An under-valued stock has little downside but an under-priced stock gives returns only over longer timeframes
The Efficient Market Hypothesis (EMH) have been around for over 50 years. The EMH logic is, given an efficient market, where participants have equal access to information and equal ease in trading, stock prices change randomly. Any price-sensitive information is received instantly by many traders, who promptly act upon it. Their interactions tend to quickly push prices close to fair value. So it is very difficult in such an efficient market for any given player to consistently log returns higher than the average.
Systematic plans of investment will rarely beat dart-throwing methods of random selection. Hence, it makes sense to lock in returns by mirroring the indices, which represent broadly-diversified portfolios .
EMH is a powerful, logical tool for market analysis and at the heart of passive strategies. Returns over the long-term suggest that it is a good model. A small percent of actively-managed funds beat the benchmark index return. That is mostly due to chance, since very few managers log consistent outperformance.
EMH is a good model but not quite perfect. Over decades, a few traders and a few investors have demonstrated that it is possible to consistently generate returns above the index. Since those few seem to use systematic methods, the EMH doesn't perfectly model reality. It also seems price changes don't occur totally randomly, they are influenced by previous price changes.
No mathematical construct ever perfectly models reality, of course. One weakness is that EMH ignores the presence of hedgers, who are implementing a broader strategy and hence, prepared to lose money in a given position. The EMH's approximations leave room for smart systematic players to make more money than predicted by the theory. For example, some participants do have extra information. They may not be insiders in the legal sense. They may have greater knowledge of either market processes, or the specific sectors they track.
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There are massive vested interests ranged both for and against EMH. A hedge fund or any other active money manager is going to dispute EMH's validity because it implies active stock selection is useless. An index fund or ETF will back EMH to the hilt on the other hand because it validates their methods. Both sides can bring some evidence in support of their positions. One interesting point is that increasing institutional participation makes the market more efficient since it makes it harder to beat. The bulk of the money is controlled by people with roughly similar access to information and every major player knows basic strategies.
Most investors consider convenience an essential adjunct to investing. If you have little time and cannot track a portfolio on daily or even monthly basis, an index fund or ETF-based portfolio is convenient. The evidence shows most active managers don't beat indices anyhow.
If you do want to actively invest or trade, the EMH represents a logical barrier. Some people do beat the benchmarks regularly. But what special advantage do they possess? Isolating the key factors are difficult and emulating them is tough.
Many systematic approaches have been tried with varying success. Benjamin Graham believed that the EMH was roughly correct. He sought stocks priced markedly below what he considered intrinsic value– places where EMH had “failed”. Buffett has focussed on businesses, with highly predictable growth patterns. Some traders have beaten the market by zeroing in on stocks with predictable volatility, even if they cannot predict direction. Other traders have followed price-trends in disciplined mathematical fashion.
But once a lot of money is allocated using a specific method, the returns from that style of investing/ trading tends to revert to average. Also any method has inevitable periods of underperformance due to business cycles.
Value investing underperforms in hot bull-markets. Buffett-type portfolios underperform during booms led by unpredictable, high-tech businesses. Traders take a beating when volatility suddenly changes. .
India is an interesting case. The stock market has become increasingly efficient with smoother trading systems, more institutional players and better information dissemination. However, there is also a lot of crony capitalism and information leaks. India doesn't have a liquid debt market- EMH theory assumes that the bond market is efficient.
There is more scope to beat the stock market in India than in developed countries. The cycle is in the early-mid stages of a boom, which means chasing predictable growth is likely to fetch returns in 2010-11.
But pure value investing is safer precisely because valuations are high. An under-valued stock has less downside but under-priced stocks will yield returns only in longer timeframes.