This column has referred previously to the "overreaction hypothesis," according to which people tend to overreact to "unexpected and dramatic events," creating opportunities in the stock market for investors who display greater composure. The hypothesis was first proposed by Richard Thaler and Werner de Bondt in a 1985 paper.
This columnist believes in (and has, on occasion, profited from) the hypothesis. There is money to be made in that type of situation, which exhibits a significant degree of uncertainty.
However, investors shouldn't confuse a favorable bet with free money; even favorable bets aren't all winners. There is a reason the market abhors uncertainty: Things can turn out worse than investors expected them to, especially when the range of possible outcomes is unknown.
Take the case of Volkswagen AG. This week, the troubled auto manufacturer admitted, albeit somewhat cryptically, that the rot was more widespread than initially reported.
In September, the company owned up to installing software on 11 million vehicles specifically to cheat nitrogen oxides (NOx) emissions testing. On Tuesday, Volkswagen announced that, during the course of its internal investigation, it had turned up "irregularities" in "type approval CO2 [carbond dioxide] levels."
Translation: Volkswagen understated CO2 emissions levels and, consequently, fuel consumption figures.
Volkswagen said the problem may affect 800,000 vehicles; significantly, not all of them are diesel vehicles. Their initial estimate of the economic toll: 2 billion euros ($2.15 billion). Add that to the 6.7 billion euros ($7.19 billion) the automaker has already reserved to recall and fix the vehicles with the NOx emissions cheating software.
The Volkswagen AG ADRs lost 5.5% on the news that the scandal had expanded. Nevertheless, this week's low of $25.46 is 12% above the 52-week low, which suggests there was an overreaction.
The other great scandal of the day is Valeant Pharmaceuticals International, shares of which lost 14.7% yesterday, hitting a new low yesterday on questions regarding the level of support CEO J. Michael Pearson has among the company's largest investors (many of which are hedge funds).
On the basis of forward earnings multiples, Valeant's stock looks very cheap, but the market is heavily discounting consensus earnings estimates. Investors have lost confidence in the viability of Valeant's acquisitions-driven business model and, thus, in the company's long-term earnings power (not to mention in the integrity of Valeant's leadership).
Poor earnings visbility requires a discount. If you drive into a heavy patch of fog, you're well-advised to slow down rather than maintain the same speed.
Are Volkswagen and Valeant the same? They are in that both have been tainted by scandal. However, I don't think anyone is fundamentally questioning the viability of Volkswagen's business model on the basis of the emissions testing scandal (its governance structure is another matter).
At current prices, I think it's likely that, a year or 18 months from now, the evolution of Volkswagen's shares will suggest retrospectively that they are now underpriced. I can't say the same for Valeant.
Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.