Good Value and Efficient Market Theory

Q. With so many investors looking at shares, don't you think that most shares will be trading at a price that reflects their current balance of risk?


A: God no. Indeed the longer I invest/trade the more I laugh at the idea of efficient markets. I would say that behavioral finance is much more appropriate to look at markets than efficient market theory. Sentiment tears through markets moving stocks to all sorts of extremes in either direction. Markets half the time don't believe the fundamentals - when things are good no one believes they can become bad and when things are bad it becomes even more extreme and people extrapolate that forever ignoring all fundamental and historical data.

So for a calm investor, prepared to do the work and taking reasonable sensible strategies then the odds are nothing like 50:50. They are biased way more towards winning.

What is price of a stock?

The price is the sum total, a culmination, and a measure of all the hopes, aspirations, fear, and greed, of all the millions who hold the stock. It is this sum total which affects the supply and demand for the instrument. A person is buying or selling a stock for any reason under the sun. It could be a retirement plan, it could be for raising money for a house, or it could be for naked greed and desire for profit, in short, anything. Whatever the motivation is, the result is that either the stock is bought or sold. It is this buying or selling, which reflects on the prices. An individual could be accumulating stock with some insider information, which bids up the price. It could be desperation to meet a margin requirement, which hammers down the price.

In a nutshell, therefore, do not think that a small trader or investor does not matter in the grand scheme of pricing. Each drop counts, because it contributes to the sum total of the buying and selling ratio. The final price is the balance where the buying and selling stabilizes.

So what's the problem?

The problem is that behavioral finance isn't particularly great at giving investment timing signals of any kind. Its detractors argue that this means that efficient market approaches are seemingly better at ignoring the inconvenient fact that the signals from EMH models can be devastatingly wrong.

Possibly the most interesting recent stream of behavioral finance is coming out of a body of work from Gerd Gigerenzer who thinks we're neither rational or irrational - we're not organic computers, but are very efficient at optimally limited processing information which tend to go wrong when we're overwhelmed with data. A very simple of example of this is that he asked American students to estimate the relative sizes of German and American cities. They were more accurate at estimating the German ones.

This fits in with similar research on expert horse racing tippers - give them a bit of information then they get above average results, give them more then they get no better. All of which is uncannily similar to the situation many of us find ourselves in when analysing shares: we're drowning in information.

Anyway, I obviously believe that markets aren't efficient - far from it - but I don't think the existing state of behavioral finance tells us much beyond the fact that we're all influenced in our investments by things we don't really understand - like other people - and need to be very careful not to let our biases blind ourselves to the risks we sometimes take.

Q. If a stock is said to be 'Good Value' what is meant by that?

A: Value investing is concerned with investing in companies that look undervalued when analysed through fundamental analysis. Usually this means that the stock current value is below the company's net asset value. For instance, if a firm's share prices is lower than its dividend yield, or its book value... Famous advocates of this strategy include Warren Buffett, and for those with the stamina to invest in companies that have been ignored by the market, then the rewards can be substantial. However, in some cases analysts include the company's overall profitability (not just assets) to arrive at the valuation. This implies that a stock's value has little relevance to that of the company's overall true worth.

Note that value investing isn't just about buying a stock because it is cheap; a value investor will carefully inspect the balance sheets of companies and invest in companies that offer both good value and have good economic fundamentals (like low debt and high levels of cash reserves). But of course you shouldn't blindly invest in companies (even those with a healthy balance sheet) if you don't understand their business model...

Q. What about buying into underperforming 'badly managed companies' hoping for a turnaround?

A: I rarely invest in a stock that has continually underperformed (you shouldn't be throwing your money after any risk imo) unless I saw board changes and director buying. Don't just blindly believe directors' optimism - there needs to be stimuli that they have got their act together enough to make them a buy - and director buying helps to build confidence.

I think an underperforming stock that has done so on a long term basis needs:

  1. chart starting to rise.
  2. change of at least one major director on the board, better to have several.
  3. positive outlook from the board or one that's less negative.
  4. director buying.

 ...Continues here - Spread Betting - Sources of Investor Information

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