One of the reasons is human nature. We have a short memory. We are all momentum traders. We like to buy winners. If we keep buying the winners, we will push the price of winning stocks higher and higher, and that much higher above value, to levels that eventually clear the way for a correction. The correction will bring the stock price closer to its value.
The opposite is the case for losing stocks
Because we like to sell losing stocks, we drive their prices well below their value, ultimately paving the way for a recovery. If we can manage to buy stocks at or below the safety margin and wait patiently for the stock price to recover, we can make a good profit. Normally, opportunistic (pure Ben Graham type) value investors have a holding period of three to five years. If the stock doesn’t reach NAV within three to five years, value investors think they either made a mistake or that for some reason the stock will never reach NAV. Something can prevent the stock from reaching intrinsic value.
A good example is a company called H. Pauline & Co. As part of a project in 2010, a group of my MBA students valued the company in 2000 and found it undervalued and a bargain. Also valued in 2010, ie 10 years later, the stock remained undervalued. In other words, for some reason this stock did not converge to its net asset value. My students were looking for an explanation. What they found was that this company had good assets, but a bad manager, who unfortunately was also the majority shareholder. He was unable to efficiently use the assets to produce potential cash flows, so the market did not place enough value on the stock. And the market knew there was nothing they could do to correct this situation because the manager was also the majority shareholder. But in 2012, the owner/manager decided to retire and sell his ownership stake in the company. Within three days, the stock jumped close to the NAV determined by the student.
What my discussion from ten years ago implies is that value investors believe that while markets can be very inefficient in the short run, they become efficient in the long run, with prices tending towards value.
Markets need to become efficient in the long run because if they didn’t, we’d never know if we were going to make money or not. It is the tendency of stock prices to converge towards true value that allows us to make money by buying at or below the margin of safety and selling at or above the net asset value. If convergence never happened, we would never be able to say whether we would make money. Ben Graham saw stock prices as the planets orbiting the sun. Gravity keeps the planets in this pattern. Intrinsic value acts like gravity that causes stocks to revolve around it.
Prices do not equal value
Again, it’s important to understand that prices don’t always equate to value, as market efficiency advocates argue. We don’t see this in real life. If that were the case, we would never be able to make money. It is the combination of short-term market inefficiency and the long-term convergence of prices to value that provides opportunities for value investors to make profitable trades.
Experimental economist Vernon Smith won the Nobel Prize in Economics in 2004. He experiments in labs with test subjects and tries to imitate real life. Professor Smith has repeatedly shown in his research that “traders bid each other much higher than the true value of an investment….that people don’t normally buy and sell based on fundamental value…and that people are momentum traders, a process that, if it is repeated enough, eventually it should end in crashes.” In addition, Professor Smith found that “the smart traders took the bidding way above the fundamental value and generated a bubble equal to the bubbles produced by beginners.” In other words, it doesn’t matter whether one is a novice or professional trader. Human nature tends to produce these kinds of stock price movements, both in a lab environment and in real life.
George Athanassakos is a professor of finance at Western University’s Richard Ivey School of Business in London, Ont. He holds the Ben Graham Chair in Value Investing and is director of the Ben Graham Center for Value Investing. This article is an excerpt from his new book Value Investing: From Theory to Practice (January 2022).
This post What do value investors believe in?
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