Before Investing, You Should Understand What Drives the Price. It’s Always About Supply and Demand

Before investing in any stock, piece of real estate, cryptocurrency or business, you need to understand what drives the supply and demand before even considering price. And don’t limit yourself to the products or services of the company and its direct competitors. 

Consider whether customers can choose substitutes. My concern about cryptocurrency is how easily new currencies can be coined until there’s one clear winner. One tech stock’s initial public offering followed another in the late 1990s until the industry shook out. The cryptocurrency binge today reminds me vividly of those days. 

Once you’re confident in your supply/demand outlook, then and only then can you consider whether an asset is cheap or rich. 

Most of the time, the market gets it approximately right by averaging out everyone’s mistakes. Some investors might be overly optimistic and buy too high while others might be too pessimistic and sell too low. Usually those errors cancel each other out, but once in a very long while, crowd psychology takes prices to extremes. 

If you become good at spotting when markets may be ahead of themselves, you have a better chance at profiting from one of those life-changing opportunities or avoiding catastrophic mistakes. 

With that said, you can overpay for a great company and still make money if you are patient and the company continues to grow. If it grows quickly enough, it can catch up to the price you paid and go on to turn a losing position into a profitable one. BetterInvesting stresses focusing more on buying at a reasonable price than the perfect price. 

The most urgent challenge is to find companies that can stimulate demand for its products and ward off competition.

Price is always an approximation; any precision is an illusion.

Price is a number that is often a delusion and nearly always a distraction.

The price attached to a stock or other financial asset changes in a frantic hum, often several thousand times a day, causing corrosive intellectual damage.

It may have little relation to VALUE, although it is more interesting and keeps most of the financial media quite busy.

The continual flux and spurious precision of price will cast an illusion of certainty, fooling many investors into thinking that the exact worth of a stock is knowable at any given moment.

That tricks investors into believing that even tiny changes in price can have great significance when, in fact, the constant twitching of stock prices is nothing but statistical noise.

Under the illusion of certainty created by PRICE, investors forget that VALUE is approximate and that it barely changes on even a monthly time scale.

Investors who fixate constantly on price will always end up trading too much and overreacting to other people's mood swings; only those who focus on ascertaining value will achieve superior returns in the long run.



Example:

If asked what your house is worth, would you respond, "$237,432.17?"  Of course not.

You know perfectly well that nobody, including you, knows what your house is worth to the nearest thousand dollars, let alone to the nearest penny or fraction of a penny. 

Instead, you would say, "Between $200,000 and $250,000 maybe."



With stocks and other financial assets, price is also an approximation; any precision is an illusion.

THE BIG PICTURE. Investing is less about the stock price and more about the value of the business.

The Big Picture

Finding companies you know is only the beginning; the circle of competence is only meant to help you stay within your arena of expertise. 

Once you have generated a list of the companies you understand, the next step should be conducting an analysis of the financials. 

Don’t worry — you don’t have to be a finance whiz to understand the basics of the stock market. 

For example, Berkshire Hathaway’s investment philosophy is surprisingly simple: The company should have 
1.  consistent earning power, 
2.  good return on equity, 
3.  capable management and 
4.  be sensibly priced. 


Investing is less about the stock price and more about the value of the business — is it a good one?

Successful investing is more about learning over time and slowly expanding your circle of competence. For now, stick with what you know and focus on the long term. 

Anyone can find success in the stock market; you just have to keep it simple. 

As Buffett has famously said, “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” And you know what? $60 billion says he’s right.

Ask yourself this ONE question, every time a stock price goes up or down.

Every time a stock goes up or down, you should ask yourself:

Is this price movement based on changing fundamental or changing sentiment?

Sometimes the answer is not so obvious. 

In such a situation, here is a good guiding principle.

It is better to be approximately right than to be exactly wrong.

Price is the essential determinant in every investment equation.

Zweig:

How does Baupost define a value company, and what is your average holding period?

Klarman:

With the exception of an arbitrage or a necessarily short-term investment, we enter every trade with the idea that we are going to hold to maturity in the case of a bond and for a really long time, potentially forever, in the case of a stock.  Again, if you don’t do that, you are speculating and not investing. We may, however, turn over positions more often.  If we buy a bond at 50 and think it’s worth par in three years but it goes to 90 the year we bought it, we will sell it because the upside/downside has totally changed. The remaining return is not attractive compared with the risk of continuing to hold.  In our view, there is no such thing as a value company. Price is the essential determinant in every investment equation. At some price, every company is a buy; at some price, every company is a hold; and at a still higher price, every company is a sell. We do not really recognize the concept of a value company.

The ABCs of Screwball Economics

The ABCs of Screwball Economics
By Alyce Lomax April 13, 2009 Comments (2)

We've had TARP (and the return of the TARP), we've had TALF, now we've got the PPIP. Our government's interventions into the economy have come hand in hand with a great propensity for acronyms that are becoming less clever all the time. (I mean, come on, PPIP?)

I've got some great acronyms for what I think these are going to do for our economic situation, but most are not appropriate for our family-friendly site. Here's one that makes it through: SNAFU. Or how about ROFLMAO, if you've got a gallows sense of humor. I still see little possibility that the government's actions are going to help our economic situation in the least.

IPS (It's the price, stupid)

The new PPIP basically fails to admit what more and more people have been arguing, and that is that the major banks like Bank of America (NYSE: BAC), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC) don't have liquidity problems, but rather solvency problems.

There is toxic garbage on their books (and continued lack of transparency on them). The prevailing idea that it's acceptable to price these assets at fantasy levels sounds absurd to me, but the banks want to price these assets at unrealistic levels, and the recent loosening of mark-to-market rules pretty much tells you what you need to know -- somebody wants the fantasy to continue. (Even worse, some are wondering if the banks are just going to sell the assets to one another, with government help.)

The real marketplace wants to price those toxic assets, as low-down and nasty as those prices may be, and doesn't want to pay artificially inflated prices. (Meanwhile, why would we want the government to subsidize purchase of these assets at artificially high prices anyway?). Suffice it to say, it doesn't follow that prices should be whatever these companies decide they should be and the government should support that.

IDS (It's the debt, stupid)

The government's programs have been geared toward stimulating lending again. But here's the thing that's been driving me crazy for ages: There's a heck of a lot of indebtedness in our system already; it's part of the problem, and that goes for corporations, consumers, and our government itself.

Of course, the government wants to kick up lending again. Our past economic growth was based on an artificial daisy chain fed into by bubbly asset prices, low interest rates, and the inevitable loads and loads of debt being taken on. Of course, this has to correct because if you really think about it, it's been utterly unsustainable, but nobody wants to take the inevitable medicine. The smart consumers and companies that didn't dig themselves into massive debt holes probably don't want to borrow right now. So, who's left?

Consumers were melting the MasterCard (NYSE: MA) and Visa (NYSE: V) cards buying up Coach (NYSE: COH) handbags and Tiffany baubles, or flat-screen TVs or Sirius XM (Nasdaq: SIRI) radios. Unfortunately, we can now gather that a heck of a lot of their spending wasn't based on real income, but rather subsidized by debt or taking equity out of their bubbly priced homes. Now many consumers are busted broke, with slashed credit lines, defaulted loans, and lost jobs. Should they borrow more?

Meanwhile, many corporations loaded up on debt, too. I remember thinking it was weird for companies to take on debt to say, pay dividends or buy back shares (much less to finance their operations). Back then, it made sense to just about everybody, and everybody was doing it. But now? It's pretty clear that many companies weren't concerned about a rainy day coming, a day when it might become difficult for them to service that debt. Well, it's come. Should they borrow more?

IES (It's the economy, stupid)

It's morally reprehensible that the government should expect already overly indebted consumers to keep on borrowing to reinflate our deflating economy. Some of us are concerned that our economy has been an accident waiting to happen, given the fact that consumer spending represents 70% -- the lion's share -- of GDP. The emphasis on services and the financial industry's love for pushing pieces of paper around has put us in a precarious position indeed, as has the emphasis on debtor spending to make our economic world go round.

Meanwhile, it looks like my fears of a zombie apocalypse economy are coming to pass. Throwing good money after bad not only robs taxpayers, but it also robs healthy companies of capital as the zombies are kept alive. Propping up losers means that soon, all we'll have are losers, and an awfully big bill to pay.

BBIAF, with more bad acronyms

There are many arguments emanating from many different schools of thought about what to do. I've always thought that the government should stay out of this so we could have a difficult, but likely shorter lived, correction, clear out the artificial excess, and get to work on moving back to an economy with real innovation and truly healthy businesses -- all the while leaving bubbly fakery behind.

I know many people don't agree with my point of view, but it seems like more and more people from many different economic camps are starting to come around to the idea that the fixes from government intervention from both the previous administration and the current one are simply helping politically connected bankers and doing little to actually fix what ails the real economy. The word "oligarchy" seems to be cropping up an awful lot, in fact.

Let's hope that the next acronym program won't be one that denotes being completely out of luck, but after endless government interventions that don't seem to help and seem more likely to hurt, it's starting to feel like that's our destiny. Let's hope not.


Alyce Lomax does not own shares of any of the companies mentioned. The Fool has a disclosure policy.

http://www.fool.com/investing/general/2009/04/13/the-abcs-of-screwball-economics.aspx

Three Main Influences on Stock Prices

Three Main Influences on Stock Prices
By Ken Little, About.com

There are three main areas of influence that move a stock’s price up or down. If you understand these influences, it will help you decide whether the price movement is a buy, sell or sit tight signal.

Fundamentals

Clearly, the most direct influence on a stock’s price is a change in the economic fundamentals of the business.

If revenues and profits are on a steep upward trend with no indication of leveling off, you can expect to see the stock price rise as investors bid up this attractive company.

On the other hand, if the profit picture is flat or, worse, declining with no change in sight, look for investors to abandon the stock and the price to fall.

These are simple examples of changes in fundamentals. Other, more complex and subtle changes can occur that may not dramatically affect the stock price immediately (increased debt, a poor acquisition and so on can also trigger price changes).

The point is that changes in the underlying business have a direct impact on the stock’s price. Smart investors spot the subtle changes before they become price-movers and take the appropriate action.

Sector Changes

Changes in the stock’s sector can have positive or negative affects on price too. Some sectors or industries are cyclical in nature and you should know that would affect price.

However, when whole sectors catch of fire (think dot.com stocks) or burn up (think dot.com stocks, again), even those companies that have solid fundamentals are pulled along with the rest of the sector.

You may hold a stock that is a victim of “guilt by association” when an industry falls out of favor. Likewise, stocks can see prices artificially inflated if they find themselves in the right industry at the right time.

Market Swings

The market goes up and the market goes down. That’s about all you can say with certainty concerning the stock market.

As the market moves up and down, your stock may move with or against it. Most large-cap stocks will follow the market to some degree, but smaller companies may not get the same push every time.

In general, a strong market move either up or down will carry more stocks with it than not, so your stock may be up or down for no other reason than the market was up or down.

Conclusion

How do you use this information?

A change in fundamentals may be an opportunity to buy more shares of a growing company or it may signal the time to sell if the changes are for the worse.

A change in the sector is usually temporary so most long-term investors will ride out dips due to these factors. However, if something drastically changes in the stock’s industry due to regulation or a new technology, for example, you may want to reevaluate your position. Is the company capable of adapting or do you own a dinosaur?

Market swings that move your stock’s price can be opportunities to buy additional shares (assuming all the company’s fundamentals still checkout). If the rising market pushes up your stock’s price, it may be time to take a profit on part of your holdings and wait for the price to come back down to earth to reinvest.

http://stocks.about.com/od/evaluatingstocks/a/0317threefact.htm

Stock market as a conduit for transferring wealth

The stock market is a conduit for transferring wealth from those who confuse price with value to those who do not, and from the impatient to the patient.

An investor, armed with knowledge of what their stock is worth, will sit tight and ony buy and sell when the price created by speculative traders is most advantages. Real investors don't generate a lot of brokerage fees.

Also, if a recommendation by advisory newsletters is not accompanied by an assessment of value and the business performance that created the value, a stock can only be bought on faith and sold on ignorance.

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.

Value above Price

Clear-cut undervaluations of leading common stocks (blue chip stocks) tend to occur only during bear markets. The intervals between successive market bottoms have been much longer, so that this type of opportunity must now be considered as infrequent.

In the secondary field (non-blue chip stocks), by contrast, undervaluations may be found at all times except when a bull market is well advanced. Thus the investor or analyst who is strongly interested in the undervaluation approach will find what he is looking for, more continuously or consistently, among the secondary issues.

Ref: Security Analysis by Benjamin Graham

[Bear markets occur infrequently. As a guide, perhaps, for every 4 bulls, one expects to meet 1 bear. Very severe bear markets were uncommon. This occured about 1 in 10 years, namely 1987 and 1997.]

Why is the price falling?

Question: After buying some shares, the price keep on falling. The company is doing well - there is no bad news. "Why is the price falling?"


Basically, share price movement depends on demand and supply.

When demand exceeds supply, the price will rise.

When supply exceeds demand, the price will fall.

The price movement is thus determined by all the investors and speculators in the market. The instantaneous action of the aforesaid will propel the price of the shares in a particular direction - up or down.


Movement of share price = Demand vs Supply

Demand > Supply = Share price rises

Supply < Demand = Share price falls

Thus when share price falls, it means there are more sellers than buyers.


Ref: Making Mistakes in the Stock Market by Wong Yee

Investment merit at a given PRICE but not at another

Investment Policies (Based on Benjamin Graham)

PRICE: is frequently an essential element, so that a stock (and even a bond) may have investment merit at one price level but not at another.

______________________________________

Having selected the company to invest based on various parameters, the next consideration will be the price we are willing to pay for owning part of its business.

Price is always an important consideration in investing. At a certain price, the company can be acquired at a bargain, at a fair price or at a high price. Each scenario will impact on our investment returns.

We should ALWAYS buy a good quality company at a BARGAIN PRICE (margin of safety). This allows us to lock in our potential gains at the time of buying at a favourable reward/risk ratio. This maybe when the upside gain: downside loss is at least 3:1.

There maybe FEW exceptional occasions when we may be willing to pay a FAIR PRICE for a good quality company. This is often the case when a good quality company is fancied by many investors and is often quoted in normal time at a high price.

However, we should NEVER (NEVER, NEVER) buy a good quality company at HIGH PRICE, whatever its earnings and growth prospects maybe. To do so will not only diminishes our potential investment returns, but may even results in a loss of our capital due to the unfavourable reward/risk ratio.

Don't time the market, it is difficult. However, there will be time when the market is on sale and the prices of stocks are at a bargain and there will be time when the market is exuberant and the prices of stocks are high or very high.

The market will always be there and we should choose when to buy and when to sell. We should only buy a stock when the PRICE IS RIGHT FOR US and sell a stock when the PRICE IS RIGHT FOR US.


(What is market timing? Timing is a term that refers to investing by buying everything or selling everything on the basis of the (faulty) assumption that one can predict the market's next move. Attempts to time are common, but academicians and practitioners have concluded that success happens through luck only on occasions that are quickly reversed and very costly.)

Growth Stocks: Searching for the Sprinters

Growth Stocks: Searching for the Sprinters

by Douglas Gerlach

Investors who focus on growth try to predict which companies will grow faster in the future -- faster than the rest of the stocks in the market, or faster than other stocks in the same industry. If you're successful in buying a company that does grow faster than other companies, then it's likely that the price of that company's stock will increase as well, and you can make a profit.
(My comment: Provided you did not pay too high a price to buy it.)

The stock of a company that grows its earnings and revenues faster than average is known as a growth stock. These companies usually pay few or no dividends, since they prefer to reinvest their profits in their business.

Peter Lynch primarily used a growth stock approach in managing the Magellan mutual fund. Individuals who invest in growth stocks often prefer it because their portfolio will be made up of established, well-managed companies that can be held onto for many years. Companies like Coca-Cola, IBM, and Microsoft have demonstrated great growth over the years, and are the cornerstones of many portfolios. Most investment clubs stick to growth stocks as well.

Investment, speculation and gambling

It is commonly thought that investment, is good for everybody and at all times. Speculation, on the other hand, may be good or bad, depending on the conditions and the person who speculates.

It should be essential, therefore, for anyone engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justifiable one.

Investment, speculation and gambling (Security Analysis, Ben Graham.):

1. Graham defined investment thus: An INVESTMENT OPERATION is one which, upon THOROUGH ANALYSIS, promises SAFETY OF PRINCIPAL and a SATISFACTORY RETURN. Operations NOT meeting these requirements are speculative.

The difference between investment and speculation, when the two are thus opposed, is understood in a general way by nearly everyone; but it can be difficult to formulate it precisely. In fact something can be said for the cynic's definition that an investment is a successful speculation and a speculation is an unsuccessful investment.

The failure properly to distinguish between investment and speculation was in large measure responsible for the market excesses and calamities that ensued, as well as, for much continuing confusion in the ideas and policies of would-be investors.

2. Graham's addition criterion of investment: An investment operation is one that can be justified on BOTH QUALITATIVE and QUANTITATIVE grounds.

Investment must always consider the PRICE as well as the QUALITY of the security.



Main points:______________

INVESTMENT OPERATION: rather than an issue or a purchase.

PRICE: is frequently an essential element, so that a stock (and even a bond) may have investment merit at one price level but not at another.

DIVERSIFICATION: An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly.

ARBITRAGE AND HEDGING: it is also proper to consider as investment operations certain types of arbitrage and hedging commitments which involve the sale of one security against the purchase of another. In these rather specialised operations the element of SAFETY is provided by the combination of purchase and sale.

THOROUGH ANALYSIS: the study of the facts in the light of established standards of safety and value, including all quality of thoroughness.

SAFETY: The SAFETY sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experiences indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.

SATISFACTORY RETURN: is a wider expression than "adequate income", since it allows for capital appreciation or profit as well as current interest or dividend yield. "Satisfactory" is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

_______________


For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement.

Speculation, on the other hand, may always properly – and often soundly – derive its basis and its justification from prospective developments that differ from past performances.

GAMBLING: represents the creation of risks not previously existing – e.g. race-track betting.

SPECULATION: applies to the taking of risks that are implicit in a situation and so must be taken.

INTELLIGENT SPECULATION: the taking of a risk that appears justified after careful weighing of the pros and cons.

UNINTELLIGENT SPECULATION: risk taking without adequate study of the situation.