| October 29, 2013
In this paper we investigate whether stocks' current prices reflect "mispricing" or a reflection of their intrinsic value?
This is important as identifying between these competing hypotheses can aid investors in making rational decisions on whether to exploit the market's misunderstanding of the stocks' future potential or to avoid these companies as they are "cheap" or "expensive" for a genuine reason.
We classify stock returns unexplained by the valuation model as „mispriced‟ and evaluate the efficacy of this signal. We find „mispriced‟ stocks deliver an IC of 3.8% or return of 5.1% pa, which is better than that for value factors. They also have low correlations to style factors like value and analyst sentiment. This makes it an attractive signal for systematic managers. Moreover, we note that the signal works well across global regions, albeit better in larger markets.
We attempt to rationalise whether a stock is „cheap‟ or „expensive‟ for a reason, or „mispriced‟. We highlight the limitations of valuation models in that stock price can be driven by sentiment, which is difficult to capture, or due to errors in forecasting earnings or discount rates which limits the usefulness of valuation models. We show that identifying additional drivers of returns like sentiment, management quality, earnings visibility and leverage helps to discriminate between stocks that are „mispriced‟ and „cheap/expensive‟ for a reason.
We leverage RavenPack‟s news-flow database to identify corporate actions like Share Buybacks, M&A, Executive Employment, Clinical Trials, etc. that act as catalysts in either driving mean reversion or explain the persistence of stock „mispricing‟. We show that complementing the „mispricing‟ signal with corporate action news-flow helps to gain a better understanding of stock price behaviour and improves the performances of these trading strategies.
Conceptually this approach is not different from an alpha model; however, its advantage is that we start with a valuation framework, which is how fundamental analysts evaluate investment opportunities. Additionally a valuation approach broadens the appeal to investors who view investment decisions outside the dimensions of styles. To us, this approach appeals to both fundamental and quantitative managers, i.e. a „quantamental‟ approach to stock selection.
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