Wednesday 27 October 2010

For traders: Always keep in mind that the company and its stocks are distinct

A company may reach new heights of prosperity while you as individual stockholder own a bit of it, but you still can lose money.  Why?  You and other temporary owners have bought merely rights to cash in on whatever changing level of perception other people (taken as a whole, the market) may hold about that company.

1.  They may like it less tomorrow
  • because of buying in too late (too high), 
  • because interest rates are rising (making all equities less attractive relative to bonds or Treasury bills); 
  • because of adverse public opinion about its products or industry;
  • because of press publicity over high executive salaries; 
  • because general corporate reputation might deteriorate; 
  • because investment tastes shift in favour of other industries; or 
  • because of a rising fear of recession.
2.  Or the overall stock market may be declining from a too-high prior level.

3.  Other investors collectively may be right or wrong about the company over the short to medium term.  And you as an individual may prove correct, while the majority are incorrect, about fundamentals.


To determine whether now is the time to hold or to sell, focus on changes in perception rather than on long term fundamentals.  An investor can be dead-on right about fundamentals, but if the market collectively decides that it no longer is willing to pay as much for this company's reputation or earnings, its share price heads south.  Eventually, an individual's logic may be vindicated again as value reasserts itself and other investors resume their willingness to pay for it.  But in that interim, the individual is going to suffer a loss for fighting the tape.

As Benjamin Graham noted in The Intelligent Investor, markets act as voting machines in the short term but in the long run function as weighing machines.  Thus, actions and opinions of the crowd determine share price in the short to medium term, which is the most important factor because that share price determines whether you have a gain or a loss, and when.  So buy and sell not just on personal judgment of a company behind a stock but on your studied assessment of what other investors think of the company and how that thinking seems to change.  A great company can be a bad stock (for trading or investing) if bought at just any price without regard to reasonable value.

Prices on the tape reflect people's reactions and perceptions and beliefs translated into buying and selling decisions; they do not reflect the truth about a company's fundamentals.  So keep in mind that the company and its stock are distinct.  

Being able to keep a company and its stock strictly separate in your mind has become ever more critical in recent years.  Excellent companies may suffer single-quarter earnings shortfalls against analyst estimates or might even experience actual interim declines in earnings.  Such minor stumbles usually call down immediate and massive institutional selling.  While such selling may be vastly disproportionate to any long-term true fundamental meaning of the triggering event, it does signal a coming period of more cautious appraisal by major investors.

If you maintain the mental agility to view a stock as merely an opinion barometer because you have separated it from the company's fundamentals, you will be able to sell without costly hesitation.  Fail to differentiate a company and its stock in your mind and you will have great difficulty over separation and loyalty issues and will be less successful in your investment moves.  Unless you plan on holding forever, which will produce merely average or even sub-par returns, you need to buy and sell.

Swings in market psychology drive prices to fluctuate around true long-term value (if only the latter could ever be known accurately today!).  Another way of viewing these price swings is to think of them as changes in the consensus of esteem given to a company by all investors taken together.  When esteem runs up above reasonable valuation of fundamentals, price will eventually correct downward to redress that temporary mistake.  Above-average profits accrue to those who capture such positive differentials of esteem minus reality.  (Similarly, on the buying side of the equation, handsome profit opportunities can be captured when reality minus esteem is a positive number, meaning that the stock in more common terms is temporarily undervalued by the market of opinion.)

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