The key to value investing is to follow a less biased and less emotional approach in estimating the true value of a stock. There are two schools of thought that attempt to do just that: Efficient Market Theory and Fundamental Analysis.
Efficient Market Theory
According to Efficient Market Theory, the stock market is an efficient marketplace where a stock’s price reflects its true value at all times. The theory states that the market is efficient for two reasons:
Investors are rational. Every investor is a rational human being using her skills and knowledge to the best of her ability to maximize her own profits. Don’t laugh. Some people actually believe this statement.
All public information has been factored into the price. All the information the company made public already has been factored into the price of the stock. A stock’s price may move in the future as new information becomes available, but because you can’t know what that information will be, you have no way of knowing whether that move will be up or down.
According to Efficient Market Theory, you can’t possibly gain an advantage over other investors because investors are rational and all of them have access to the same information. In other words, you may as well just buy an index fund.
Fundamental analysts believe the Efficient Market Theory is a bunch of hooey. Although the market may be efficient on a yearly basis, it sure isn’t on a daily, weekly, monthly, or quarterly basis. Value investors are fundamental analysts. They analyze a company’s past results to evaluate its current financial health and then to predict the company’s future growth in earnings, revenues, and stock price.
Although past results are certainly no guarantee of future performance, past performance can be a good predictor of future performance. A company with a proven history of good management, innovation, and revenue and earnings growth can be expected to continue along that path until experiencing a drastic change.
According to Fundamental Analysis, the stock market is inefficient because both of the core assumptions of Efficient Market Theory are wrong. Fundamental Analysis relies on the following theories:
Investors are irrational. Many individual investors don’t use their skills and knowledge to the best of their ability to maximize their own profits. They follow hot tips and rarely research their investment choices. Typically, most people spend more time planning their next vacation than they do researching their next investment. In addition, many investors run between the two extremes of fear and greed — buying when they should sell and selling when they should buy. Examine any bubble burst, and you quickly realize how irrational investors can actually be. Value investors use this knowledge to their advantage.
All available information has not been factored into the price. Although all the information is out there, the majority of investors, including the big Wall Street firms, ignore most stocks. Retail investors typically buy what is hot at the moment. Institutional investors, such as mutual funds, pension funds, endowments, and charitable trusts, often have tight restrictions on what they can own. So, the market contains a lot of hidden gems waiting to be discovered. Finding a bargain is often a matter of simply doing the research. If you find one before everyone else, you can see some nice capital gains.
Fundamental Analysis isn’t foolproof. Trying to predict the future is always risky, but thorough research and careful analysis significantly improve your odds.