Before buying shares of a company you would definitely like to know how much they cost, or better to say how much they should cost. But you might ask: aren’t the companies already fair-valued in the Market? Can I buy an over/undervalued one?
Well, it turns out the first question is very tricky and tricky to the extent that recently two guys received the Nobel price on that issue. One of those, Fama, says that stock markets already reflect and incorporate all the possible information about company’s profitability potential in the price. It means that if you buy a company in the market, you don’t over/underpay. Moreover, stock markets are supposed to react precisely (in the right direction and with right magnitude) by adjusting the price immediately to the information.
Now think about APPLE Company: millions of investors around the globe follow the news related to the company. As soon as something new pops out (like maybe iPhone with 3-D projector 😉 ), young enthusiastic investor sitting Riga most probably sees its impact already incorporated into the price because he is definitely among the last who notices this. It doesn’t mean that all those millions of people calculated the precise value of the company with future iPhone sales, rather they ended up with some range of values – somebody with higher, while others with lower, but on average (by the law of large numbers) the price should be what is called “fairly” estimated.
Is it observed in practice? Well, some studies suggest that if you try to pick companies individually, you would hardly outperform the market portfolio (or Index fund) performance, so it doesn’t make sense to make some research and bear costs of money/time loss. Also, one interesting experiment was carried out: a monkey was given a chance to pick a random set of stocks and it turned out that the portfolio of those stocks did no worse than created by professional analysts.
At the same time, the other guy, Shiller, would object to that. What he says is, basically, that people are not perfect creatures and they tend to act irrationally, thus overemphasizing the impact of news on the price. He claims to observe some patterns in the price movements that can help to predict its future fluctuations. The practical evidence of that is in the history of the US stock market crashes. Not going back so far, Shiller managed to predict the crashes of internet bubble at the beginning of the 2000s and housing prices crash in 2006-2008 long before these occasions.
As an example, think about some internet company X in 1998 with small (if not negative) profits and practically no tangible assets. It could be traded 10, 20 or even 100 times more in relation to earnings than a company with large intangible assets and good past earnings records. In other words, the price to earnings ratio (P/E) for internet companies could be 600 while for industrial company could be 30. Why such an absurd difference? It turned out that people laid too optimistic expectations on the profitability of Internet companies. Together with leading analysts’ projection about bright future of internet industry, outstanding performance of funds and traders who comprised their portfolios with internet stocks more and more people could get into the trap of overvaluation. Such actions pushed the price higher and higher until everything collapsed in one moment.
Fama might object here, saying “what if analysts of those periods incorporated only the information that was available in the market? ” It means that collapse could happen because of the new set of negative information that popped out after the prices had already grown so rapidly.
Well, we can continue this argument forever… for those who are interested we would recommend reading the articles about Fama and Shiller and find something on their own. Possible topics: efficient market hypothesis, are markets really efficient, stock market bubbles in the US history.
What is our opinion here for this topic? Well, we also think that it’s hard to profit from Apple news releases (unless you are a friend with Apple CFO or CEO who tells you about the company’s plans), especially sitting here in Riga. That is why, for our portfolio we would prefer to buy the Index Fund of the US stock market. As for the individual picking, we would look for some companies in the Baltics region or Russia which we know much better and where the competition among investors is not so severe. In such situation we can find some undervalued companies and thus profit from holding them in the long run.
Also note that there is no point in looking at every company that you see in the market and trying to analyze them in order to arrive at certain “buy/sell” conclusion. Undervalued stocks are quite rare in the days of computer technology, but still they can be found if you look at some indicators about which we will talk in the next articles.
You can take a look here:
http://economix.blogs.nytimes.com/2013/10/21/the-inefficient-market-hypothesis/?_php=true&_type=blogs&_r=0
http://economix.blogs.nytimes.com/2013/10/21/the-inefficient-market-hypothesis/?_php=true&_type=blogs&_r=0
