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12 May 2015
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I feel a little extra pressure for my first post, going second after Wayne Collins last week. There’s always been an element of healthy competition between us. Considering we’ve known each other since the age of 4 that may be no surprise! So I’m hoping to get more comments and feedback on my thoughts below, just a friendly nudge to the reader…!
Just ask yourself that question from a general point of view for now, not looking at the Stock Market.
What comes to mind? Did you struggle to articulate it or do you have a clear distinction between the two? It’s actually not an easy question to answer as often there are a number of variables involved, however I like to summarise as…
Price is what you pay. Value is what you get.
In normal life this isn’t too difficult to understand. Imagine that you are considering buying something in a shop. You will only pay for it if you feel that the benefits you’ll get from owning the item is equal to or greater than the price tag.
These benefits aren’t always directly related to the ability of the item in question to fulfil its purpose. They can be softer, such as emotional, aspirational, egotistical and is always influenced by the perception of your own individual views on how important all of this is to you.
Consider if you were looking to buy a watch. The price you will be willing to pay will depend on the value you expect to receive from owning one.
If simple functionality is the most important, then a £10 Casio may be perfect for you. But if you value fashion, prestige, impressing others etc. then this isn’t valuable to you, even at this cheap price. You’d have little pleasure in owning this.
You want an Omega at £5000. You want this because you want to feel like James Bond. You want to communicate sophistication. You want people to notice your watch and make a snap judgement on you and how successful you are. You would be willing to pay £5000 for all this, so you feel the price is fair for the total value you receive from ownership.
I hope you’ve stuck with me here, because what I’m saying is that value is subjective in normal life. It lives in the perception of individuals. Companies can sell products to the public at different price points because they are able to target groups of people who share similar views, communicate the benefits and influence the perceived value of their product.
You came here to learn about the Stock Markets right? So how does this relate to my ramble above?
The stock market behaves in essentially the same way.
At its most simple, all the financial markets are is a group of people who are constantly buying and selling based on their own perception of whether the price on offer is a true reflection of the value they believe the true worth of the company to be.
What I often see from private investors is that they can focus too much on the price of a stock and not enough on the underlying value. They look at where the price is now in comparison to where it’s been, and if it’s lower they think it’s good to buy.
However if they haven’t looked at the reasons behind these price drops related to the value in the stock, this can lead to losses as they are really buying a low-priced stock with little inherent value, rather than a higher-priced but more valuable stock.
Basically it’s cheap so they think it’s a bargain. Like when you walk out of a shop that had a sale on holding that abdominal exerciser that was so cheap at only £10 for a ‘trim waistline just by watching TV for 10 minutes a day’, that never made it out of the box… You got no value out of that and just lost money.
There are many, many ways that investors and traders use to come to their own opinion on the true value of a stock, commodity or any other traded instrument. I’m not offering advice on specifics here, but if there’s enough interest I may focus future posts on some of these. Leave your comments below if this would be helpful.
Some examples of the methods available include financial statement analysis, Price per Earnings ratios, price-to-book analysis, industry analysis, product knowledge, market knowledge just to name a few. You must make sure that you understand what each of these mean before you use them.
What the most successful investors and traders have that sets them apart is a consistent or systemised way of reaching their value number, and they act each time it’s higher than the current price. They have clear entry and exit points both for profit and loss.
If after looking at a company and doing your own research and analysis you believe this company’s value is really £2, but you can currently buy it for £1. I’d suggest that it’s likely you’ll buy it as you expect the price to reflect the true value at some point in the future.
What you’re really saying is that you believe you can see the true value of a company ahead of the rest of the other people operating in that market. Others may start with the opposite view, but if the weight of opinion starts to side with you over time and more of the market participants also believe this company is worth £2, they will start buying at every price on its way to this price target.
This is both the challenge and the opportunity of being in the Stock Market. You need to develop a consistent way to carefully sift through all the information on each company, commodity or whatever instrument you are trading, and be able to quantify the real value. You will then need to find the gap between price and value and at the same time limit your emotional reactions and be confident enough to go stick to your plan as this may mean you going against the crowd.
So in summary, don’t fall in to the trap I so often see private investors succumb to by only focusing on low price when investing in stocks.
Don’t rush out and put a chunk of your money on a stock just because its “cheap”, you read about it in the financial press or a guy in the pub told you it’s a ‘sure thing’. Buying stocks just because they’re cheap is a good way to lose money in the Stock Market.
Always consider “where is the value?”
Does this ring true with your approach? How do you approach stock selection? Let me know in the comments below or email email@example.com.