Over the long run, there is substantial evidence to suggest that stock market valuations correctly reflect underlying value and its fundamental drivers. But what about those circumstances when share prices fluctuate in unexplainable and volatile ways? Discuss this in the context of mispricing in the market that can occur over the short run and corrections towards intrinsic value over the longer term. Over the long run, share prices follow underlying value and its drivers (ie. stock market valuations reflect companies' long term return on invested capital, revenue growth and the economic fundamentals that drive their long term cash flows). Over the long term (10 years and more), higher ROIC and growth lead to higher returns of shareholder in the stock market. However, over shorter periods (3 years and less), returns to shareholders can be strongly influenced by changes in investor expectations In the short run, emotions may rule (ie the market may get it wrong) example: HSBC share price in its cross-listing on UK and HK exchanges the pessimism in London for financials during 2008 significantly undervalued HSBC via its UK listing which was not fully reflected via its HK listing, giving rise to an arbitrage opportunity. Certainly, prices for some stocks in some sectors can be driven in the short term by irrational behaviour. For shorter periods of time, the market as a whole can lose touch with fundamental laws grounded in economic growth and return on investment. Another example: mispricing of the Royal Dutch Petroleum shares (Amsterdam/UK cross-listing at a fixed 60:40 portion) The implications are that share prices following intrinsic or underlying value over the long term but are volatile over the short term. Company-specific deviations usually last only as long as the particular barriers preventing intrinsic investors from correcting them. Company management should focus on creating value for shareholders, and not be distracted by share price fluctuations. Yet many managers remain obsessed by the representation of cash flows rather than their quality, an obsession demonstrated by managers' efforts to meet earnings per share targets or to remain included in a major stock index Further, underlying value tells you more about the balance of risks, rather than the likely immediate share price direction if you have a stock that appears cheap with respect to its underlying (eg DCF) value, it has a risk skew to the upside (ie a large margin-for-error). Value mainly works on average and over time Over the long run, there is substantial evidence to suggest that stock market valuations correctly reflect underlying value and its fundamental drivers. But what about those circumstances when share prices fluctuate in unexplainable and volatile ways? Discuss this in the context of mispricing in the market that can occur over the short run and corrections towards intrinsic value over the longer term. Over the long run, share prices follow underlying value and its drivers (ie. stock market valuations reflect companies' long term return on invested capital, revenue growth and the economic fundamentals that drive their long term cash flows). Over the long term (10 years and more), higher ROIC and growth lead to higher returns of shareholder in the stock market. However, over shorter periods (3 years and less), returns to shareholders can be strongly influenced by changes in investor expectations In the short run, emotions may rule (ie the market may get it wrong) example: HSBC share price in its cross-listing on UK and HK exchanges the pessimism in London for financials during 2008 significantly undervalued HSBC via its UK listing which was not fully reflected via its HK listing, giving rise to an arbitrage opportunity. Certainly, prices for some stocks in some sectors can be driven in the short term by irrational behaviour. For shorter periods of time, the market as a whole can lose touch with fundamental laws grounded in economic growth and return on investment. Another example: mispricing of the Royal Dutch Petroleum shares (Amsterdam/UK cross-listing at a fixed 60:40 portion) The implications are that share prices following intrinsic or underlying value over the long term but are volatile over the short term. Company-specific deviations usually last only as long as the particular barriers preventing intrinsic investors from correcting them. Company management should focus on creating value for shareholders, and not be distracted by share price fluctuations. Yet many managers remain obsessed by the representation of cash flows rather than their quality, an obsession demonstrated by managers' efforts to meet earnings per share targets or to remain included in a major stock index Further, underlying value tells you more about the balance of risks, rather than the likely immediate share price direction if you have a stock that appears cheap with respect to its underlying (eg DCF) value, it has a risk skew to the upside (ie a large margin-for-error). Value mainly works on average and over time
