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.

Industry Capacity determines the competitive environment in an industry.

Limited capacity gives companies more pricing power as demand exceeds supply.

Excess capacity results in weak pricing power as excess supply chases demand.

In evaluating the future competitive environment in an industry, we should examine current capacity levels as well as how capacity levels are expected to change in the future.

It is important to keep in mind that:

• If new capacity is physical (e.g., manufacturing facilities) it will take longer for the new capacity to come online so tight supply conditions may linger on for an extended period.  Usually however, once physical capacity is added, supply may overshoot, outstrip demand, and result in weak pricing power for an extended period.
• If new capacity requires financial and human capital, companies can respond to tight supply conditions fairly quickly.

Investors will frequently not know why security prices fluctuate. Must look beyond security prices to underlying business value.

Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception.

• The shares of many biotechnology companies doubled and tripled in the first months of 1991, for example despite a lack of change in company or industry fundamentals that could possibly have explained that magnitude of increase. 
• The only explanation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing.

In the short run supply and demand alone determine market prices. 

• If there are many large sellers and few buyers, prices fall, sometimes beyond reason. 
• Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumor. 

Most day-to-day market price fluctuations result from supply- and-demand variations rather than from fundamental developments.


Investors will frequently not know why security prices fluctuate. 

• They may change because of, in the absence of, or in complete indifference to changes in underlying value. 
• In the short run investor perception may be as important as reality itself in determining security prices. 
• It is never clear which future events are anticipated by investors and thus already reflected in today's security prices. 

Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level,  investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.


Main Point: 
Investors will frequently not know why security prices fluctuate and must look beyond security prices to underlying business value, always comparing the two as part of the investment process

Security Prices Move Up and Down for Two Basic Reasons: Business Reality or Supply and Demand

Security prices move up and down for two basic reasons:

• to reflect business reality (or investor perceptions of that reality) or 
• to reflect short-term variations in supply and demand. 

Reality can change in a number of ways,

• some company-specific, 
• others macroeconomic in nature. 

Company-specific factors

• If Coca-Cola's business expands or prospects improve and the stock price increases proportionally, the rise may simply reflect an increase in business value. 
• If Aetna's share price plunges when a hurricane causes billions of dollars in catastrophic losses, a decline in total market value approximately equal to the estimated losses may be appropriate. 
• When the shares of Fund American Companies , Inc., surge as a result of the unexpected announcement of the sale of its major subsidiary, Fireman's Fund Insurance Company, at a very high price, the price increase reflects the sudden and nearly complete realization of underlying value. 

On a macroeconomic level

These factors could each precipitate a general increase in security prices:

• a broad-based decline in interest rates, 
• a drop in corporate tax rates, or 
• a rise in the expected rate of economic growth.

Buffett (1978): Commodity type businesses must earn inadequate returns except under conditions of tight supply or real shortage

In this write up, let us see what Warren Buffett has to say to his shareholders in the 1978 letter:

"The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. (Comment: Note Glove companies!)  As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital. We hope we don't get into too many more businesses with such tough economic characteristics."

The above paragraph once again highlights the fact that no matter how good the management, if the economic characteristic of the business is tough, then the business will continue to earn inadequate returns on capital. This can be further gauged from the fact that despite all the capital allocation skills at his disposal, the master was not able to turnaround the ailing textile business that he had acquired in the early years of his investing career. He further adds that such businesses have little product differentiation and in cases where the supply exceeds production, producers are content recovering their operating costs rather than capital employed.

While the comment is reserved for the textile industry, we believe it can be extended to all commodities like cement, steel and sugar. Infact, the current downturn the sugar industry is facing has a lot to do with supply far exceeding demand and this in turn is having a great impact on returns on capital employed by these businesses. The only hope for them is a scenario where demand will exceed supply.

"We get excited enough to commit a big percentage of insurance company net worth to equities only when we find 

• (1) businesses we can understand, 
• (2) with favorable long-term prospects, 
• (3) operated by honest and competent people, and 
• (4) priced very attractively. 

We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were equities of identifiably excellent companies available - but very few at interesting prices."

Those of you, who are regular readers of content on our website, the above paragraph must have rang a bell or two. Indeed, time and again, in countless articles, we have been highlighting the importance of investing in good quality businesses run by honest and ethical management. That the master himself has been looking at similar qualities does go a long way in further reinforcing our beliefs. Buffett then goes on to make a very important comment on valuations and says that no matter how good the businesses are, there is a price to pay for it and he in his investing career has let many investing opportunities pass by because the valuations were just not right enough.

Comparison can be drawn to the tech mania in India in the late nineties when good companies with excellent management like Infosys and Wipro were available at astronomical valuations. While these companies had excellent growth prospects, investors had become far too optimistic and had bid them too high. Thus, investors who would have bought into these stocks at those levels would have had to wait for five long years just to break even! Hence, no matter how good the stock is, please ensure that you do not pay too high a price for it.

http://www.equitymaster.com/detail.asp?date=6/28/2007&story=2

The stock market provides a market for setting prices based on supply and demand

More about the stock market

The stock market provides a market for dealing in listed shares, and for setting prices based on supply and demand.

It is for this reason that prices of equities fluctuate.

Just as in any open market, prices will go up if there are more buyers than sellers and vice versa.

Most of the buying and selling occurs electronically today.

The performance of the stock market is often gauged by the performance of an important index.  An index reflects the performance of a grouping of shares. 

The best known index in the world is the Morgan Stanley Capital Internation (MSCI) Index, which represents the biggest shares in the world based on market capitalization.  When the prices of these shares dip, the index will also go down, and vice versa.

For each country, the main index consists of the biggest shares based on market capitalization.  There are also other sub-indices (financials, industrials, mining, etc.).  Each of these indices represents a certain grouping of shares based on their market capitalisation.

What drives prices to change?

In the long run, yes, definitely the fundamentals or value.

But between now and that distant tomorrow, the answer is supply and demand. 

And the balance of those forces is not always rationally based.

It is at market-negotiated prices, not values, where we sell (and buy) stocks. 

And markets reflect people, not fundamentals alone!

It is not the news itself that moves prices, but instead the response of investors and traders to that news. 

To the degree that news constitutes a surprise, price will move dramatically.

The extent of changes in opinion can be measured in trading volume.  That tells us the degree of surprise hitting the market and the urgency with which the affected traderss and investors feel they need to take action. 

What studying volume does, in effect , is to reveal

• what the crowd is thinking and
• how big that crowd is. 

Understanding the crowd's collective mind set is crucial to being on the right side of the price action. 

Watching the crowd and the trading volume it creates will add a new dimension to your market and stock analysis.