Investing101: Why Stocks Become Undervalued?

Why stocks are undervalued

Warren Buffett’s value investing approach to investing in security made many investors stopped believing in the efficient market hypothesis that dictates that the current market price always reflects the value of the security. Instead, value investors believe that stocks may be undervalued or overvalued for a variety of reasons. As a result, value investing is now recognized as a smart approach to investing in the stock market. Consequently, many individual investors are constantly looking for different ways to know overvalued and undervalued stocks.

Before going that far, it is important to understand why stocks become undervalued and what the major factors are behind to make stocks undervalued. This article aims to make recommendations on why stocks become undervalued.

Herd Mentality

It has often seen that many individuals invest in stock market irrationally based on psychological basis rather than company fundamentals. Everyone is looking to buy low and sell high. So, whenever the market is rising or a particular stock rise in price, they buy. It is because they see that if they had invested 5 or 6 weeks ago, they could have made higher returns. In addition, they come in a state of #FOMO (Fear of Missing Out).

Conversely, when the market is declining or a specific stock is falling in price, they start panic selling. So, instead of holding onto their investments, they accept the losses and exit the market. Such investors’ behaviour is so influencing that it affects the price of individual stocks.

Market Crashes

Whenever the market reaches an unbelievable high, it usually results in a bubble. However, since the levels are unsustainable, the investors end up panicking, which results in massive sell-offs. This results in a market crash. This has happened before when the companies whose prices shot up beyond what the companies were actually worth.

Unnoticed Stocks

Everyone is looking for trendy stocks to buy and make profits. It is what limits the vision of many investors in search of stocks to invest. In reality, investors must wide their vision and see beyond the trendy stocks, which provides the opportunities to find some good undervalued stocks that may not be on people’s radar like small-cap stocks that can generate huge returns over an extended period.

Instead, people want to be part of the next big thing like blue-chip stocks that are most likely to be affected by the herd-mentality investing.

Cyclicality

Cyclicality depicts the fluctuations that affect a business. As we all know that companies are not immune to economic ups and downs, whether that’s seasonality, currently going COVID-19 pandemic, or consumers’ behaviour. Any or all of this can affect a company’s profit levels and the market price of the company’s stock. However, it does not affect the company’s actual worth or value in the long-term.

Bad News

There are many factors behind the stock market volatility and movement in stock prices. Any latest update, quarterly result, or some major announcement related to a company or relative sector can affect a company’s stock price. Even good companies face setbacks. However, just because a company is facing some setback due to some single negative event or a quarterly result does not mean the company is not fundamentally valuable or its stock price will not bounce back.

Many investors start panicking on such news but value investors see beyond the negative event or news and recognize the company’s worth in long-term.

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