Price versus value in stock investing  

redmustang91 57M  
8701 posts
5/9/2006 10:27 am

Last Read:
5/10/2006 2:35 pm

Price versus value in stock investing

Morningstar keeps pushing neglected value growth stocks like Walmart, Microsoft and Coke. They are not exciting, still too expensive and have gone nowhere for the last few years. But the discussion is interesting and keeps you focused on some important principles. The market can drive certain fad favorites to ridiculous heights before they return to Earth!

The Difference Between Price and Value
by Emil Lee | 05-08-06

When I tell people that I'm an equity analyst, I'm often presented with a rather bizarre question: "So, what actually makes stocks go up and down?" I usually fight the urge to rattle off some sort of sunspot-and-Fibonacci-sequence conspiracy theory and tell them the mundane truth: The stock market, literally, is an auction in which people around the world bid for fractional ownership of companies. We think one of the biggest, if not the biggest, mistake in investing is confusing the price of stocks with the value of the businesses they represent.

I've created a highly scientific indicator known as the "nag factor," which can explain the decoupling of price and intrinsic value in all types of markets. A couple of years ago, Tickle-Me-Elmos, which usually sell for $20-$30, were bid up at Christmas time to hundreds of dollars in auctions on eBay EBAY . (Incidentally, we think beaten-up shares of eBay, a member of our Hare Portfolio, are undervalued.)

I attribute this to the "nag factor" and the desire by otherwise rational adults to avoid this at all costs. "But BILLY got a Tickle-Me-Elmo from HIS parents!" A similar phenomenon can occur in financial markets. "You CAN'T sell Google GOOG now--you'll underperform the Nasdaq for sure!" Here, the nag factor is especially potent because it can come from media, neighbors, coworkers, and friends whose mission in life is to convince you that they're smarter than you because their hot nanotech stock is killing your stodgy (but profitable) auto-parts company.

In deflating situations like these, take a deep breath and recite one of my favorite mantras, "Fools rush in where value investors fear to tread." To illustrate this, here's a quote from a Berkshire Hathaway BRK.B meeting during the dot-com era:

Shareholder (asking Berkshire chairman Warren Buffett): "By my calculation, you, Mr. Buffett, personally lost over $10 billion in 1999… I personally invested in four technology, computer software and aggressive growth mutual funds and made up all my '99 losses on Berkshire. Are we asking too much as shareholders for you men [referring to Buffett and vice-chairman Charlie Munger] to put your brains to work and possibly speculate a little.... Again, I made a 100% profit on my aggressive position..."

I am not making this up. A shareholder, his ego grossly inflated after making a couple of lay-ups, basically lectured the Michael Jordan of investing about how to shoot free throws. Unfortunately, those tech investments and aggressive mutual funds subsequently got decimated.

Back to Value and Price
Let's be clear: Price and value are two completely different things. Not knowing the value of something can be deadly. In the stock market, the last selling price is applied to every single share, regardless of value. If you owned a house, and your next-door neighbor sold his identical house for $1 (assuming mortgage is paid off), would you A get scared that the quoted price of your house had fallen by nearly 100% and rush off to sell your house at a huge loss, or B run to your neighbor and get on your knees and beg him to sell you the house instead (maybe at $2) because you KNOW the value of the house is more than $1?

In the stock market, many investors often get scared out by a falling stock price because they have absolutely no idea what the company is really worth. Value investors are more like the experts who, because they know more, can go to yard sales and buy priceless paintings from clueless sellers for pennies on the dollar.

Fundamentals, Fundamentals, Fundamentals
If you were thinking about buying a house, would you plot a graph of its historical selling price, and chart it to see if momentum indicators were up and the current price was selling over its 200-day moving average? Probably not. You'd probably check to see if education in the area is good, crime rates are low, and the house is in good shape. These are fundamental factors that determine the quality (and value) of the asset. You'd also probably want to estimate your eventual cash return. We use the same method in valuing companies.

Of course, some investors have made fortunes using technical analysis and other "non-value-investing" tactics. Legendary hedge fund manager George Soros reportedly has a debilitating back spasm, which serves as a warning mechanism when his positions are wrong. The last time I had a back spasm was while going for a rebound, not because my body somehow realized the yen-krona carry trade was going to unwind, so I think I'll stick to value investing.

Price, Price, Price
Why do stocks become undervalued? Human nature being what it is, we desire the safety of the herd. In nature, loners not only have a lower chance of reproducing, they also a greater chance of being eaten. Not so in investing.

Imagine a nightclub in which the alcohol is served in an auction format. No one wants to drink alone. However, once the party gets started, not only will people wait in long lines (as long as everyone else is doing it) to pay the overpriced entrance fee to get into an overcrowded club, they'll also then wait in lines at the bar to pay for overpriced alcohol.

We think a better method would be to buy at low prices, either before the frenzy starts, when people are too timid, or after the frenzy, when the hangovers begin and people are sickened by the very thought of alcohol. We apply essentially the same discipline to value investing. Keep in mind that this strategy, like value investing, requires patience and isn't very fun while the party's going, but it is a lot more profitable in the end.

redmustang91 57M  
8559 posts
5/9/2006 10:34 am

I still like gold and base metals ( esp. titanium and uranium), energy and alternative energy, emerging foreign stocks (esp. China and Latin America), railroads, stockbrokers, heavy earthmoving manufacturers, and Boeing!

Can you say increasing at an annual rate of 300 to 400%!

Become a member to create a blog