Investing is a tricky business. On the one hand, successful investors need to be humble and mentally flexible, and be able to admit when they are wrong in their thesis. On the other hand, investing - to quote Seth Klarman (Trades, Portfolio) - is a fundamentally arrogant act. For every buyer, there is a corresponding seller, so when you buy a stock what you are doing is saying: “I believe that I know more about this investment than you, the seller.”
Value investors need to take that arrogance one step further. The "typical" value investment is a beaten-down stock in some obscure industry, quite possibly not in the S&P 500. The typical value investment is not looked upon favorably by the market as a whole. It stands to reason, therefore, that value investing can only work as a consistent money management strategy if the market is frequently incorrect - that it is inefficient.
Price and value are not the same
Klarman, like most value investors, believes the efficient market hypothesis is wrong. To recap, the efficient market hypothesis states that the price of an asset always accurately reflects all available information about that asset. In other words, it is impossible for price and value to deviate and that if the price of a stock changes, that must mean that some new information has become available. Of course, prices don’t completely ignore reality, but at the same time it should be pretty clear that there have been many investors who have successfully bought low and sold high.
What are some reasons why prices might get out of line from value? Klarman gives a few strong ones:
“If a stock is part of a major market index, there will be demand from index funds to buy it regardless of whether it is overpriced in relation to underlying value. Similarly, if a stock has recently risen on increasing volume, technical analysts might consider it attractive; by definition, underlying value would not be a part of their calculations. If a company has exhibited rapid recent growth, it may trade at a "growth" multiple, far higher than a value investor would pay.
Conversely, a company that recently reported disappointing results might be dumped by investors who focused exclusively on earnings, depressing the price to a level considerably below underlying value. An investor unable to meet a margin call is in no position to hold out for full value; he or she is forced to sell at the prevailing market price.”
Clearly, there are plenty of reasons why someone might choose to buy a stock that have nothing to do with the intrinsic value of the underlying company. I recently wrote about how automated traders exacerbate the ups and downs of market cycles - this is yet another example of how price discrepancies can be created. In short, there is no reason to believe that markets are efficient - in fact, history has given us plenty of evidence that it is not.
Read more here:
- Howard Marks: Will Computers Wipe Out Market Cycles?
- Seth Klarman: Value Investors Should Work from the Bottom Up
- Howard Marks: Why Investors and Dentists Are Different
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