In the recent years, stock markets have become a center of attraction for most us. Equities and related financial products are becoming a popular asset class. This can be clearly seen from the growth in the number of participants, volume of transactions and overall turnover, and the growing assets under management with the Asset Management and Investment Companies.
Someone has rightly said - “If history repeats itself, and the unexpected always happens, how incapable man must be of learning from experience.”
It is not wrong to say that most of these downfalls happened because of ignoring or not correctly understanding and implementing Financial Discipline. Even after knowing and having experienced the ignorance, the emotions still make an individual a slave and make him deviate from rationality and common sense.
In this era of growing booms and busts, it is important to learn lessons from every failure in order to survive and grow. A lot can be learnt from the cases of Enron, Barings Bank, LTCM, Lehman and many such episodes. The most common reason of losing money at an institutional or individual level has been Lack of Financial Discipline.
“Common sense is the heart of investing and business management. Yet the paradox of common sense is that it is so uncommon. For example, people often refer to a stock or the market level as either “overvalued” or “undervalued.” That is an empty statement. A share of stock or the aggregate of all shares in a market index have an intrinsic value, which is the sum of all future cash flows the share or the index will generate in the future, discounted to present value.
Estimating that amount of cash flows and its present value are difficult, but that defines value, and it is the same without regard to what people hope or guess it is. The result of the hoping and guessing game—sometimes the product of analysis, often not—is the share price or market level. Thus, it is more accurate to refer to a stock or a market index as overpriced or under priced than as overvalued or undervalued.”
-Lawrence A. Cunningham, How to think like Benjamin Graham and Invest like Warren Buffet
One of the important aspects of stocks is value and price difference. Let us start the discussion by understanding the two terms. Consider a showroom offering a computer with certain configuration for a price of Rs. 30,000. One way to look at it is that the true value of this computer would be the aggregate the price of every single part of the computer (monitor, keyboard, multimedia, RAM, Hard disk etc). One would realize that if he gets every single part of the computer separately paying a few bucks to get it integrated, the same computer with same configuration would cost him say Rs. 25,000. This is its original value; it is the intrinsic value of that computer. Therefore, in the above case, the price of the computer is Rs. 30,000 whereas its value is Rs. 25,000.
With the help of the table below, we would try understand some the differences between value and price in the context of stock markets -
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Price
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Value
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It is quoted on the Stock Exchange
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It is not quoted anywhere
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It is a product of demand and supply forces
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It is a function of various factors like financial strength, quality of management, Investor’s expectations and Assumptions.
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It keeps changing very frequently
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It does not change very frequently
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It is an absolute concept
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It is a relative concept
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Price is what you pay
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Value is what you get
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Today, the global economic system is based on the concept of money and not barters. Thus, in stock markets, price and value both are to be expressed in terms of some currency. Nevertheless, price and value are different, and one has to look at them differently. In successful investing, value plays an important role. It ensures a margin of safety. Thus, understanding a business is essential. That would be the key to arriving at a fair value with reference to investing. Fundamental analysis is therefore an important aspect affecting investment decisions as it ensures a margin of safety for the investment. It involves the study of the business, its financials, management efficiency, growth potential etc.
Stock Market Investing is an arbitrage opportunity, which exists because of a mismatch between value/worth of a stock and its market price. If market would have always priced stocks at their fair value, then logically speaking, the scope for investing and making returns would have never exist. The scope for investment is there only when the price will be less than the value by a reasonable margin. The prices that the stock market ticker shows are just numbers; at any given point of time they may not necessarily reflect the worth or the true value of the company or an economy and its prosperity.
We have been studying in our theory, as well as all great Investors including Warren Buffet have mentioned that there are numerous opportunities in Stock Markets. These opportunities are there because of price-value difference. This difference exists most of the times.
“We start with the assumption that the stock market is always wrong," Soros told a Wall Street Journal reporter in 1975. He says –
“I contend that financial markets are always wrong in the sense that they operate with a prevailing bias, but in the normal course of events they tend to correct their own excesses. Occasionally the prevailing bias can actually validate itself by influencing not only market prices but also the so-called fundamentals that market prices are supposed to reflect; the crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets manage to always be right is caused by their ability to affect the fundamentals that they are supposed to reflect.
The prevailing wisdom is that markets are always right. I take the opposition position. I assume that markets are always wrong. Even if my assumption is occasionally wrong, I use it as a working hypothesis. It does not follow that one should always go against the prevailing trend. On the contrary, most of the time the trend prevails; only occasionally are the errors corrected. It is only on those occasions that one should go against the trend. This line of reasoning leads me to look for the flaw in every investment thesis.”
George Soros, from the book - Alchemy of Finance
We need to understand and accept the fact, that there is something called “Market” just because everyone has different views. There cannot be a market if at any given time, everyone wants to buy or everyone wants to sell. Market will come into existence only when some want to sell and some want to buy. So the point Mr. Soros is making is that the markets will be wrong most of the times i.e. they will price the stocks higher or lower than their intrinsic values thus giving opportunities for Investments. Very rarely they will price the stocks near about its true value.
Till now, we have studied the concept of “intrinsic value” and we know that this will depend on factors like company’s assets/liabilities, expected future profits, discounting rates and certain other assumptions. On the other hand, price is a function of demand and supply. This demand and supply comes from Market participants which includes all, right from retail investors (Accountants, MBAs, Engineers, Doctors, Shop-keepers etc) to Institutional Investors, Mutual Funds, Venture Capitalists, Private Equity players etc. Among all these classes of Investors, there will be differences of opinion/view on future expectations, intrinsic values (because every one of them will have different ways of arriving at one). All this will help give birth to the concept called “Market”. And the market is wrong just because they do this job of integrating the expectations of millions of investors/traders and factoring it at any given point of time.
“Markets can remain irrational, more than Investor can remain solvent” Keynes famously remarked.
Another reason for market being wrong could be the fact that there are lots of people who have access to all valuable information before others have, and if they get a chance to make money due to it, they would certainly do so. These are people who have access to every piece of information much earlier than it comes to the public/media at large. Such big time gamblers and operators who have first hand information are one of the real causes for making the market irrational. The other causes for market wrong can be attributed to all the factors of behavioral finance as discussed earlier.
Thus, another lesson history teaches us is that the “Market is always wrong.” That is one of the reasons Mr. Buffet mentions that the right time to buy is when everyone is fearful and the right time to sell is when all are greedy. He quotes - Be fearful when others are greedy; be greedy when others are fearful...History has always revealed that the best time to buy is the time when most of the market players are bearish and it is the vice-versa. All bull markets have taken a pause when most of the participants by and large where invested and quite bullish, and it is the vice-versa for bear markets reversing. People tend to get very excited and become extremists often. Extreme points often are points of desperation. At one point of time, people become extremely desperate to sell stocks, they dump all of them at any price and walk away, whereas at other point you will also notice that people feel so left out that they get extremely desperate to put money into markets and buy stocks at any prices.
“Those quotations did not represent prices of stocks to me, so many dollars per share. They were numbers. Of course, they meant something. They were always changing.”
-Jesse Lauriston Livermore, Reminiscences of a Stock Operator
Logically, the markets do a very good job of predicting events and trends. In short/medium term, the prices are generally higher or lower than their respective values. Under this period, the prices on the stock ticker can be referred to as numbers which are built up on expectations. These numbers (prices) change on expectations, news, rumors, speculation, and changes in government policy, economic numbers etc. All these events may not always materialize in the way they are expected to be. For example, the inverse relation between commodity prices and stock prices as it seems to be existing according to many theories was no where seen in the last decade. A particular news or event might be negative or positive for a company, but in the long term, it might not materialize that way.
“The reason for what a certain stock does to-day may not be known for two or three days, or weeks, or months. Your business with the tape is now not tomorrow. The reason can wait. But you must act instantly or be left. Time and again, I see this happen.”
-Jesse Lauriston Livermore, Reminiscences of a Stock Operator.
Yes, the next few lines may sound like a paradox to our conversation till now. However, I think this is a must and is the way it happens. The MARKET IS ALWAYS RIGHT AS WELL. I say this because no matter how much manipulation is done in the short or the medium term, the market and its participants always consolidate the stock PRICE near its true VALUE and the deviation between the two is minimized over a period. Thus, I say that the market is always right as well in the long term. We may not understand why the price of a particular security is moving (up or down) (may be its manipulation or price-rigging or just plain expectation by market participants) but the market knows exactly why it is moving and it is prepared to consolidate it when the right time comes. All the irrationality in the market is in the short term to medium term. The market is wrong in this period.
Nevertheless, in the long term, we have always seen the survival of the fittest. Good stocks have always traded at higher valuations and have performed well. We all know how the arbitrage opportunities cease to exist over a period of time, whether it’s the futures market case or it’s the case of the arbitrage opportunities in case of the mismatch of the value/worth of a stock and its market price. Long term investing has been always the most advisable and systematic approach as everything takes its own time.
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