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more likely to have under valued stocks. Given the size of the universe of stocks, this not

only saves time for the analyst, but increases the odds significantly of finding under and

over valued stocks. For instance, some efficiency studies suggest that stocks that are

'neglected' be institutional investors are more likely to be undervalued and earn excess

returns. A strategy that screens firms for low institutional investment (as a percentage of the

outstanding stock) may yield a sub-sample of neglected firms, which can then be valued

using valuation models, to arrive at a portfolio of undervalued firms. If the research is

correct the odds of finding undervalued firms should increase in this sub-sample.

What is an efficient market?

An efficient market is one where the market price is an unbiased estimate of the true

value of the investment. Implicit in this derivation are several key concepts -

(a) Contrary to popular view, market efficiency does not require that the market price be

equal to true value at every point in time. All it requires is that errors in the market price be

unbiased, i.e., that prices can be greater than or less than true value, as long as these

deviations are random1.

(b) The fact that the deviations from true value are random implies, in a rough sense, that

there is an equal chance that stocks are under or over valued at any point in time, and that

these deviations are uncorrelated with any observable variable. For instance, in an efficient

market, stocks with lower PE ratios should be no more or less likely to under valued than

stocks with high PE ratios.

(c) If the deviations of market price from true value are random, it follows that no group of

investors should be able to consistently find under or over valued stocks using any

investment strategy.

1 Randomness implies that there is an equal chance that stocks are under or over valued at any point in

time.