Here are perhaps the most common hypotheses about stock prices.
- The Efficient Market Hypothesis. A stock’s price is based purely on supply and demand. It will increase when investors buy it and decrease when investors sell it. A stock’s price therefore always reflects perfectly the estimation of investors as to the company’s worth. There is no such thing as a mispriced stock. It is therefore impossible to profit from a rise or fall in a stock’s price, and the best thing you can do with your money is to buy a broad-based index fund. (Here is a well-written argument for this position.)
- The Value Hypothesis. A stock's price will occasionally be far below or above its intrinsic value. It is therefore possible to buy a stock when its price is lower than what it's really worth and to sell it when its price exceeds its value. The real value of a company is determined by its net asset value plus an educated guess of the present value of its future earnings.
- The Price Pattern Hypothesis. Certain patterns emerge as a stock's price rises and falls. You can use technical analysis of these patterns to predict investor sentiment based on trades that are being made. Most brokers push this way of investing very hard, since they get a lot more commissions from people who trade this way.
- The Momentum Hypothesis. When a stock’s price is rising or falling, that behavior will persist for a while. The way to make money in the market is to buy a stock (or ETF) when its price is rising or about to rise and sell it after it has reached its peak. One common method is to buy stocks whose prices have risen over the past year (or six months) and sell them when their price drops more than a certain percentage, using a trailing stop (an order to sell when a stock's price falls a certain amount from its peak) to protect your gains. Another is to use technical analysis to find a trend that's just beginning or has suffered a temporary setback and then to ride it until its end.
- The Growth Hypothesis. Price doesn’t matter very much. A company is either growing, has reached maturity, or is declining. This was the great (and ironically named) investor T. Rowe Price’s theory, more or less. Buy stocks of companies that are growing, sell them when they reach maturity, and avoid them like the devil if they’re declining. There are all sorts of ways to judge a company’s stage of development, and price isn’t one of them. After all, will the price of its stock affect a company’s ability to grow? No.
- The Relative Value Hypothesis. The best way to judge a company’s worth is to compare its revenue, assets, and earnings to other companies in the same industry and/or to other companies with similar characteristics. Then compare the price of the company’s stock to that of comparable companies, and you can get a good idea of whether it’s over- or undervalued. Buy undervalued stocks and sell them when they’re overvalued.
I have problems with all of these hypotheses.
The Efficient Market Hypothesis disregards all the investors who are making short-term and long-term trades for reasons that have little to do with company performance. Thousands of traders are buying and selling based on minute movements in prices. Some investors are wildly overreacting to market news while others have decided to keep buying stock in a company no matter what happens. In other words, there’s nothing efficient about the market. The job of a good investor is to find market inefficiencies, and they are legion.
The Value Hypothesis is dependent on the idea that a company has an intrinsic worth, which makes about as much sense to me as the idea that you can find your true voice as a writer or that you have an indissoluble core to your personality. Companies, like people, are constantly in flux, and anyone who has ever worked for (or, even better, tried to acquire) a small company knows that it’s impossible to put a dollar value on it. Not only that, but you have to value the company’s equity, not the company as a whole, since when you buy and sell stock, that’s all you’re dealing with. Considering that a company possesses, besides its equity, fixed assets whose worth is constantly changing, debt which is increasing or decreasing, cash on hand, employees, inventory, intangible assets, good or bad managers, not to mention the present value of its future earnings, can you really come to any estimation of the real worth of its stock? And even if you could, you'd have to find another investor to pay you that amount for it. Although it can happen, you probably won't be getting an offer from the company to buy its stock back from you at exactly what you think it's worth.
The Price Pattern Hypothesis has a lot in common with astrology. There can be no logical link between star position, birth dates, personality, and fate. But the charm of astrology has little to do with its illogic. After all, a stopped clock is right twice a day. The same can be said of price patterns. Yes, an engulfing candlestick often indicates a strong change in direction. Except when it doesn't.
As for the Momentum Hypothesis, the momentum effect is real: stocks that have gone up in the past year are more likely to go up some more in the near future than stocks that have gone down in the past year. But it’s a minor effect purely related to the quality of a company. Stocks that have gone up in the past year are usually stocks of companies that performed well in the last year, and these companies are slightly more likely to continue to perform well than companies that performed badly. The momentum effect is therefore at a remove from its actual cause. Certain analytical tools—stochastics, the relative strength index, the money flow index—may be somewhat reliable indicators of future price movement, especially when used in conjunction with similar tools. But trading behavior, which is what these tools were designed to measure, has changed a great deal since most of these technical tools were invented. As for trailing stops, well, imagine you collect high-quality jewelry. You buy a few rings at $1000 each and consider you’ve paid a decent price for them. The price rises to $1,100, then falls to $800. What do you do? Sell the rings, realizing a loss, or buy more at that price? The same goes for stocks. If the price drops and the quality of the company hasn’t changed, don’t sell—buy more! Momentum is a basic fact of life. But inertia is also a fact of life, and so is Brownian motion. When will a price stop rising and start falling? And will it then reverse course again?
The Growth and Relative Value Hypotheses are, in my opinion, the most theoretically sound. But not every company goes through a growth-maturity-decline cycle. Some companies never grow much; others decline for a while and then suddenly grow; still others grow but fail way before they have a chance to mature. As for relative value, how do you find comparable companies? Most of us use the Global Industry Classification Standard to determine what industry a company operates in. But so many companies operate in a number of different industries. And on what basis do we compare these companies? On the basis of their earnings, their revenue, their free cash flow, their book value?
I invest in small, healthy, honest, and little-known companies that are growing at a sustainable rate and sell them if they no longer fulfill those criteria. But I invest in them only if they are relatively low priced. I especially use the price-to-sales ratio to compare the company to others in the same industry, because a company’s revenue is more stable than its earnings or free cash flow, and its book value tells you almost nothing about its prospects.
In general, individual investors pay way too much attention to price. And "traders" pay attention to almost nothing but price. The price of a stock actually tells you almost nothing about whether a company is worth investing in.
A few months ago I asked my fellow subscribers to Portfolio123 (the world's best investing research and strategy service) whether they’d had any experience experimenting with a price-blind strategy—a strategy with no momentum factors and no value factors, a strategy based solely on financial strength, quality, growth, investor sentiment, and trading volume, a strategy with no price ratios, no price performance considerations, and not even one reference to market capitalization (which is based on stock prices). None of them had. Designing a price-blind strategy that actually works was a useful exercise, and I’ll devote a future post to it. In the meantime, just remember this: how well a company is going to perform has absolutely nothing to do with the price of its stock.
My ten largest holdings right now: LNTH, FONR, BLBD, UWN, EMMS, ESXB, HBP, RBPAA, GSOL, JOUT
YTD CAGR: 35%
