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Tuesday, October 13, 2009

Does the Price of a Stock reflect its Value?

"Price is what you pay. Value is what you get." - Warren Buffett

Many small investors face a problem with stocks that have a 'high price'. They don't want to buy them, because they feel they can't afford them. They prefer to buy stocks that have a 'low price', because they appear more affordable and capable of giving high returns.

Last weekend, I was discussing the state of the markets with a friend and inevitably the discussion veered towards what stocks are worth buying now. I suggested that he look at a medical devices stock trading at 200 or a hospitality stock trading at 80.

His response was typical. He wanted to buy the 'cheaper' stock. I pointed out that the cheaper stock was actually more expensive on several counts - it had a Re 1 face value (vs. Rs 10 for the other), its net profit margin was less than half, and its Return on Equity (RoE) was just about a fifth.

What he said next left me speechless: 'When I can buy 1250 shares with Rs 1 Lakh, why should I buy only 500?' 

Such an approach to investments is illogical. This fixation on price and affordability is one of the prime reasons why small investors do not become successful investors. It is like saying: 'I can't afford the price of gold, so I'll buy some brass instead.'

The 'Efficient Market' theory was postulated by French mathematician Louis Bachelier in 1900 and developed further by Eugene Fama in his PhD thesis at the University of Chicago in the 1960s. It states that stock prices reflect all available information and adjusts to any new information as and when it becomes known.

It is very unlikely that an individual investor can consistently outperform the market indices because the financial news and information he uses for his stock selections is already available to every one else. Any future information will only be available on a random basis, and will affect stock prices randomly. Therefore, investors will be better off investing their money in a good index fund.

The Efficient Market theory anticipates rational behaviour from investors. But by nature, human beings tend to be irrational. And nowhere more so than in the stock market. Otherwise, why would they enter when the market has already gone up, and refrain from buying at the depths of a bear market?

Experienced investors learn to pick up value-stocks that may appear expensive but are cheap on a valuation basis - at or near market bottoms. Inexperienced investors chase after cheaper growth-stocks that are actually more expensive value-wise.

To answer the question: a stock's price tends to reflect its underlying value in the longer term. In the shorter-term, price and value mismatches do happen, that allow smart investors to build wealth.

4 comments:

tax_trp said...

Dear sir,
Mind blowing article, i think u have touched relevant and pertinent issue for the small investor like me.
I would appreciate if you write more on this type of articles on fundamentals and other relevant issues like this, which would be beneficial to small investors like me,who rarely follows any technicals.
By the way sir, I happen to found one growth stock MUNDRA PORT,does that fits into your criteria of growth stocks, please comment.
thanks
mansoor panjwani

Subhankar said...

Appreciate your comments, Mansoor.

One of the reasons for writing the blog is to make technical analysis simple and understandable for small investors.

Lack of technical analysis concepts make small investors buy when the market has already moved up and sell when it has moved down - instead of the other way around.

I will continue to write about fundamental analysis and investor behaviour.

Sorry, do not track Mundra Port, or the shipping business.

tax_trp said...

Dear sir
Wish you a Happy Diwali.
On this day let's pray that Goddess Laxmi and Saraswati bless us all with wealth and wisdom.
MUNDRA PORT is not into shipping business its a infrastructure and logistics play.
On BSE site its been compared with Hindustan construction company as a peer group.
Thanks
mansoor panjwani

Subhankar said...

Very pleased to reciprocate your Diwali greetings, Mansoor.

As India's largest private port, Mundra Port's fortunes are closely tied to the shipping industry. Stock's high P/E leaves very little 'Margin of Safety'.