As we explain in the previous three chapters, if the wisdom of crowds is functioning properly, then the stock price will fully reflect all available information and be a close approximation of the company’s true intrinsic value. As a result, there will be no mispricing to exploit and no opportunity to outperform with this investment.
Take as an example Dollar General when the stock was trading in mid-2016 at $83 per share. The consensus estimate of the 21 sell-side analysts who followed the stock at the time was a one-year price target of $93, implying a 12% return. If you are researching Dollar General as a potential idea, unless you can identify a mispricing, your estimate of the company’s intrinsic value would match consensus expectations, as shown in Figure 8.1.
To identify a mispricing in a particular security, however, you must find a situation where there is a breakdown in one or more of the three tenets of market efficiency:
- Dissemination—There is information the market is missing.
- Processing—There is a systematic error in processing (caused by a lack of diversity or breakdown of independence).
- Incorporation—There is something preventing information from being incorporated in the stock price (trading is limited because of liquidity or other institutional ...