Value investing: there is recurrent mis-pricing of securities
Investors should understand not only what value investing is but also why it is a successful investment philosophy.
Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong.
The efficient market hypothesis takes three forms.
Implication of efficient market hypothesis
Of the three forms of the efficient market hypothesis, I believe that only the weak form is valid. Technical analysis is indeed a waste of time.
As to the other forms: yes, the market does tend to incorporate new information into prices - securities prices are neither random nor do they totally ignore available information - yet the market is far from efficient.
The implication of both the semi-strong and strong forms is that fundamental analysis is useless. Investors might just as well select stocks at random.
Investors applying disciplined analysis can identify inefficiently priced securities and achieve superior returns while taking below-average risks.
There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns.
Specifically by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks.
The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare.
While hundreds of investment analysts follow IBM, few, if any, cover thousands of small-capitalization stocks and obscure junk bonds. Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor's 100 than within it.
Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, thereby creating pricing inefficiencies.
Efficient-market theory is at odds with the reality of how the financial markets operate.
Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time?
I believe it is.
The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate.
Buffett's "The Superinvestors of Graham and Doddsville"
If the markets were efficient, then how could so many investors, identifiable by Buffett years ago as sharing a common philosophy but having little overlap in their portfolios, all have done so well?
Buffett's "The Superinvestors of Graham and Doddsville" demonstrates how nine value investment disciples of Benjamin Graham, holding varied and independent portfolios, achieved phenomenal investment success over long periods.
His view is that the only thing the many value investors have in common is a philosophy that dictates the purchase of securities at a discount from underlying value.
The existence of so many independent successes is so inconsistent with the efficient-market theory.
Investors should understand not only what value investing is but also why it is a successful investment philosophy.
At the very core of its success is the recurrent mis-pricing of securities in the marketplace.
Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong.
- If, on the one hand, securities can become undervalued or overvalued, which I believe to be incontrovertibly true, investors will thrive.
- If, on the other hand, all securities at some future date become fairly and efficiently priced, value investors will have nothing to do.
The efficient market hypothesis takes three forms.
- The weak form maintains that past stock prices provide no useful information on the future direction of stock prices. In other words, technical analysis (analysis of past price fluctuations) cannot help investors.
- The semi-strong form says that NO published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices.
- The strong form maintains that there is no information, public or private, that would benefit investors.
Implication of efficient market hypothesis
Of the three forms of the efficient market hypothesis, I believe that only the weak form is valid. Technical analysis is indeed a waste of time.
As to the other forms: yes, the market does tend to incorporate new information into prices - securities prices are neither random nor do they totally ignore available information - yet the market is far from efficient.
The implication of both the semi-strong and strong forms is that fundamental analysis is useless. Investors might just as well select stocks at random.
Investors applying disciplined analysis can identify inefficiently priced securities and achieve superior returns while taking below-average risks.
There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns.
Specifically by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks.
The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare.
While hundreds of investment analysts follow IBM, few, if any, cover thousands of small-capitalization stocks and obscure junk bonds. Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor's 100 than within it.
Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, thereby creating pricing inefficiencies.
Efficient-market theory is at odds with the reality of how the financial markets operate.
Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time?
I believe it is.
The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate.
Buffett's "The Superinvestors of Graham and Doddsville"
If the markets were efficient, then how could so many investors, identifiable by Buffett years ago as sharing a common philosophy but having little overlap in their portfolios, all have done so well?
Buffett's "The Superinvestors of Graham and Doddsville" demonstrates how nine value investment disciples of Benjamin Graham, holding varied and independent portfolios, achieved phenomenal investment success over long periods.
His view is that the only thing the many value investors have in common is a philosophy that dictates the purchase of securities at a discount from underlying value.
The existence of so many independent successes is so inconsistent with the efficient-market theory.
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