I’ll gladly send a complimentary Peridot Capital 2007 Select List to the first person who can explain how this graphic from the Wall Street Journal Online (“When Buying a Stock, Plan Your Goodbye” – 01/14/07) makes sense. Put another way, how can Morningstar analysts justify calculating the fair value of a stock and then recommend investors not sell the shares when they reach that level?
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Excellent question.
;)
Hi Chad,
The graph “makes sense” if you invest without a margin of safety.
We know that Mr. Market sometimes offers to sell you a security for less than it is worth, or to buy it for more than it is worth (the first part being why value investing is even possible). A prudent investor takes advantage of the first situation when it arises, and also operates with a margin of safety because the future is unpredictable.
But one needn’t be that prudent. You could purchase a security at a good price but then hold it for a better-than-fair price. Sure, the market may never overvalue your stock, but if it does you stand to make some excess gain, and if it doesn’t, perhaps the risk of holding hasn’t been too great because the stock is only trading at its fair value.
Not my personal philosophy, but there is a logic to it.
I have no problem with people concluding that their “fair value” calculations won’t always be correct, or that the market won’t always price stocks efficiently, even if the fair value estimate is correct.
In my view, that logic would hold up if every stock traded around fair value, because you would have no better alternatives.
However, assume all stocks can be put into one of three groups; undervalued, overvalued, or around fair value. It is certainly true that stocks in the third group could rise in value due to market inefficiencies or valuation model inaccuracies. But, how can a firm that offers investment advice, such as Morningstar, suggest that investors should hold stocks in group three as opposed to selling them and using the proceeds to either 1) buy stocks in group one, or 2) short stocks in group two?