How Long Should Market Be Given to Close Existing Valuation Gap?

| About: Harvest Natural (HNR)

In the January issue of Downside Protection Report we announced we would occasionally revisit previously featured ideas if they deserved renewed consideration. The company we revisited in January was Harvest Natural Resources (NYSE:HNR). We wrote the following:

While Harvest shares are up 28% since our write-up last April, intrinsic value has also increased. Harvest recently revised upward its reserve estimates and announced the start of drilling operations on the U.S. properties in which it has an interest. Chavez-ruled Venezuela recently conducted successful international auctions of stakes in government-led oil and gas projects. These auctions serve to validate the value of Harvest’s large asset base in the country.

We felt that the positive developments at Harvest made it a timely investment idea, but we had no clue when the market might agree with us. Perhaps surprisingly, it has taken investors less than two months to start revaluing the shares. As of today, Harvest’s stock price has increased by 68% since the January update.

This brings us to a couple of fascinating questions: Is there any way to know how quickly the market will reflect new information? And why do some stocks stay undervalued for months or even years? We have given these questions a lot of thought but admit we haven’t reached any clear answers.

Some investors try to identify “catalysts” that will force the market to revalue a stock in the foreseeable future. While this approach works occasionally, more often than not a company will not sell at a cheap price if there is a visible catalyst.

Ultimately, we find the advice of famed value investor Joel Greenblatt most illuminating. According to Greenblatt, investors should assume that if their thesis on a stock is correct, the market will agree with them within 2-3 years. We find the corollary to this statement helpful as well: When considering whether to invest in a company, we should have a time horizon of 2-3 years; otherwise, we may give up on a correct thesis just before the market starts agreeing with us. If you’ve ever sold a stock simply to watch it go on to new highs without you, this lesson may resonate.

Disclosure: No positions