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.

About Growth Stocks and Value Stocks

Should the title of this post be changed to Growth stocks vs. Value stocks? So many dichotomies have become part of our everyday lives - like Good vs. Evil, Black vs. White, East vs. West, Fundamental analysis vs. Technical analysis - that we have come to believe them as truths.

The reality is different. By creating compartments and divisions through our imagination or dogma, we get into behavioural patterns that are detrimental to our emotional and financial well-being. Once we decide to cut the Gordian knot of needless differences, life and investments become so much simpler.

Enough philosophy for a short week of trading. Let us get down to the nitty-gritty.

What is a Growth stock?

These are stocks belonging to companies that have shown a consistent above-average growth in sales or earnings in the past, and are expected to maintain the rate of growth in future. One measure of growth is RoE (Return on Equity) above 15%.

To fuel such growth, cash is a major requirement. So companies often forego dividend payments to plow the earnings back into the business. When the earnings are inadequate to fund the growth, companies resort to share issues and debt.

Typically, these are high P/E stocks with volatile price movements that make them risky to own. Investors expect to make large capital gains and often get trapped by the 'greater fool theory'.

What is a Value stock?

These are stocks belonging to companies that are considered to be trading at a level lower than their intrinsic values, as determined by fundamental analysis of sales, earnings, dividend payments.

These stocks have low P/E or P/BV ratios and high dividend yields. Hence they have lower risk and a bigger 'Margin of Safety'. Value stocks tend to out-perform growth stocks during bear markets and under-perform in the later stages of bull markets.

Like in life, which has more shades of gray than black or white, there is no distinct dividing line between a Growth stock and a Value stock.

No company can have a high growth rate forever. Sooner or later, as its size increases, growth rate will begin to slow down. If it survives, it will become a stalwart and pay regular dividends and grow steadily.

The key phrase is: 'if it survives'. Taking on too much debt, or issuing too many shares in the singular pursuit of growth can weaken the balance sheet so badly that the company can collapse under the weight of its interest payments. Stocks from the retail and realty sectors come to mind.

Should investors choose Growth stocks or Value Stocks for their portfolios? It need not be an either/or situation. Why not choose Growth stocks and Value stocks?

How about using the 80-20 rule? Keep 80% of your portfolio in Value stocks, and 20% in Growth stocks. Remember that the best time to look for Value stocks is when the stock market is down, not when it is up 70% from its recent low. That doesn't mean that Value stocks are not available in bull markets. They are just very difficult to find.

(Do you have an opinion about any good growth or value stocks in the current market? Please share it here for the benefit of other readers.)