One of the fundamentals of investing in the stock market is understanding what a share price represents. Each share is a part ownership of a company, and the value of all those shares adds up to the overall value of the company.
That of course begs the question of how that value is arrived at. How does anyone know what a company is actually worth?
The textbook definition is that a share price represents the present value of the company’s future cash flows, divided by the number of shares. In other words, owning a piece of a company means you have a claim on that share of all its future cash flows.
Where that breaks down
That is what a share price should be. However, as William Lam, co-head of the Asian and emerging markets equity team at Invesco, explained to the recent Morningstar Investment Conference in London, that’s not necessarily what a share price is.
This is because a share price also reflects “the average opinions, at any one moment, of hundreds of people who trade the share”. And those opinions are subjective. They have to be for any trade to take place, since for every person buying a share, someone else must be selling it. They therefore need to have different views on its value.
The decision-making process that gets those two respective parties to that point is rarely completely rational.
“People are biased in their decision making because our brains are very efficient machines that allow us to make decisions without having to process all of the information,” explains Lam. “We have to be selective in the information we are using, and it turns out that people are much more able to recall information that they have been frequently exposed to, which is especially easy to recall if it’s negative, and especially easy to recall if its recent.”
Bad news sells
It’s obvious how this can affect share prices, as evidenced by the sometimes sharp reactions to bad news about a company or poor results.
At the end of last month, for example, shares in Google’s parent company Alphabet fell as much as 8% in one day after its quarterly results were worse than expected. It’s hard to argue that the company’s fundamentals changed that dramatically in the course of a few hours.
“If there is a recent bad news flow, the share price is unduly affected,” says Lam. “That is the core of what a contrarian is looking for.”
Occasionally these dips may be followed by just-as-sudden reversals. At other times, the mispricings they produce can persist for a long time.
“That’s because the brain is effective at enabling you to function with a working hypothesis,” explains Lam.
In other words, we carry certain beliefs even though we don’t have all the facts to support them.
Generally this is because we crave certainty. In the stock market, however, this has clear implications.
“Just as you go about life with various working hypotheses, you go about investing with various working hypotheses,” says Lam. “You decide if a stock is a buy or a sell and put a barrier around those beliefs. You don’t see a lot of the evidence that is actually telling you something else.”
The opportunity for contrarians
This is also known as confirmation bias, and was perhaps most obviously demonstrated by how Steinhoff divided investor opinion. There were many who believed so strongly in the good news story about the company’s global expansion and success that they disregarded the warning signs that kept many others away from the share.
Steinhoff was also a good example of how often share prices are set not on fundamentals, but because a particular idea or company becomes popular. When the company’s share price began to climb noticeably in 2013, many investors bought in to the stock simply because they didn’t want to miss out on those kinds of gains.
“Where psychology really comes into play in markets is where mispricings get amplified by herd mentality,” says Lam. “That’s when investors get affected by what other people are doing.”
This can, of course, occur to the downside as well. A number of local investors would argue that this is currently the case with quality South African mid-cap shares. Even in the current economic environment their share prices do not reflect the true value of their future cash flows.
That is the kind of opportunity that a contrarian investor looks for.
By being willing to be different, by being able to see long term value despite short term bad news, and being prepared to be patient and wait for the fundamental value of a share to return, it is possible to benefit from the difference between what a share price is, and what a share price should be.
“We do believe that share prices will, over time, trade at their fair value,” says Lam. “But share prices can meaningfully be different from that value in the short term.”