How to Exploit Stock Market Inefficiencies

stocks
  • The stock market can incorrectly price stocks based on current publicly available information
  • The internet stock bubble of the 1990s highlights the improper valuation of stock prices
  • Dividend yield and price-earnings ratio can help spot inefficiencies in stock price 
  • New and unfamiliar industries are ideal for market inefficiencies in stock price

 

The stock market can incorrectly price stocks based on current publicly available information

I want to explore the academic thesis “Regression to Mean Phenomenon (2017)”. The thesis talks about the efficient market hypothesis problem, which has been hotly debated among investors. Investors and economists commonly believe that the market is efficient, meaning the current price already reflects all current publicly available information. However, this might not be 100% correct.

The idea is that information is immediately reflected in stock prices and of tomorrow’s price is only a reflection tomorrow’s events and historical information can’t be used to determine stock price:

“Economist presents that if stock markets are efficient and totally unpredictable then a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the portfolio selected by experts.”

Dividend yield and price-earnings ratio can help spot inefficiencies

The whole argument here is that we can’t make predictions about the future price of a stock.

However, several examples contradict this phenomenon. It turns out that certain historical financial statement indicators can help predict future stock returns. For example:

“initial dividend yields have shown that investors have earned a higher rate of return from the stock market compared to buy and hold.”

The dividend yield is a ratio that compares annual dividends to its share price. Dividends are important because it shows that the company can afford to give its investors a return. However, not all increases in the dividend yield reflect a financially secured company. The dividend yield can increase in one of two ways. The annual dividend increases, or the share price decreases. For any investors, the key is to figure out which situation is presented in the ratio. An increased dividend yield from a decrease in stock price may not represent a “growing” company but an increase in annual dividend will. You can analyze the ratio against the historical dividend yield ratio and against the dividend yield ratio of companies in the same industry.


Moreover, value stocks have a higher return than the average stocks. Value stocks are defined by the above-average price-earnings ratio. Stocks with relatively low price to earnings ratios can help predict future returns. A price-earnings ratio can mean either that a company is currently undervalued or that the company is doing exceptionally well relative to its past trends. The ratio should be used to compare against the historical price-earnings ratio against the price-earnings ratio of companies in similar industries.  

However, a price-earnings ratio can be deceiving. Investors must also look at the cash flow from operations as well to determine if the company is making any money. The cash flow from the operation section isolates the cash inflow from the “core” business. Accountants can pad net income by accelerating revenue, delaying the recognition of expenses, and isolating non-recurring expenses. Therefore, we must understand exactly why the price-earnings ratio is low, to begin with.


The internet stock bubble of the 1990s highlights the improper valuation of stock prices

The two cases above highlight cases of “inefficiency” in the market, in which investors can exploit the market for a higher return. We can also see that stock prices are not always correctly represented by the market. The internet stock bubble of the 1990s highlights the improper valuation of stock prices. Therefore, the stock market can temporarily fail to correctly price stocks.

“As long as stock markets exist, the collective judgment of investors will sometimes make mistakes.”

New and unfamiliar industries are ideal for market inefficiencies

Therefore, an investor must look for and find overlooked, neglected, and miss-priced stocks in the current stock market. To do so, investors should look into industries such as deep learning, blockchain, genome sequencing, robotics, and energy storage. The market value of these companies, which is the aggregate of collective investor judgment, often fails to correctly price companies in new and unfamiliar industries. 

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