The history of the stock market is quite fascinating. While all stock prices will reflect their true value based on earnings in the long run (consistent with the Efficient Markets Hypothesis), these prices can swing with wild volatility in the short run.

Not to mention the tulip bulb craze in Holland during the 1500s, our own market history is rift with stories of stock over and under valuation during temporary times of great optimism and pessimism. One need only remember the electronics bubble of the early 60s, the Nifty Fifty bubble of the 70s, and the biotechnology bubble of the 80s*.

This foam froths up into our history books and bad investment decisions list because of our bare naked humanity. We are not machines, but people of emotions. So we easily become captured and want to identify ourselves with a "good stock that everyone else is holding."

The purpose of this column is to merely point out that you should still examine the fundamentals of a company, since "hype" over a company or industry can overvalue the price of the stock in the short run.

And this short-term price overvaluation can lead to lower returns when a stock's price changes to reflect the true value of the company.

Mathur & Waheed [Aug 95] measured this short term price inflation and subsequent negative abnormal returns in the long run, on securities noted in Business Week's "Inside Wall Street." In a similar academic study, Janijigian [Summer 97] noted that a stock recommendation service, while demonstrating abnormal returns in the short run, did not beat the market in the long run.

If you are truly looking for undervalued companies with solid records, avoid those mentioned to you by a dozen friends. As Peter Lynch has said, "If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favored publicity, the one that every investor hears about in the car pool or on the commuter trainand succumbing to the social pressure, often buys."

And as David Gardner of The Motley Fool points out, "If everyone else already loves your stock, they already own it... Who's going to buy it [and hence drive the price up]?"

The recurring theme here is to research your company from both a moral and financial perspective before taking the blind suggestion of your next door neighbor. Suggestions are good, but you are the steward, for "it is required that those who have been given a trust must prove faithful." 1 Corinthians 4:2

* See Burton Malkiel's Random Walk Down Wall Street or James Grant's The Trouble with Prosperity fun tromps through investment history.


Citations

Gardner, David. Distinguished Speakers Lecture. Pasadena, March 11, 1999.

Janijigian, Vahan. "Forbes Special Situation Survey: A Study in Market Efficiency." Journal of Investing. Summer 97: pp. 65-70.

Lynch, Peter. One Up On Wall Street. New York: Penguin Books, 1989.

Mathur, Ike and Amajad Waheed. "Stock Price Reactions to Securities Recommended in Business Week's 'Inside Wall Street.'" The Financial Review. Aug 95: pp. 583-604.