This classic column originally ran on April 17, 2000.
Have you bought stock in the past four months -- before last week? You probably feel some sense of regret. An older woman I barely know came up to me after church yesterday and said, with a hint of a smile on her face, "Now what do you think of the stock market?"
My answer was that I think the same of it now as I did before. The stock market is our opportunity to become part owners of companies. Our challenge is always to find the best companies, purchase as much of them as we can in a diversified (but not over-diversified) portfolio, and look to add to those holdings over time. The challenge is and will always be to determine what are the best companies: the best managed, the most profitable, the most defensible, the most comprehensible and dependable. The long-term shareholder tends to be psychologically well-prepared for market fluctuations, particularly since he isn't expecting to take his money out of the market for at least five years at the very minimum.
She expressed regret that she hadn't bought more of a certain bond yielding 7 3/4% -- presumably she had instead put the money into stocks. I can understand it, and up to a point, feel it. We all have a sense of regret at having bought something that quickly turns down or, alternately, not having bought enough of something that quickly goes up.
You can beat yourself silly with this mentality. In fact, you can manage never to feel satisfied. For every loser, you think, "I was so stupid. I should have avoided that, or at least gotten out of it sooner." For every winner, you think, "If only I had bought more...." This way madness lies.
Over the past week, we've had an interesting talk on the Rule Breaker Strategies discussion board about price, prompted mostly by some very good questions from Heihojin. "Does price matter?" is the root of his question. Are we as Rule Breaker investors not at all concerned with the market price for a given potential investment?
That little three-word question packs a lot of punch. Let's unpack it.
First of all, price matters. No one will pay $1000 for a freshly baked Twinkie -- unless they were starving to death, let us say, and they had the money, and it was the only option. But if you walked into your local supermarket and found Twinkies selling for $1000, you would not buy and neither would anyone else. There would be no market for the things. Price matters.
But second, price doesn't matter. We frequently get calls to our radio show from people who are convinced that high-priced shares (a stock at $276, let us say) are not as good a buy as low-priced shares (a stock at $12). But price per share is just a function of how many shares are outstanding, not how good or bad this investment is. Studies have shown that lower-priced stocks are generally more volatile than higher-priced stocks, but volatility cuts both ways. In the end, you are becoming part owner of a company, and share price (and number of shares you hold) are almost completely irrelevant. We're talking here about one of the great red herrings of our time, befuddling more investors than perhaps any other. (The confusion over stock splits being a "good thing" has its root in this misunderstanding.) So here, price does NOT matter.
Third, we come to valuation. When we use price to indicate "valuation," does price matter? Well, our first point about Twinkies speaks directly to this point, to valuation. You see, the price you find quoted for Twinkies in your supermarket is generally "the right one." It has been optimized to generate the right number of Twinkies supplied for the number of Twinkies demanded. If Twinkies were priced at $1000, there would be no demand despite the millions of Twinkies supplied. If Twinkies were priced at one cent, there would be so much demand that there would shortly be no Twinkies on the shelves. Note in both cases that the Twinkie manufacturer will be put out of business -- in the first place, because of no sales, and in the second, because of huge losses.
That's the backdrop for my thinking on stock market prices. If stock market prices were "wrong," we would see either no one trading stocks (the $1000 Twinkie problem) or everyone buying all available shares immediately and not selling (the one-cent Twinkie problem). But contrary to these illiquid situations, today the Nasdaq traded 2.5 billion shares and the New York Stock Exchange traded 1.2 billion shares. Let's just pretend that the average stock price on the public markets is $40 per share. That means about $150 billion traded today on the stock market. In order to induce that kind of volume between buyers and sellers, your prices have to be tightly optimized -- they have to be very like the Twinkie at the "right price."
No prices are perfect, of course, and prices fluctuate dramatically on the stock market, far more than for Twinkies. But that's because stock market prices are reacting to near-term perceptions of changes in value... and not past or present value, but expected future values.
Given all of this, I accept the prices I see on the market as mostly "fair." That's another way of saying that on the public markets, there are NO Twinkies for sale at $1000 or one cent, just as at your grocery store. Stock market pricing is very much like grocery store pricing -- set by a thousand factors. And while Wall Street fluctuates far more, its prices still always reflect the agreement of tens of thousands of buyers and sellers who are shaking hands to buy, or sell -- or even just hold -- at whatever the price is this moment. Like many, I too have seen rinky-dink third-tier companies get bid up on the Nasdaq after their IPOs, and have thought, "No way I'm paying that." And I wouldn't. But in general, I wouldn't want to become a long-term part owner of those companies anyway, so even if you quoted me a very "attractive" price, I still wouldn't bother.
To conclude, as a long-term shareholder I do not find valuation arguments, per se, to be compelling reasons to buy stocks. I remember hearing from a "value" investor (these are terms I don't care much for -- same thing goes for "growth" investor), how screamingly undervalued Smith Corona was, in the early '90s. (Yes, the typewriter company.) It was "way below its historical P/E," "trading near book value," the market was ignoring it, etc. My thought at the time was that Smith Corona was accurately priced. Its metrics SHOULD have shown what they did, because the market looks forward (to new sorts of keyboards, no?). Most valuation measures befuddle people because they are backward-looking... for the simple reason that they are typically predicated on real "hard" numbers, which the future doesn't offer. Smith Corona, needless to say, hasn't done too well since.
So on the one hand, price matters, very much! I will not pay any price for any given thing, ever, sorry. On the other hand, price doesn't matter much. Price per share really doesn't matter, and many investors are badly misled by their belief that low-priced stocks are good, and high-priced are not. And price as a valuation consideration is also overrated and doesn't matter so much to me as an investor. That's because I believe our incredibly liquid, increasingly democratized markets today reflect rational prices.
Completely rational? No, never. But rational enough. If prices were truly irrational they would quickly be "corrected" by a flood of buyers or sellers who would suddenly come in, take advantage of that arbitrage by buying or selling in massive amounts, and we would have rationality again. That's the way market prices work for oil futures, lemons, and stocks. And Twinkies.
- David
