Buying and Selling: When Opportunity Knocks
Long-term stock investors can capitalize on market inefficiencies.
It sounds simple enough, but as you've probably discovered, those firms with the best long-term potential often have price tags reflecting their prospects. So how exactly might a fat pitch opportunity come to pass?
As it turns out, not everyone calls pitches the same way we do at Morningstar. Different types of investors have varying assumptions, outlooks, and motivations when valuing stocks. And as you'll see, these differences can occasionally be the windup to the fat pitch you've been waiting for.
Morningstar publishes research on more than 1,100 companies, and estimating a fair value for each of them takes up a good deal of our analysts' time. Here's how we define fair value:
The sum total of all future free cash flows of a company, discounted to the present at a rate commensurate with the riskiness of the cash flows.
As you can see, there are two explicit components to this type of fair value, which I'll refer to as the "intrinsic" fair value throughout this article:
In truth, it's not. It is possible to make an educated guess, however, and that's what we do. In fact, that's what all long-term investors do when they attempt to place an intrinsic fair value on a stock, whether they're using the price/earnings ratio, the PEG ratio, the price/book ratio, or a discounted cash-flow model such as ours. It's all the same thing--figuring out if the current price accurately discounts the long-term free cash flows of a business. (The PEG and P/E ratios simply use earnings as a proxy for cash flow.)
These are the explicit assumptions that go into our valuation model. But embedded within our methodology are at least three implicit assumptions:
Other Time Horizons and Motives
There are many different submarkets within the stock market, and thus, many different fair values for a stock depending on who's doing the valuing. Consider the following:
There are, of course, other submarkets within the broad stock market. Examples include the submarket for highly liquid mega-cap stocks (large mutual funds can't invest in small, thinly traded companies), the submarket for companies with earnings momentum, the submarket for companies that are inversely correlated with other stocks in times of turmoil (e.g., gold mining stocks), the submarket for stocks that Warren Buffett has been buying, the submarket for stocks that will benefit from a modernization of the Chinese economy, and the submarket for stocks that look good on paper just as a fund manager is getting ready to send out his quarter-end report to shareholders.
So, at any given time, various submarkets within the stock market are inefficiently priced. Often, participants in these various submarkets are willing to pay a premium for stocks that meet their coveted criteria, and these stocks temporarily sell above their intrinsic fair values. Eventually, though, this divergence will correct itself--it's not a matter of if, but when.
All these different submarket participants interact daily, and the average of all their valuation guesses shows up in a stock's closing price. Different investors have different motives for buying a stock, and different time horizons for holding on to it. So it's no wonder they also have different estimates of fair value for the same security. Typically, this whole process results in a reasonably efficient market, but there are times when things get way out of whack, when one market subset dominates the trading in a stock, causing a wide divergence between price and intrinsic fair value.
And that's when things get interesting.
The Market for Long-Term Total Returns
Based on this discussion, it seems possible to isolate the three crucial ingredients of successful long-term investing:
In plain English, this means your goal is to figure out when a stock is inefficiently priced for no other reason than sentiment. When market participants who do not have the same time horizon and motives you do are negative on a stock, and your estimate of its long-term cash flows hasn't changed, it's time to back up the truck. This doesn't happen too often, but when it does, you need to be able to recognize it and act quickly.
When the opposite happens--market participants with a different time horizon or set of motives are temporarily too bullish on a stock--consider taking some money off the table, or at least refrain from buying any more shares.
In the absence of these conditions, do nothing. Hold on to your stocks and wait for an opportunity.
A version of this article was published on Sept. 3, 2003.
Mark Sellers does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.