As per efficient market theory, price of a stock reflects the current value of the stock incorporating all known information in the price. However, value investors disagree with this proposition. Warren Buffet wrote in one of his annual reports that while stock market is usually efficient, that does not mean it is always efficient. The difference between usually and always is 'night and day'.
It is instructive to understand that why would market misprice a stock when investors (many of whom are highly educated ) focus enormous amount of time to analyze a stock. The simple answer is emotion and time horizon. Lets take this one by one.
First the basic of human emotions that affect stock price is fear and greed. Market has a tendency to swing to extremes during both good and bad times. It is not unusual for the market to extrapolate both good and bad times into distant future.
A case in point about too much optimism in good times is tech stocks during late 90's. Tech stocks like Cisco were very good companies making lots of money. But their stock price reflected enormous optimism about future and that was not achievable. This even extended to tech stocks that did not have earnings or just went public. The late 90's provide an extraordinary learning opportunity to learn for value investors.
Similarly pessimism about future too can be taken to new heights. Currently credit agencies like Moody's or Mcgraw hill (MHP- owns S&P credit rating agency) seem to reflect a gloomy future forever. At some point housing will recover to ordinary levels if not to the extraordinary levels of 2005 and 2006. Similarly capital markets will likely return to normal levels at the very least.
Take the case of Moody's. It's price fell from high of $76 to around $36+ dollar within a matter of months. It is difficult to believe that the value of the company was 100% more than today's price just a few months earlier. Either market over estimated earlier high price or is discounting the current value significantly or bit of both. Either case, market misprices during uncertain (read fear or greed) times. Only time will tell if Moody's price is under valued. But it does show that market takes wide swings and value of solid companies usually do not swing that much in short order of time.
Further Warren once said that it is important to note that these emotions are here to stay. As a whole human race does not get any wiser with respect to these emotions. These will occur many times in future. That is good news (not bad) for value investors who seek to find mispriced stocks.
Time horizon introduces some mispricing because of the way Wall street operates. I have found that if a business has a temporary problem and has a very bright future and will return to creating value in two to three years, Wall street usually will leave it for "dead". It is called "dead money" and the stock is beaten down. Wall street will plan to get back on the stock once it gains "traction"! I am always surprised why this occurs but it is an indirect effect of compensation systems. Most compensation system operates on quarterly or yearly rewards. compensation systems drive behavior and usually this results in intelligent people doing things that they would not normally do. This provides unusual opportunity for those willing to wait. This is the critical information that provides regular investors a leg up over Wall street.
The key point for a value investor to take away is price of a stock is not necessarily it's value. Price is set by auction type market by all market participants which by it's very nature is affected by emotion and time horizon of it's participants. Value of a stock instead is derived by discounting it's future cash flows to present. When they coincide or when price is greater than value, value investors need to walk away. When value is significantly higher than price, swing your bat. Also, usually market is good at recognizing value and will match it's price with value.
It is intructive to read Warren Buffet's lecture on this topic and can be had by
http://www.tilsonfunds.com/superinvestors.html
I hope this seals the discussion about market mispricing. Happy value investing...
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