How You Could Profit From Market Mis-Pricing

You may have spotted a short interview with Standard Life’s David Cumming in the press recently (although given all the column inches written about Brexit, you’d be forgiven for missing it!).

In addition to being Standard Life’s head of equities, Mr Cumming also personally manages the Standard Life UK Equity Recovery fund, which is up 13% over the last three months, and 23% over the last six months.
The reason isn’t difficult to discern: as the fund’s name suggests, Mr Cumming invests in temporarily unloved businesses with battered share prices — one of the same strategies followed by our Motley Fool Share Advisor analysts, of course.
Looking at Mr Cumming’s holdings as at the end of May, for instance, we can see hefty positions in mining and commodity firms such as Glencore and Anglo American, and banks such as Barclays, Royal Bank of Scotland and Standard Chartered.

And I can certainly identify personally with the sparkling performance of Mr Cumming’s fund in recent weeks. Towards the end of January, I too invested in some temporarily unloved businesses — specifically BHP Billiton (since up 39%) and Royal Dutch Shell (since up 38%).

Buying to a strategy

Of course, such investments aren’t a one-way bet. Companies’ share prices can take longer to recover than investors expect, and may indeed not recover. Sometimes, cheap shares simply stay cheap.
But even so, studies show that value-oriented and recovery-oriented strategies usually pay off well in the end, provided that a representative sample of shares is purchased.
Don’t bet the farm on just one share in other words: you’ll do spectacularly well if it does recover, but wind up losing your shirt if it doesn’t.
And my own favourite strategy — higher-yielding shares — is often a proxy for these value-centred and recovery-centred strategies, anyway, as the yield is usually high because the share price is depressed.
Want to know more? David Dreman’s excellent Contrarian Investment Strategies books have a wealth of detail. The 1998 edition contains the most ‘backtesting’, and can be had for a couple of quid on Amazon. The updated 2012 edition, while more expensive, may be more readable.

This is what markets do

What is it that makes these strategies possible, though? The answer is three words: the stock market.
But as I’ve remarked before, many ordinary savers and would-be investors don’t think that the stock market is for them. They see its fluctuations, they see that it marks companies down, and they see its day-to-day volatility as news and events are reflected in share prices.
But that’s the way that markets work. You’ll see precisely the same things in any market, anywhere. No market — by definition — goes steadily up in a straight line, no matter how much novice investors might hope so.
And yet, perversely, it’s this very up-and-down behaviour that investors should welcome. Because that’s where profitable opportunities come from.

Overreaction = market mis-pricing

Let’s go back to Mr Cumming’s mining and resources shares for a moment. Back in January, oil prices were below $30 a barrel, down from almost $65 a year ago. The price is now $50, up 70% since January’s low.
Iron ore and other metals haven’t staged quite the same recovery — more like 25% — but the direction of travel is still the same: up.

And with underlying commodity prices going up, is it any surprise that mining and oil companies’ shares prices are also up? Not at all.
In retrospect, January’s plunge in mining and resources shares was probably not a carefully considered reflection of their long-term earnings potential, but a panicked overreaction — the sort of mis-pricing opportunity that investors should welcome, because it provides a low entry point, and a potential profit.

Opportunity knocks?

Of course, it’s not just mining and resources shares that see this sort of mis-pricing. All companies, and all sectors, can be the subject of mis-pricing opportunities — especially under-researched smaller companies.
The trick lies in spotting such opportunities, and in making a judgement about the companies’ longer-term potential. Is the market right, in short — or is it wrong?
And as our Motley Fool Share Advisor analysts will tell you, that judgement call isn’t always easy or straightforward. Or, for that matter, correct: surprises can and do happen.
The trick lies in being right enough of the time. And here, of course, practice helps. As do those moments when it’s not just individual share prices that suffer, but the market as a whole falling into a swoon.

And I could be wrong, but the forthcoming referendum might — just might — be about to throw up just such an opportunity.

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Malcolm holds shares in BHP Billiton and Royal Dutch Shell. The Motley Fool UK has recommended shares in Royal Dutch Shell and Barclays.