Buying an expensive soap.
Yesterday I had gone to the supermarket to buy soap for myself and found out that if your regular brand is not there, buying soap is not an easy thing to do.
All the brands looked familiar, but not familiar enough to tilt the decision in their favor. The packaging was also similar and I had no patience to read through the contents or any other such thing. So I did what any other rational consumer looking for quality would do, I bought the most expensive one on that aisle on the premise that if its expensive itâ€™s got to be good.
This is probably one of the most common â€˜rationalâ€™ irrational buying behaviors we all suffer from.
A lot of investors have the habit of tracking the daily price of a few stocks and then if they see the price of one moving up, they automatically come to a conclusion that the company is a good one.
This is quite similar to buying the expensive soap and if you canâ€™t buy the right soap based on its high price, what are the chances of buying the right company based on its price going up?
Similarly the real value of a company is not going to change on a daily basis and if you are purchasing the stock at a higher price just because the stock has gone higher in the last few trading sessions you may be paying more than what you could have gotten if for.
Price should not determine whether a company is good or not, it should be the second level of filter that needs to be applied in order to buy the stock.
The first filter should be the fundamental strength of the company, factors like the operating history of the company, competitive landscape, profit margins, revenue growth, management caliber, availability of raw material and such determine this. After analyzing companies on such parameters and arriving at a conclusion that the stock is worth investing, the second step is to see whether the price that the market is asking for the stock is justified or not.
This is not a difficult task but itâ€™s not an easy one too. The key is to look at the price as a function of earnings and the P/E Multiple is a good way of determining whether the stock is decently priced or not. For example if there is a company which makes an EPS of a dollar and the asking price is 55 then the market is demanding 55 times the stockâ€™s earnings in every year. This is quite high and can only ever be justified for smaller companies in their high growth period. Such companies would be doubling revenues every two or three years and because their size is smaller it would be possible for them to achieve this feat. However to expect this from larger companies in unrealistic.
For larger well established companies the P/E should be near their growth rates over the long term or a little above it, it can be a little above it because usually larger companies with an established track record trade at a premium. They give the investors comfort of knowing that the company has been functioning for decades and will continue to do so and therefore investors do not mind paying a little extra to become stock holders for such companies.
A good way of finding value in the market is to look at big companies who have taken a hit due to one off reasons or external factors while their core business still remains strong. A lot of top rung Indian IT companies are now trading at P/E multiples lower than their historical and future predicted growth rates. While this has been caused due to slowdown in the US markets and rupee appreciation, the companies are still going strong based on their growth rates in the past few quarters of around 20% or so and therefore this may be a good time to buy into such stocks.
What investors should definitely shy away from is to look at stock prices in isolation and if the price is moving up determine that the stock is a good one.
That is the total reverse way of looking at stocks and deciding on what should go in your portfolio.
Buying a stock is like buying any other asset and if you were buying a used car you certainly wouldnâ€™t take this approach. If you were taking this approach you would have narrowed down your options to two or three cars and then you would have been tracking prices on e-bay or some other place and based on which car is priced highest you would go ahead and buy it. If that doesnâ€™t sound reasonable then why monitor stock prices with intent to buy whatâ€™s going up?