Why Knowing the Reason a Stock is Undervalued is Critically Important

When Buffett purchased shares of the Commonwealth Trust Co. of Union, New Jersey, he indentified the reason that was largely responsible for the depressed price of the company’s stock. It was because the company was not paying a cash dividend. Identifying this reason reduced the probability that there were other unknown or poorly understood reasons why the stock price was depressed which could have materially reduced the intrinsic value of the company and lead to a permanent loss of capital.

When I attended the Value Investing Executive Education course at Columbia, in June of 2007, our professor, Bruce Greenwald, stressed the importance of asking yourself, when you’ve identified a great bargain, why the market is making it available to you at such a great price. If you can’t answer the question, perhaps there are people on the other side of the trade who know something you don’t or who are smarter than you. This is why it also makes sense to look carefully at who else has taken a position in the stock or who has not taken a position in the stock. For example, it may be meaningful to observe that, even though newspaper stocks are selling at extremely low multiples, Warren Buffett and Rupert Murdoch have not stepped in and made purchases. What does it tell you when two of the savviest and knowledgeable media investors in the world have passed on stocks that you may deem to be a great value? This is not in opposition to the idea that an investor needs to do his own independent thinking. It is just another fact in the investment appraisal and a recognition that others may have access to more or better information than you do.

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