Value Investing: How Stocks Become Undervalued
By Amy Fontinelle
If you don't believe in the efficient market hypothesis, you can find a number of reasons why stocks might be trading below their intrinsic value. Many of these factors interact with one another to drag a stock's price down or to push it up beyond what it should be. Here are a few.
Market Momentum and Herd Mentality
People invest irrationally based on psychological biases rather than analysis of market fundamentals. They buy when the price of a particular stock is rising or when the value of the market as a whole appears to be rising. They don't want to miss out on the gains that they assume others are achieving. They see that if they had invested 12 weeks ago, they could have earned 15% by now. They don't want to miss out on future increases of the same magnitude. They hear other people bragging about their paper profits and they want in.
Likewise, when the price of a particular stock is declining or when the value of the market as a whole appears to be falling, myopic loss aversion forces most people to sell their stocks. They don't want to lose everything, and they're afraid of the uncertain. So instead of keeping their losses on paper and waiting for the market to change directions, they accept a certain loss by selling. Such investor behavior is so widespread that it affects the prices of individual stocks, exacerbating downward market movements. (Such behavior also has a dramatic, negative effect on the portfolio returns of people who invest this way.)
- Bubbles and Market Crashes
When market momentum and the herd mentality run to extremes, bubbles and crashes result. The early 2000s tech bubble and the mid-2000s housing bubble were fueled by dramatic levels of overinvestment that bid up the prices of tech stocks and real estate beyond what the underlying companies and properties were worth. When the unsustainable highs began to fall, investors panicked and a crash ensued, causing some stocks to be priced closer to their true values and others to fall below their true values. (Bubbles are deceptive and unpredictable, but by studying their history we can prepare to our best ability. Check out 5 Steps Of A Bubble.)
- The Stock Is Unnoticed
Companies might sell for less than they're worth because they're under the radar. Small cap stocks, foreign stocks, and any other stocks that aren't in the headlines or aren't household names sometimes offer great potential but don't get the attention they deserve.
- The Stock Isn't Glamorous
Everyone wants to invest in the next big thing or even the current big thing. Not only do investors think they can make a fortune this way, but it's a lot more exciting to say you became a millionaire by purchasing shares of a technology startup than by purchasing shares of an established consumer durables manufacturer. Media darlings like Microsoft, Apple and Google are more likely to be affected by herd mentality investing than conglomerates like Proctor and Gamble or Johnson and Johnson.
- A Company Announces Bad News
Even good companies face setbacks like litigation and recalls. However, just because a company experiences one negative event doesn't mean that the company isn't still fundamentally valuable or that its stock won't bounce back. Companies with real value can experience a significant drop in share price when something bad happens. However, investors often overreact to the magnitude of the information, opening up buying opportunities for value investors who strictly follow fundamental principles. Those who are willing to consider the company's long-term value and ability to recover can turn these setbacks into profit opportunities.
- One Part of the Company Is Underperforming, but Other Parts Are Still Strong
Sometimes a company has an unprofitable division that drags down its performance. If the company sells or closes that division, its financials can improve dramatically. Value investors who see this potential can buy the stock while its price is depressed and see gains later.
- The Stock Doesn't Meet Analysts' Expectations
Analysts do not have a great track record for predicting the future, and yet investors often panic and sell when a company announces earnings that are lower than analysts' expectations. This irrational behavior can temporarily depress a stock's price.
- The Stock Is Cyclical
It's common for companies to go through periods of higher and lower profits. The time of year and the overall economy affect consumers' moods and cause them to buy more or less. Their behavior might affect the stock's price, but it has nothing to do with the company's long term underlying value.
In the next section, we'll talk about how to find undervalued stocks.
Value Investing: Finding Undervalued Stocks
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