The essence of value investing is buying a stock at a price that is significantly lower than the intrinsic value of the company. Given that the future price of a stock is uncertain, the main purpose of value investing is to generate wide “margin of safety” in order to protect principal and seek good returns of investment.
Factors of Market Inefficiency
One may question how the price of a stock can be different from its intrinsic value. Even though it is claimed that market is always efficient, especially in today’s market where numerous investors can compete fairly with easy and nearly equal access to the same amount of information, reality is that as long as humans are involved in making trading decisions, the market is subjected to psychological bias of investors even if fancy statistical models are used in analysis (the design of trading algorithms also requires some human subjective input, such as risk tolerance).
One source of inefficient pricing of stock is human psychological factors. For instance, people tend to overreact to unexpected incidents. When a company misses an earning or growth expectation, its stock is subjected to panic selling and the price can be lower than its real value.
Another type of psychological bias is that people tend to impose a pattern on totally random incidents. It is often called gambler’s fallacy. For example, if I fairly flip a coin 5 times and record the first four outcomes in the table below. What do you think the 5th outcome would be? If you think head is more likely than tail, then you fall into the gambler’s fallacy. The reason is that every flip is independent from others and therefore totally random.
|Flip 1||Flip 2||Flip 3||Flip 4||Flip 5|
On the other hand, if you think the tail outcome is more likely, then you may fall into fallacy of extrapolation, the belief that short-term trend can last for long term. This bias can be observed in the previous economic crises when the market believed that assets prices can continuously rise simply because it rose in the past.
These two types of biases could also affect short term stock analysis (e.g. the so-called technical analysis) and long-term estimation of company fundamentals which requires bold assumptions about future (Studies have found that professional analysts tend to be optimistic in estimating future earnings). Regarding the limitation of long-term estimation, Charles Brandes wisely said in his book Value Investing Today, “be wary of any projection that extends beyond the time that the analyst expects to be in that job.” To become a value investor, one needs to learn to resist these types of psychological biases and take advantage of others’ irrational behavior in the market.
Another set of sources for inefficient market is somewhat “political”. Undervalued stock by definition underperforms. Sometimes a stock underperforms because the company has bad fundamentals. Other times a company that makes good earnings can also have underperforming price because the company or the industry it is in is considered to be “unpopular”, such as waste management and funeral services, or simply not being included in major stock indexes. In particular, Professional investors, such as mutual fund managers, can face the pressure from their supervisors or clients to avoid stocks not included in certain index, like S&P 500. They may also have more difficult time justifying their investment in certain “unpopular” but profitable industries as oppose to fancy but risky ones.
Time also plays an important role in market inefficiency. Often, investors don’t have time or can’t afford to be patient to wait for undervalued stocks realize its real value. It is especially relevant to professional investors whose performances are evaluated in short time windows. One of the scenes in the Academy Award movie The Big Short illustrates the pressure professional investors face that may prevent them from making the right decisions, namely taking advantage of irrationality in the market.
The consequence of the aforementioned factors is that popular/outperforming stocks attract more demand, which eventually pushes price to a higher level than its real intrinsic value. Any negative surprise about the company or the economy could trigger significant panic selling pressure on the stock, like what happened in 2008; whereas the prices of undervalued stocks drop below their intrinsic values, and a good return is likely when the market clams down and recognizes the real value of the company.
Behave like a Value Investor
If a person spends $100 in a mall, this piece of information alone is not enough for us to tell if he or she gets a good deal. Rather, it depends on what he or she gets for $100. Value investors are the type of people who would buy swimming suits in winter or down coat in summer. These items are on sale not because there is anything wrong with the quality but simply because they are not “popular” during certain season. Value investors love to take advantage inefficiencies like this.
In stock market, unvalued stocks can often be found among unpopular industries and underperforming stocks. But value investing is not just about investing in unpopular industries or buying cheap stocks. Value investors focus on the relations between prices and the real value of assets. So, cheap stocks are not necessarily undervalued. For the same reason, expensive ones are not always overpriced comparing to its real value either (valuation of stocks will be covered in the future post).