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In the value investing strategy of Warren Buffett, Benjamin Graham, etc. an investor is searching for stocks that are reasonably priced considering the value of the company as a whole. You are buying a business, not just a stock. When following this strategy, a question comes to mind... If the stock price is overvalued or undervalued, what eventually causes it to return to being fairly valued?

"In the short run, the market is a voting machine but in the long run, it is a weighing machine."

Right, yes.

What are the mechanisms of the weighing machine.

Here is one mechanism, which I think if very convincing:

  • A small company's stock is under-priced.

If that occurs in the real-world, it's possible that a larger company will see this bargain, and they could buy all the stocks, taking the company private, or merging the companies. Or buy a quantity of stocks, reap the benefits of dividends and growth, and eventually a buyout might occur. In any case, it does not seem confusing to me that market forces would correct this mis-pricing. It's not mysterious. This is similar to when a quantity of commodities (coffee beans) are priced too low. Obviously, someone will buy it, and then turn around and sell for a profit. That is clear enough.

PROBLEM:

A very very large company (Apple, Amazon) is different. They are too expensive to be bought-out, right? What are compelling reasons, if any, behind why the stock price will trend towards being fairly priced, either upwards or downwards. Or maybe it could stay out-of-whack for years.

Also... imagine a mid-sized company that's somewhat over-valued. The stock is a bit pricey. What, if anything, is stopping this situation from remaining the same for an extended period of time? What are reasons behind why the price will tend to return to a fair level.

JohnFx
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Sam
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2 Answers2

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Firstly, know that much of Buffet's strategy does not necessarily apply to passive investing. In fact, his advice to most passive investors is to just buy index funds and ride the market wave.

His strategy was to find companies (not stocks) that were undervalued so he could buy a controlling share and unlock that extra value, either by changing management, strategy, or tactics. If you can't buy enough to have an influence on the company, you're just hoping that someone else does.

You are correct in that there's not an overarching market force that always corrects under- or over-priced stocks. It often takes a few quarters of realized earnings in the other direction, or a change in market sentiment to correct a mispriced stock. People buy stock more for their future earning potential than their current value. If a company does not realize that potential, the market could get tired of waiting. However, it does not mean that the market always corrects mispricing. Companies can, in theory, be mispriced in perpetuity. But more often than not, the market requires some tangible proof of their earning potential.

Commodities are a little different. Commodities have an intrinsic value, and it's not always easy for consumers to switch from one commodity to another, so there is a more inherit supply/demand force that applies.

Since stocks are "fungible", these same types of forces do not apply.

D Stanley
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It doesn't require the whole company to be taken over to correct the price. In general, if lots of people want to buy a stock, it starts going up in price. If lots of people sell, it starts going down.

So if a company us under-valued, then investors will realise it's under-valued, and will buy the shares. That makes the price go up. It stops when the srahes aren't under-valued any more.

If the current investors think their company is over-valued, they will sell in order to bank the profit. They know that if they wait too long, the price could fall and they would lose out. But the people selling their shares will make the price fall. If's a self-fulfilling prophecy.

In addition, if a share is over-priced, then short sellers may move in and start selling, in the hope that it drives down the price.

But shares in over-hyped companies may remain unrealistically high for many years. Any idea that the stock market is rational is a myth.

Simon B
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