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The Price is Wrong

April 07, 2008
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Krasimir Karamfilov

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It is official: I’m sick of stock prices. Wherever I turn, people talk about stock prices. You hear things like, “Apple is cheap at $152,” or “Lucent is down 8 bucks today,” or “Visa went up $25 the other day.”

Here’s a question: Why do people care?

Here’s another one: Why do millions of investors check the prices in their portfolios every day?

And again: Why does the price matter?

Before I answer these questions, let me take you to a supermarket.

It’s lunchtime and we don’t have bread in the house. We go to the store, knowing that there are 9,000 different breads and they all could taste delicious. What are we looking for? Basically, we are all looking for a cheap, but delicious, loaf of bread.

So we check the breads and their prices, and pick a loaf. Do we buy the one-of-a-kind, 12-grain, organic, artesian bread, made in Ojai this morning, which costs $7.99 per loaf, or do we buy a whole wheat bread for $1.69?

Nine out of ten people will buy the whole wheat bread. Why? Because the price seems right to them.

What about the hydrogenated oil used in the bread? – What about it? It’s some kind of oil. It’s good for you.

What about the word “demoxin” in the ingredients? – I’m sure it’s something to keep the bread fresh longer.

We pay for the bread, go home, and have lunch. A year later, after we’ve had a hundred loafs of the same bread, we get cancer.

What’s the moral of this story? It’s not “always buy the most expensive bread.” It’s “know what you’re buying.”

The same thing happens with millions of investors. They buy a stock without knowing its ingredients, which for a business consists of finances, products, history, management, intrinsic value, market share, and so on.

How many investors study a stock longer than 15 minutes? Not many. Would you marry somebody 15 minutes after meeting him/her? And if you did, wouldn’t you wake up every morning, thinking whether you made the right choice?

That’s why, before I buy a stock, I always, always, ALWAYS read the quarterly and annual reports of the company I want to invest in.

Why didn’t I invest in Visa? I’d been waiting for its IPO for a year. I didn’t invest in it because I read the 2006 annual report and realized that 2007 will be worse that 2006. And I was right—Visa lost over $1 billion in 2007. And when the stock started trading, the starting price of $40 was 24 times 2006 earnings. In other words, the company was in trouble and the stock was expensive. “But it’s Visa, man” one would say. “It’s a great franchise and the price is right.” Great franchise—yes, right price—no.

Now let me give you an example, in which a company’s stock sold also for 24 times earnings, but the price was right.

The company is General Steel Holdings Inc. (GSI). The company aims to become the biggest privately-owned steel company in China . Most of the steel industry in China is owned by the government.

When the company caught my eye, its earnings per share were $0.33 and the price was $8.00. Very few people knew the company existed because it traded on AMEX. When I read the 3 rd quarterly report for 2007, I saw that the company made $121.3 million in the second quarter and $345.4 million in the third.

Now, you tell me which company, stock, and price was right: Visa—with billions on the line in lawsuits and negative net income for 2007, or little General Steel Holdings—with over 500% annual revenue growth, amazing prospects, and a clean balance sheet?

Right.

So people check the price of their stocks because they don’t know the real value of the company at a given moment in time. If they did, they would not check the price. Period.

Would I check the price of a good company every day, if I owned 10% percent of the company’s stock? No, sir. I’m a partial owner of the company. I don’t care if the stock trades at $10.54 or $73.87. Does Warren Buffett check the price of Coca-Cola Company every day?

People care about the price because they care about LOSING THEIR MONEY. Fear is the driving force here, not thirst for knowledge.

And lastly, the price matters only to investors who buy stocks the way they buy cheap bread—you buy it today, throw it away tomorrow, and buy a new one the day after. The effortless disposability of stocks makes investors price-centered.

Imagine if the Securities Act of 1933 said that you couldn’t sell a stock for 5 years after you bought it. What kind of investors will we be then? Will we be ignorant, price-centered investors, or will we be long-term knowledgeable investors? Will we be buying a piece of a business we know inside out, or will we be buying an empty price number attached to 3 or 4 letters that mean nothing?

Your answers to these questions will shape your destiny as an investor. That is guaranteed.

The last brief paragraph is devoted to the fans of the Efficient Market Theory, who think that the price of a stock is always right because it already reflects all the information available about the company in question.

Dear friends, consider these two points:

Information does not reach all market participants at the same speed. I read a company’s annual report today; you read it in four months from now. I buy the stock at book value; you buy it at 7 times book value four months later. You and I have the same information, but it reached me faster than it reached you. We also interpreted the information differently. That’s why I made a killing when I bought the stock and you were killed by the stock when you bought it, or vice versa.

Information, regardless of its kind, is almost always subjective (tainted), biased, or incorrect. That’s why people go to jail for insider trading. Because they use information based on the real truth of a company’s finances or situation to enrich themselves at the expense of held-in-the-dark investors like you and me.

No matter what your investing approach is, remember:

The price of a stock is always wrong… for somebody.

About the author:

Krasimir Karamfilov
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.0/5 (11 votes)

Comments

Dr. Paul Price
Dr. Paul Price premium member - 6 years ago
I your September 15, 2007 article "Nimble Baby" you said you sell a stock if it goes up 50% or you've held it for 2 years.

That's seems completely the opposite of what you're now writing as it is totally based on price or time.

That gave no consideration at all to the 'value' of the shares.

How do you explain the conflict in your advice from September to April?
Krasimir
Krasimir - 6 years ago
Yes, what I wrote in "Nimble, Baby" last September is the opposite of what I wrote in "The Price is Wrong."

Why did I do that?

Well, what I know and understand about investing at a certain point in time is what I write about. Since I'm not all-aware and my investment knowledge is constantly developing, I'd rather express what I know now than not express anything at all.

I thank you for reading my articles, and please measure their merit by what you know, not by what I know. In the end, how you use your own judgement and knowledge about investing is what will make a difference in your life.

What I write has mostly thought-provoking and, rarely, educational nature. I believe in being exposed to every theory about investing, and then picking what works for me. Sometimes the theories are contradictory, but that's the beauty of it. That's the nature of our world.

I hope this answers your question.
tkervin
Tkervin - 6 years ago
"..........Would you marry somebody 15 minutes after meeting him/her? And if you did, wouldn’t you wake up every morning, thinking whether you made the right choice?" ...............but if divorce was only a mouse click away.........:-)
Krasimir
Krasimir - 6 years ago
There's more to add to my earlier comment:

The article "Nimble, Baby" was written from my experience as a money manager. A money manager has to be nimble because he/she manages clients' money. He can't have a client's account go down 50% and tell the client, "Don't worry about it. The company is great and it will rebound in a year." Clients don't care about our valuations and shop talk. They want to see their account grow. And by being numble, I deliver the growth. I feel like a bee, jumping from flower to flower, but it works for them, which makes me happy.

The article "The Price is Wrong" expressed my thoughts as an individual investor of my own money. I'd rather hold a stock forever than sell it. I buy my stocks as if I buy the whole business. That's why I don't care much about the quoted market price when I buy a stock for my own account.
VISAat74
VISAat74 - 6 years ago
Why would Warren Buffet set the price at $74?

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