Disparity between Price and Value

"The business performance creates the value - the price creates the opportunity."

We are taught that value is the price a willing but not anxious vendor is prepared to accept and a buyer is prepared to pay. However, such a definition applies to collectables, commodities and resources that are subject to variations in supply and demand.

Although stock prices are also generated by supply and demand, their value is not. Positive sentiment will increase demand (optimistic buyers) and reduce supply by limiting the number of willing sellers, while negative snetiment will have the opposite effect.

Although few would support the notion that the value of a financial security such as a stock is determined by the influence on prices of greed, fear, optimism and pessimism (market sentiment), reality implies the opposite.

At his breakfast meeting address to the Philanthropy Roundtable on 10th November, 2000, Charlie Munger said:

"It is an unfortunate fact that greed and foolish excess can come into prices of common stocks in the aggregate. They are valued (priced) partly like bonds, based on roughly rational projections of value in producing future cash. But they are also valued (priced) partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far. This situation, combined with big 'wealth effects', at first up and later down, can conceivably produce much mischief."

Let us try to investigate this by a 'thought experiment'. One of the big British pension funds once bought a lot of ancient art, planning to sell it ten years later, which it did at a modest profit. Suppose all pension funds purchased ancient art, and only ancient art with all their assets. Wouldn't we eventually have a terrible mess on our hands, with great and undesirable macroeconomic consequences? And wouldn't this mess be bad if only half of all pension funds were invested in ancient art? And if half of all stock value became a consequence of mania, isn't the situation much like the case wherein half of pension assets are in ancient art?

One thing we know with absolute certainty is that stock prices and their value can vary hugely. If price and value were synonymous, all stocks whose future business performance was in accordance with market expectations would produce similar long-term investment returns - a notion tha is contemporaneously accepted as valid, although universally acknowedged in retrospect as false. Market commentators who fail to recognise this by referring to market prices as valuations, are by inference treating stocks as common commodities.

Althoug prices are deemed to reflect consensus, it should be remembered that prices are determined not by the majority of shareholders who are uninterested in buying or selling at the current temporary price, but by the tiny minority who are.

Following the adage that says it's impossible to be reasoned out of a belief that we were never reasoned into in the first place, if stocks are bought without reference to value, they will in turn be sold without reference to value.

Warren Buffett says:

"What could be more exhilarating than to participate in a bull market in which the reward to the owners of the business become gloriously uncoupled from the plodding performance of the business themselves? Unfortunately, however, stocks can't outperform businesses indefinitely."

When prices increase at a greater rate than can be justified by business performance, they must eventually stagnate until the value cathces up or they must retreat in the directions of the value. Only when a stock is bought at less than its value can price increases that exceed incremental increases in value be justified.

It is useful to understand some of the reasons for the disparity between price and value.