The law of supply and demand helps determine the prices we pay for almost everything in our daily lives. So, asked William J. O’Neil, why wouldn’t supply and demand also be a significant factor in the prices of stocks?
Writing in chapter six of “How to Make Money in Stocks: A Winning System in Good Times and Bad,” O’Neil said, “This basic principle of supply and demand also applies to the stock market, where it is more important than the opinions of all the analysts on Wall Street, no matter what schools they attended, what degrees they earned, or how high their IQs.”
The author first dealt with the supply of shares available, based on the number of shares outstanding. The price of a stock with 5 billion shares is not so easily moved as the price of a stock with 50 million shares. Investors who are looking for growth generally prefer companies with smaller capitalizations. Of course, the share price will be more volatile and can go down just as dramatically as it can go up.
Professionals look not only at a company’s market cap, but also at the size of its float, i.e., the percentage of the total shares outstanding that are not closely held. This shows the number of tradeable shares; it may also provide insight into the commitment of management. When senior managers own a big stake, they’re considered to be better aligned with shareholders, and they are reducing the supply.
While bigger companies have some advantages, including greater stability, they often lack the entrepreneurial drive of smaller companies. In addition, the larger the company, the bigger the product or products needed to make a material change on the bottom line.
Supply is also affected by stock splits. O’Neil argued that companies sometimes split their shares too much, as in three-for-one rather than three-for-two. As he noted, “Oversized splits create a substantially larger supply and may put a company in the more lethargic, big-cap status sooner.”
On the flip side, the author generally likes share buybacks because they reduce the number of shares outstanding. Buybacks work because net income is divided among a smaller number of shares, thus increasing the earnings per share. That’s important because increased earnings per share is a major driving force behind outstanding stock price performance.
From another perspective, demand from potential new shareholders increases because the buybacks have reduced the supply at the same time that the company has signalled to the market it is confident about its future.
O’Neil wrote that Charles Tandy of Tandy Leather Factory (TLF, Financial) had told him, “when the market went into a correction, and his stock was down, he would go to the bank and borrow money to buy back his stock, then repay the loans after the market recovered. Of course, this was also when his company was reporting steady growth in earnings.” Tandy’s stock price reflected the increases in earnings and more, zooming from $2.75 to $60 in the early 1980s—because of increasing demand.
Shrewd buyers will also favor companies with a low corporate debt-to-equity ratio, the latter being an expression of the relationship between the proportions of debt and equity. Put another way, a low debt-to-equity ratio is called low leverage. The lower the leverage, the less risk there is of bankruptcy. When bubbles are forming or bursting, many investors will seek safety, thus increasing the demand for low debt-to-equity stocks.
O’Neil pointed out that banks, brokers, mortgage lenders and quasi-government agencies like Fannie Mae (FNMA, Financial) and Freddie Mac (FMCC, Financial) used extreme leverage between 1995 and 2007; in some cases, their debt-to-equity ratio exceeded 40-to-1. Conscientious value investors would demand companies with little or no leverage at all.
Now that we have explored some of the factors that contribute to changes in volume, how do we assess it when making decisions? By watching the daily trading volume, which captures the effects of supply and demand. Charts provides perspective, since we can quickly see how volume has varied over time.
O’Neil added, “When a stock pulls back in price, you typically want to see volume dry up at some point, indicating there is no further selling pressure. When the stock rallies in price, in most situations you want to see volume rise, which usually represents buying by institutions, not the public.” In the case of meaningful rallies, volume will pop by 40%, 50% or even 100% on the breakout day. Strong volume suggests solid buying and the possibility of future price increases.
The following chart from the book shows how O’Neil looks at volume and related factors; in this case it illustrated how Apple (AAPL, Financial) fared as the S&P 500 plummeted in 2009:
A few personal notes on this chapter:
First, as O’Neil made clear, supply and demand does affect prices, and value investors can profit by recognizing the “law” as at least a background factor. In establishing discount rates for future cash flows, supply and demand factors can help us be more accurate.
Recognize stock splits and share buybacks not only affect supply and demand, but also that these management actions can send a signal of confidence to the market.
Finally, stock charts are hardly a staple of value analysis, but checking volume stats before buying or selling might be an advantageous idea.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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