and was widely reported but remained unresolved.

Table 1: 3Com-Palm Price Discrepancy (Closing Prices on March 2, 2000)

Broken Arbitrage Engine: Market Frictions and Limits

Theoretically, such price discrepancies should be immediately corrected through arbitrage. Arbitrageurs could short the overvalued Palm shares and buy the undervalued 3Com shares to earn riskless profits. Why didn’t this mechanism work?

The answer lies in the concept of Limits to Arbitrage. Arbitrage is never free in reality and involves various risks and costs.

• Noise Trader Risk: Irrational investors can push prices further away from fundamentals, risking losses for arbitrageurs.
• Implementation Costs: Direct and indirect costs of executing trades.

The Palm case perfectly illustrates how fatal implementation costs can be. Shorting Palm shares was practically impossible.

• Short-Sale Constraints: The biggest obstacle. Almost no Palm shares were available to borrow for short selling immediately after the IPO. Even if found, borrowing costs exceeded 35% annualized, an enormous expense.
• Buy-in Risk: Lenders can recall shares anytime, forcing arbitrageurs to cover at inflated prices.

As an investor, witnessing this made me reconsider faith in perfect market rationality. The market’s “invisible hand” of arbitrage was shackled by costly fees and unpredictable risks. Irrationality created the price discrepancy, and rational attempts to correct it were economically infeasible.

The Madness of Crowds: Irrational Exuberance in the Dot-Com Era

While limits to arbitrage explain why prices weren’t corrected, understanding why prices became so “wrong” requires examining investor psychology at the time.

Palm’s IPO occurred at the peak of the tech bubble, characterized by irrational exuberance.

• “Purity Premium” and Investor Ignorance: Investors preferred owning the “sexy” tech stock Palm directly rather than the complex parent 3Com. Many were unaware or indifferent that buying 3Com shares was a cheaper way to own Palm shares.
• “Greater Fool” Theory: Many speculators knew Palm was overvalued but believed they could sell to a “greater fool” at a higher price before the bubble burst.

This split the market into two: the “Palm fan” segment caught up in the IPO frenzy, and the “rational investor” segment aware of the math. However, short-sale constraints separated these markets, and prices were set by enthusiastic investors. The market didn’t fail to calculate; rather, those who could calculate were pushed out of the game.

Symphony of Errors: Confirmatory Evidence from Other Markets

The 3Com-Palm anomaly was not isolated. Similar market anomalies have been documented elsewhere.

• Dual-Listed Companies (DLCs) - Royal Dutch/Shell: Despite profit-sharing agreements, their stock price ratios deviated significantly from parity for decades.
• Closed-End Fund (CEF) Puzzle: Fund prices consistently trade at discounts or premiums to their net asset value (NAV).
• Parent-Subsidiary Puzzle - Yahoo/Alibaba: After Alibaba’s 2014 IPO, Yahoo’s market cap was less than the value of its Alibaba stake alone, implying a negative value for Yahoo’s core internet business.

These cases show that market irrationality is not a product of a specific era but a systematic feature under certain structural conditions.

Table 2: Comparison of Major Market Anomalies

Bubble in a Bottle: Insights from Experimental Economics

If such irrationality is a fundamental human trait, it should appear even in controlled lab settings. Nobel laureate Vernon Smith’s experiments provide this evidence.

• Design: Participants trade assets with known future expected dividends (i.e., “fundamental value”). In a rational market, prices should predictably decline following fundamentals.
• Result: Without exception, market prices deviated significantly from fundamentals, forming dramatic bubbles followed by crashes.

This experiment clearly demonstrates the inherent speculative nature of humans. Even with perfect information, the desire to predict others’ behavior and sell at a higher price can overwhelm knowledge of intrinsic value. This proves that the irrationality inflating the Palm bubble was not unique to the dot-com era but a fundamental feature of human economic behavior.

Conclusion

Can the market do simple addition and subtraction? The answer is “It depends on who controls the market.”

The 3Com-Palm market anomaly powerfully illustrates that the market’s mathematical ability is conditional, fragile, and ultimately depends on the collective behavior of its human participants.

• Key Point 1: Markets operate rationally most of the time but can fail even basic logic under certain conditions.
• Key Point 2: These failures arise from the combination of investor psychology (irrational exuberance) and market frictions (limits to arbitrage).
• Key Point 3: Understanding markets requires not only valuation models but also deep insight into human psychology.

So how should investors survive in such markets? This case reminds us of the importance of maintaining a cool-headed analysis of an asset’s fundamental value, resisting the madness of market manias.