Investing is a humbling experience. Even for the smartest of people in the world it is filled with failures of various magnitudes. This is because, as we all know there is no exact science or magic formula (Joel Greenblatt might disagree with me here) that leads to perfect results.
Let me take stock price movements as an example. Fundamental investing is done on the whole basis of identifying undervalued stocks and holding them till fair value is achieved. This simple logic isn’t as simple as it sounds. I want to discuss two different issues related to this which makes it so complicated.
Are market’s efficient?
The first issue is a question of market efficiency. If we truly believe that we have identified a stock which is undervalued then the market is inefficient (at least to some level). However, if the stock price is to go towards its fair value then ultimately market has to become efficient. This is a conundrum.
In frontier and emerging markets, there is no doubt that markets are inefficient to large degrees for various factors. However, even in developing world the performance of some of the top investors like Warren Buffet and Peter Lynch does show that inefficiencies do exist. Joel Greenblatt’s ‘You can be a stock market genius’ highlighted many examples of such inefficiencies which he exploited to the fullest to make tremendous returns.
Now, if we are claiming that markets are inefficient how and why are we betting that these undervalued shares will reach fair value? The answer I have is that, while markets in general can be inefficient sooner or later it does revert to its fair value. Also a more logical way to look at is by each security rather than as a whole market. So by this logic, at any given point a bunch of the stocks in an index will be fairly prices while some others will not. At a later time, we could see another bunch being fairly priced.
Stock price as a signaling factor
Here is another big problem faced by investors. The typical analyst/investor usually formulates a thesis for his investment (sometimes with numerical models and valuation methods) and concludes that a stock is over or undervalued.
However, we analysts also know that we are human beings and may miss out on factors that could influence the stock price. Or maybe a reason that we felt was insignificant may be a bigger problem. What is the easiest way to know that we missed something?
It is the stock price itself!!! When the stock price moves against our thesis we use that as evidence that we have missed something. Imagine that you have initiated a stock with an upside of 40%. The stock starts crashing and you have no clue about why. Your boss is berating you. These are the moments which makes investing very difficult. The people with more guts can stick to their thesis and buy more. But what if there is a hidden reason which you are really missing?
There is no easy answer to this problem. As analysts while we are looking for price inefficiencies we still NEED to rely on stock prices itself as signals. Experienced analysts and investors can use their experiences in such situations and decide whether they should stick to conclusions or change their views.
This is what makes investing so fascinating.