When I was young, my dad would take us to Brewers games nightly. The cost of admission: $4. One season, the price of those tickets doubled. Unwilling to pay so much for outfield seats, we attended far fewer games after that.
This summer, I'm headed back to Milwaukee to watch the Brewers play. The price for one of those outfield seats today: $30. That's not a bad price by any means, but it really shows how silly it was to get all upset over an $8 ticket.
Anchoring: a fatal investing flaw
The problem was that my family got locked into that $4 price target and refused to budge. The name for that is anchoring, and anchoring can wreak havoc on your portfolio.
In his brilliant book on behavioral economics, Predictably Irrational, Dan Ariely devotes a chapter to discussing just how pervasive anchoring is in our everyday lives.
[Price tags] become anchors when we contemplate buying a product or service at that particular price. That's when the imprint is set. From then on, we are willing to accept a range of prices -- but as with the pull of a bungee cord, we always refer back to the original anchor.
A poignant example from today's headlines is the recent Netflix (Nasdaq: NFLX ) rate increase. If Netflix had never existed before this month and then came out with separate DVD and streaming plans for $7.99 each, I think they'd be warmly received. However, since we've all anchored in on receiving both for just $8.99, we throw our arms up in protest.
Applied to investing
Going along with Ariely's observation, we can reasonably extrapolate that when we put a stock on our watchlist, we're likely to anchor to the price it's at when it joins our list. That can be a dangerous game.
Often times, a stock's price is the worst thing that we can anchor to. The four following stocks will help give you an idea what I'm talking about. I've included my own "anchor date" -- when I started following the stock -- as well as the "anchor price" and the current price.
|Travelzoo (Nasdaq: TZOO )||2/24/11||$38.42||$54.85||43%|
|Mercadolibre (Nasdaq: MELI )||8/12/08||$35.87||$79.46||122%|
|Riverbed Technology (Nasdaq: RVBD )||4/20/10||$14.10||$29.00||106%|
|UPS (NYSE: UPS )||7/1/09||$49.95||$69.14||38%|
Sources: E*TRADE, Fool.com.
If you were thinking about buying these four stocks but didn't, the question must be asked: Who in his right mind would pay up 40% to 120% for anything?
Shockingly, the answer should be: YOU!
Cut the cord to your anchor
Price is just one way to measure a stock's value -- and it's probably the worst one. A stock's price tag tells you little about the underlying business. Are sales growing or shrinking? Are margins widening or compressing? All of this matters, and all of it requires more attention than simply looking up a stock's price tag.
Although I don't necessarily think anchoring to any one metric is a good idea, let's instead look at the P/Es for these companies. This will tell us how much we are paying relative to how much each company is earning.
Source: E*TRADE, Fool.com.
*Normalized to reflect a settlement with the state of Delaware.
As you can see, you're paying about the same for Travelzoo, slightly more for UPS, and a lot more for Riverbed, but Mercadolibre seems to be on sale right now.
But here's the disclaimer: You shouldn't anchor on anything. Some investors are worried that Mercadolibre may be approaching the limits of its growth potential. That could explain why the stock is trading at a cheaper valuation than in the past.
One really cheap stock
Of all the stocks that I follow, there's none that has seen its price tag go so high at the same time its P/E has gone so low than Apple (Nasdaq: AAPL ) . I put it on my watchlist in February 2009; back then, Apple shares were trading for $87.91. Since then, the stock has rocketed all the way up to nearly $400 -- more than a 350% increase.
Yet the stock's P/E is actually lower today than it was back then (15.5 vs. 16.3, respectively, by my calculations). If you step out into the real world, you can easily see why: Sales of iPads, iPhones, and even Macs are booming.
I don't think any graphic quite captures this anomaly better than the following one. Usually, a stock's P/E correlates pretty strongly with its price, but in Apple's case, the exact opposite is true. Take a look at how the P/E (purple line) sinks as the price (blue line) shoots up.
Why is Apple showing such odd pricing behavior? Several possibilities have been thrown around:
- Apple's just too big to expect continued growth.
- The competition is fierce.
- Steve Jobs may not be around too much longer.
Whatever the reasons are, the conclusion is still the same: Despite its high price, Apple is cheap.
My takeaway from Ariely's work is that no number should be viewed in isolation; we need to do our due diligence to fill in the context. In that vein, I'm willing to offer you a special free report to get you started. The report -- The Motley Fool's Top Stock for 2011 -- highlights a little company set to profit from the broadband Internet expansion. It's yours today, absolutely free!