November 4, 2015
November 4, 2015
I love finding a good deal. It doesn’t matter if it’s at a clothing store or a grocery store. There is something really gratifying about getting something on sale. The issue I run into from time to time (or frequently, if you were to ask my wife) is that I don’t always take into account what price may say about quality. For example, I’ve learned that the cheapest fish isn’t always the best value fish. The distinction between the lowest price and the best value is even more important when shopping for stocks. The way in which stock prices are determined makes it difficult- if not impossible- to find bargains. However, investors can still do better by building portfolios based on the long-term drivers of stock returns.
To understand how stock prices are determined and why it’s so hard to find good, cheap stocks, it’s important to understand what it means to own stock. Purchasing stock is acquiring a claim on a company’s net assets and future earnings. If you own 1% of the company’s shares you are by extension entitled to 1% of whatever the company owns and 1% of the company’s profits. Of course, if the expectation is that profits will be good, the price will be higher than if the expectation is that the profits will be bad. Just as you pay extra for detergents that offer more loads per bottle, you pay more for companies with higher earnings. The difference with stocks, however, is that prices aren’t just based on today’s earnings but on future earnings. This is what makes valuing stocks so difficult.
Since no one knows how companies will perform in the future, there are no reliable ways to measure “fair” price. We have to then depend instead on the price set by the stock market. The stock market sets prices by matching buyers and sellers. When there are more buyers than sellers for a particular stock, that stock’s price goes up and vice versa. For publically traded stocks, there may be tens of thousands of these transactions each day for just one company. The price you see quoted is based upon the combined information from everyone in the market at that moment. This collective “wisdom of crowds” is generally more accurate than what any one individual might think. It also means, unfortunately, that you can only get a reliably good deal if you know something the other investors (including Wall Street professionals) either don’t know or haven’t processed correctly. Wall Street is not known to be populated by the lazy and the dumb, so assuming you have superior research and/or are smarter than the person on the other side of the transaction is perilous.
Investors can make better stock buying decisions by focusing on factors that drive stock returns over long time periods. There are three such factors most determinative of a stock’s expected return: the riskiness of the company, the size of the company, and the amount of assets the company owns.
The riskiness of a stock comes in two flavors and, as with cholesterol, there is good and bad risk. Good risk is the risk all investors assume when they buy stocks. In finance parlance, this is referred to as market risk, which contrasts with the safety of insured bank accounts and less volatile bonds. While market risk is often rewarding for long-term investors, accessing opportunity requires that investors endure losses at such time the entire stock market goes down, such as in 2008. This is the market risk to which all stock investors have exposure. Bad risk, on the other hand, is the risk that any one company does poorly regardless of what is happening in the broader stock market. This is commonly referred to as firm specific or idiosyncratic risk. Bad risk may be minimized through diversification, which acts as Lipitor for the portfolio. When you own lots of different stocks, you are not much concerned with any single company’s performance – even if that company is Volkswagen. Stock investors must take on market risk but can improve risk-adjusted returns by diversifying away the bad, company-specific risks.
The size of the company also affects the return. Many investors believe big companies with well-known brands make the best investments. The opposite is in fact true. Over long time periods, smaller companies have delivered higher returns than larger companies, and the smallest companies have delivered even higher returns. Smaller companies are a little riskier than big ones but their potential for growth is also higher. All else being equal, what is the likelihood McDonald’s doubles in size relative to In-N-Out Burger? By investing more in small companies, you can enhance the expected returns within a portfolio.
A company’s stock return is also tied to the way the market values its assets. Remember that when you own a stock, you have a right not just to the company’s future earnings, but also to its net assets. A company’s assets are the things it owns: buildings, vehicles, machines, equipment, intellectual property and so forth. Academic studies indicate that (for reasons not fully understood) investors overestimate the importance of future earnings and underestimate the value of existing assets. For example, investors tend to overpay for technology companies, such as software or microchip makers, with few assets but lots of growth potential. Conversely, railroads, with lots of assets and slower growth, are less loved by investors even though the industry has proved very enduring. As a result, companies with low stock prices relative to their net assets have better long-term returns. Appropriately, asset rich companies are called value companies. By owning more of them, investors give portfolios a leg up.
Perhaps the quandary for stock shopping lies in our quest to replicate, with a bit of research, the same kind of bargains we are able to uncover in other parts of life. It can be fun to boast about bargain shoes or the Airbnb apartment which proved both more spacious and less expensive than the nearby hotels. At the same time, the desire to find deals could get you in trouble in the stock market. A stock that is down by 50% may not necessarily be on sale. It might instead be half-way to worthless. Investing in diversified portfolios that incorporate persistent tilts to smaller and value oriented stocks provides the best possibility to come away a winner and without the queasiness occasioned by surprisingly inexpensive fish.