The success of value investing exists because securities are periodically and recurrently mispriced in the marketplace. Value investing is predicated on the idea that the Efficient Market Hypothesis (a widely held belief among institutional investors) is wrong – not entirely wrong, but periodically wrong for the broad market and more often wrong for niches within the broad market. Value investors believe in a long term market efficiency (that securities prices will accurately reflect the underlying performance of the business or value of their assets over a longer period of time). Value investors depend upon short-term inefficiency as well as long-term efficiency.
It is fair to say that markets are mostly efficient. Large caps (covered by hundreds of analysts) tend to be more efficiently priced than the thousands of Mid caps, Small caps or other less popular investment categories that have no analyst following at all.
But there is simply no question that mispriced securities frequently and recurrently exist in the marketplace. But why? The list can be very long, but a few reasons are:
-A company recently reported disappointing results and the stock was dumped by investors focused on short term earnings.
-A large investor may have a margin call, forcing the sale of a large block of shares.
-Institutional investors may be forced to sell a stock once it sells below $5 per share (a silly, but very real institutional restriction.)
-Institutional investor or index fund may be forced to sell a spin-off that is either too small or not included in the index it tracks (creating at least a temporary supply demand imbalance.)
-A company may cut or eliminate a dividend for any reason, but institutional investors may be forced to sell non-dividend paying stocks.
-Year-end tax selling may force a poorly performing security to drop further as the end of year approaches.
-Institutional window dressing – managers sell their losers and buy the winners to dress up their periodic reports to clients.
Many of the forces that cause securities to deviate from underlying value are temporary. This applies to whether the departure is overvalued or undervalued. The long term tendency is for securities prices to move toward their underlying value. There are many market forces that make this so. Overvalued securities eventually get pushed down to earth by short sellers or insider selling or results that don’t meet lofty expectations (although the overvaluation can sometimes seem to persist for many years, it is most often much shorter.) Similarly, deeply undervalued securities eventually get pushed up by assets sales and distributions, spin offs, recapitalizations, extraordinary dividends, share repurchases, hostile takeovers, proxy contests or simply a new group of shareholders coming to appreciate the value and/or track record of a business or management.