How to Think About Price

Market, Price, Psychology, Risk / Sunday, June 28th, 2020

Tesla at $1,000 per share. Topglove, one of the largest glove manufacturers, is trading at MYR$17 per share, up 360% so far this year due to COVID19. Afterpay, Australia’s leading buy now pay later, has a $15 billion market capitalization after a 560% rally since March. What do they tell you? Will they keep going up or down? For how long? Should you buy them? These are million-dollar questions.

In The Intelligent Investor, Benjamin Graham explains there are two possible ways to profit from share pricetiming and pricing.

By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks.”

Timing is important to the speculator in particular “because he wants to make his profit in a hurry. The idea of waiting a year before his stock moves up is repugnant to him.” What about investors? “What advantage is there to him in having his money uninvested until he receives some presumably trustworthy signal that the time has come to buy? He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

Investors who want to profit from market timing require some reliable signals to inform him when to buy and when to sell. As a recent example, the market staged a substantial comeback after collapsing 30%+ in March. Some investors decide to sell or stay on the sideline because they believe there’s a disconnect between the bull run and the grim reality. Sooner or later, the market is likely to come down and that provides him an opportunity to enter the market at a price that wasn’t available previously. 

But here’s the catch. These signals that “gain adherents and importance do so because they have worked well over a period, or sometimes merely because they have been plausibly adapted to the statistical record of the past. But as their acceptance increases, their reliability tends to diminish. This happens for two reasons: First, the passage of time brings new conditions which the old formula no longer fits. Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities.

Investors who time the market has several challenges:

  1. You have to be right, which depends on those signals. But those signals don’t work over the long-term, especially after they become popular. If a signal is reliable, then more people will use it; if more people use it, then it becomes less reliable.
  2. Being right isn’t enough; your view has to be a non-consensus. If you’re right and the consensus agrees with you, you’ll only make a market average return. Outperformance comes from being right and non-consensus.
  3. Being right and non-consensus is hard because non-consensus views are often wrong. 

We can think of the stock market as a pari-mutuel system like horse betting. You don’t make a profit betting on the horse that has the highest chance of winning because the odds reflected that. You only make money betting on the horse with mispriced odds. 

Graham hit home that the odds are against investors who want to profit from market timing:

“It is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public, at a given signal, rushes to sell out at a profit? If you, the reader, expect to get rich over the years by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market. There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.”

Market timing is a competitive field. Everyone is trying to outsmart one another. And it becomes harder to do so consistently over the long-term when you’re part of the market attempting to make non-consensus decisions based on information that’s available to everyone else. 

Or, one can think of the price as an offer from Mr. Market.

Imagine that in some private business you own a small share that costs you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. 

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determines your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when the price falls sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Price can either act as an influence or as information. Price is an influence to a speculator who wants to profit from it or knows nothing about a business and relies on the price to infer the business quality. Price is information when you have good judgment as to the value of the business. And the worst-case scenario for an investor is to allow the price to influence his decisions.  

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He needs to pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused by other persons’ mistakes of judgment.

Yet why do most investors continue to pay attention to the market price? Because “he has been persuaded that it is important for him to form some opinion of the future course of the stock market, and because he feels that the brokerage or service forecast is at least more dependable than his own.” This is likely to happen when subconsciously you know little about a business and thus rely on the market price or brokerage forecast to inform whether you’ve made the right decision. 

How does one avoid this fallibility? It comes down to thinking about your position as a minority shareholder or silent partner in a private business. An investor’s future return is “entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets” and one would “determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet.” So, it all comes down to how to value a business, which is a topic for another day. 

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