Price dictated stock decisions will lead to failure!
One of the most common questions I received when I recommended a stock priced in three or four digits was this — “What is the point of buying a stock this expensive? Recommend something under $10, or better, $5, or better, $1.”
The reasoning was simple — “It’s easier for a $1 stock to go $10, than for a $100 stock to go to $1000.”
At the start of my career, this reasoning sounded reasonable. But it turned out to be one of the biggest misconceptions I’ve ever had as an investor. Thankfully, I got over that misconception early.
Of course, a car that sells at $20,000 may be more expensive than one that sells at $5,000, even when you discount for better features etc. But a stock that sells for $200 or even $1000 is “not” more expensive than a stock that sells for $20 or $100, just because of its price tag.
In fact, it’s never about the price in stock investing. It’s always about the price-to-value offered, or price-to-underlying business quality.
Example from India SENSEX — The stock of Asian Paint, for instance, is priced at Rs. 1,460. The stock of MRF is priced at Rs. 60,000. Now, if I were to go purely by stock prices, MRF certainly looks like a much bigger company or a more expensive stock as compared to Asian Paints.
But, consider this. While Asian Paints’ stock price is just 2.5% of MRF’s stock price, the former’s market capitalization of Rs. 1,400,000 million (stock price multiplied by number of shares) is 560% (or 5.6 times) of the latter’s Rs. 250,000 million.
What is more, if I were to consider the price-to-earnings multiples, Asian Paint’s P/E of 65x is 300% (or 3 times) of MRF’s P/E of 21x.
That makes MRF’s stock, priced at Rs. 60,000, much cheaper than Asian Paints’ stock, priced at Rs. 1,460.
Now consider the most expensively “priced” stock in the world, that of Warren Buffett’s Berkshire Hathaway. Its current price is US$ 308,810. Market cap is US$ 500 billion, or 25% of the total market cap of all listed stocks on the Bombay Stock Exchange. This makes the stock look so-so expensive, right?
Now, what’s Berkshire’s P/E? As per Yahoo Finance, it’s 8.2x. This makes the stock much cheaper than the cheapest of large companies in India. We are not going into details of what makes Berkshire’s P/E so low. But you got the point, right?
It is that the stock price alone never tells you whether a company’s shares are expensive or not. To know that, you must relate the price to something in the denominator, like sales, earnings, and book value (even these don’t tell much about a stock’s cheapness or expensiveness but are reasonable indicators). You must also assess the underlying quality and economics of the business. An Infosys at 10x P/E is cheap. A Tata Steel at 10x P/E may not be so (commodity stocks trade at low P/Es due to cyclicality).
Let’s look at one more example. Suzlon Energy’s stock is priced at under Rs 4 now. Its market cap is Rs 2,100 crore. An investor looking just at these numbers would say, “Isn’t it easy for Rs 4 to go to Rs 20? That would make it a 5-bagger!”
My dear friend, that’s one way to look at it. But isn’t Rs 4 closer to Rs 0 than to Rs 10 or Rs 20? What stops Suzlon from going to zero? The stock is anyways down 99% from its peak of 2008.
Here, one common misconception a lot of people have is — “The stock has already fallen by 99%. How much more can it fall?”
Well, a stock that falls 99%, first fell 90%, and then 90%. What stops it from falling another 90%?
Yes, it happens sometimes that some low-priced stocks double and triple in quick time? But you won’t like the reason why this happens most of the time.
Low-priced stocks, especially the ones from the small and penny cap spaces tend to be thinly traded. So, they can skyrocket briefly on a news release or a recommendation or plain rumor, and then plunge just as quickly. Not to forget the fraud and market manipulation rampant in such stocks that ultimately cause massive losses to the gullible investors who wander into this swamp.
Of course, fraud and manipulation — business wise or in the stock market — is also seen in stocks from the more established mid and large-cap spaces, as we saw in a few cases recently. But low-priced stocks, especially from the small and penny cap spaces, are hotbeds of such evils. The base rate of succeeding here is very poor.
All in all, it comes back to the same cardinal rule that you must stop looking at stock prices while making your investment decisions.
A low price does not automatically mean cheapness and guarantees future greatness, like a high price does not automatically mean expensiveness and guarantees future mediocrity.
As a quick thumb rule, look at the P/E ratio of the stock you are studying to find out whether it’s cheap or expensive. Take the current stock price as ‘P’ and last 12-months earnings per share as ‘E’. Better, take last 3–5 years’ average earnings per share. Compare this P/E with P/E of other stocks in the industry and with the stock’s own past P/E track record.
If the stock’s P/E is lower than its peers’ or from its past, explore the reasons. Maybe the business is worse than its peers or has deteriorated in terms of sales and profit growth, or the profit margin or return on capital has come down, or maybe the debt level has increased.
If you find nothing wrong with the business’s fundamentals, the stock deserves a deeper look, for its relative undervaluation. Study that.
But, again, never ever count on a stock’s price to tell you that it is cheap or expensive, in an absolute or relative basis.
Doing that is not just lazy, but silly.