If we accept that markets are largely efficient, then why does mispricing exist? It does and oftentimes even persists far longer than it should. This week, we attempt to explain this phenomenon by looking at it from a different perspective. The conventional thinking is based on the assumption that all investors and stocks exist in one universe. In reality, stocks are more fragmented — into buckets that appeal to certain types of investors and, in other instances, by geography, regulations and so on. At certain points in time, stocks can move from one bucket to another, resulting in price gains or losses in the absence of any change in facts. What do we mean by this?
We are certain there are times you have felt frustrated when the price of your stock remains stubbornly below the expected fair valuation and, conversely, when valuations stay inexplicably high for certain stocks, in the absence of any rational reason based on the known facts. We have felt frustrated, too, but we also believe that markets are generally efficient.
The “efficient market” hypothesis says all known information and intelligence are captured in the price discovery process. Therefore, share prices will reflect the companies’ true intrinsic values (at least over the “long term”). Stocks are then aligned based on their risk-reward propositions. And investors — it does not require every investor to have the exact same information or be equally rational — as a whole can gravitate towards this market pricing. In fact, each investor will be different, and they will buy/sell stocks along this spectrum based on their own risk-reward profiles. Clearly, there is a contradiction here.
