About Quality and Price in Stock Investing

Proponents of Efficient Market Theory (EMT) believe that it is impossible to 'beat the market' because prices of stocks (and other securities) discount all available information at any time due to the efficient dissemination of information in the stock market.

Most small investors would benefit by believing in EMT. Instead of losing their shirt trying to 'beat the market' by buying 'cheap' stocks in large quantities, they should just buy index funds or index ETFs from their monthly savings. The stock index will provide them long-term returns.

Hasn't Buffett become an investing legend by doing just the opposite? Isn't he the one who thinks that EMT is meant for academicians? Doesn't the stock market periodically mis-price stocks, allowing savvy investors to 'buy low and sell high'? Yes, to all three questions. 

You can get market-beating returns if you buy stocks of quality companies at fair prices, and sell them at a profit a few years later. But do you know which are 'quality companies' and what are 'fair prices' for their stocks?

Wikipedia provides the following definition of Quality Investing: "..an investment strategy based on a set of clearly defined fundamental criteria that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft (e.g. management credibility) and hard criteria (e.g. balance sheet stability)." 

In a recent article, Ben Johnson of Morningstar.com discussed 'The What, Why and How of Quality', where he makes the following remarks: "The importance of assessing the price paid for high-quality stocks cannot be understated. While quality matters, price arguably matters more."

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Some practical examples of Behavioural Finance

Some practical examples of Behavioural Finance will show a different aspect - more from the psychological point of view - at how and why investors buy and sell stocks. It goes against the grain of Efficient Market theory that is built upon rational decision making taking into account all available information.

One of the interesting advantages of writing a blog is that readers get an opportunity to react almost immediately and let the writer know what they think about his opinions. Thereby opening a direct window to the workings of their minds.

In a recent post, I had suggested that investors should bail out of the telecom sector stocks, instead of jumping in after the price correction. In another post, I suggested investors should sell the Punj Lloyd stock at every rise, after it posted awful Q2 '09 results.

The reactions were swift. While some agreed with my views, many did not. The arguments were strong and apparently 'rational'. But what about investment behaviour?

"Bharti Airtel is the best in customer service, has a pan-Indian network, is a leader with a stash of cash, will be less affected by the price war and number portability. So, the stock was a 'steal' at 350 and more should be bought if it slipped below."

Why 350? Because it was 30% lower than its recent high of 500? Possibly. The human mind likes to work with nice round numbers. A classic example of 'recency bias' in Behavioural Finance. The price of 500 had remained in the investor's mind as a 'recent high'.

A few more readers thought 350 was a good price to enter. An example of 'confirmation bias' - investors looking for confirmation of a 'buy' decision. What happened when the stock dropped to 340?

"I sold at 340 so that I can buy it back at 325", was one comment. An example of 'loss aversion'. This is one of the most insidious biases for long-term investment success. Instead of admitting a mistake and booking the small loss, an investor tries to take on additional risk to avert the loss.

I'm not sure what this particular investor did when the Bharti Airtel stock first fell to 325 and then went below 300.

A comment about Punj Lloyd was:

"I sold the stock at 290 and was happy to buy it back at 240. Will buy more if it goes further down. The company has a huge order book, has global operations and is a Larsen and Toubro in the making."

Now that the stock has dropped below 200, 'Regret theory' in Behavioural Finance suggests that the investor has probably avoided selling the stock and is holding on to it to avoid the regret of making a bad decision.

'Prospect theory' in Behavioural Finance postulates that investors behave differently in situations depending on whether they are faced with a loss or a gain. They feel more pain at the prospect of losses than they feel elated by an equivalent gain. In other words, a 10 point loss in a stock costing 100 may cause more distress, than a 10 point gain causes happiness.

In actual experiments with different groups of investors, when evaluating the prospect of a sure gain, most investors become risk-averse; but faced with sure loss, they become risk-takers.

No wonder, Benjamin Graham has written: "The investor's chief problem - and even his worst enemy - is likely to be himself."

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.