Value investing
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13. Why do stocks become undervalued/overvalued?
A good question. All those highly paid analysts in City firms with sophisticated computer models and unlimited resources. Surely they know exactly what a share is worth, and price it accordingly? Well, some they do, and some they don't.
But in general, a value investor gets his break because of four pervasive inefficiencies in market pricing:
- Neglect
Lots of quoted companies are too small for the large professional fund managers to bother with. They are 'under-analysed'. If you want to know which companies are under-analysed, look up the institutional shareholding (if it is very small, not many professionals will be following the stock), and look up the number of analysts who research the stock. - Pressure of professional fund managers
Professional fund managers have to produce superior results on a consistent basis; if they don't they lose clients and, potentially, their jobs. This forces them to manage their portfolios actively and makes it very difficult to follow value investing principles. You don't suffer from the same pressures. - Market overreaction to bad news
Markets often mark down the price of a share drastically when it produces poor results. In some cases, the mark-down can be an overreaction and presents an opportunity for the value investor to buy. - Market overreaction to good news
The flip side is that markets also overreact to good news, become euphoric, and send its share price skyward. That's an opportunity for the value investor to recalculate his asset values and earnings ratios, and to sell if the share price no longer represents good value.
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