Wednesday, August 13, 2008

The Myth of "Market Understanding" -- Part One

The two reasons I hear otherwise intelligent people give for not investing are 1) that they don't have enough money and 2) that they don't understand the market.

Not having money, surprisingly enough, is the easy part. I'll deal with that Friday. Today and Thursday I'll focus on understanding the market.

You don't have to understand the market to be a successful investor. In fact, I'd venture to say that people who think they understand the market are far more likely to lose their ass than those who accept a certain level of indifferent ignorance.

The market, like God, women, racehorses, can only be understood to a point. You can comprehend -- at least insofar as the market is concerned -- that there are buyers and sellers. You can accurately presume a general correlation between market movement and major news events or, say, the underlying economy. And one can, over time, extrapolate a few trends. Beyond that, "understanding the market" is a fool's errand. You don't need to understand gravity, Jell-O or prayer. They all work. Move on.

That being said, you can and should cultivate an understanding of stock fundamentals. Once you've developed and honed that skill, you can participate in the market with a great deal of success.

The first thing you must know is the role price plays in evaluating an investment.

Answer: None.

Price, in and of itself, has nothing to do with whether a stock is a good value. The price of a stock is determined by the initial offering price, and that's determined by the amount of capital a company seeks to raise. (Market forces can play a role here, too.) Most companies are set up as corporations, and their stock is held by a few individuals -- the owners. If that company seeks to make a significant growth push, it could offer all or a portion of that stock to the public for cash.

If the corporation wants to raise $500 million, it can sell 500 million for a buck each, or it can sell a million for $500 a crack -- or any combination thereof. The company gets the money and does its thing and that's really the end of the transaction as far as the company goes -- after that, it is revalued by investors every time they trade shares at a new price.

The only price consideration that is sometimes reasonable to take into account is a company's market capitalization, the number of shares multiplied by the share price. There are some generalities that investors can make about companies based on size. But price on its own means nothing. It's just a number.

Prices, like most numbers on Wall Street, are useful only when they can be contextualized with another data point. The most common way to contextualize price is by comparing it with earnings. This is called the price to earnings ratio or the earnings multiple. It's determined by dividing the price by the net earnings per share and can be based on either the previous 12 months earnings or the earnings estimates for the upcoming year.

A stock with a high PE ratio is said to be more expensive that a stock with a lower PE, though that's most true when you compare companies within industries. The higher the potential for earnings growth, the higher the PE tends to be. Google and Apple have been growing their profit -- they have high earnings multiples, 33 and 35. Banks and utilities, which operate in more "mature" industries, tend to see slower growth and, as such, have lower PE ratios, usually less than 15.

Consider: Berkshire Hathaway trades at about $115,000 a share. Seems a little on the pricey side, no? But it's cheaper than White Mountains Insurance, which is in the same primary business but trades at a PE roughly the same as Google's. So White Mountain's shares can be bought for less money, but they are actually more "expensive."

Try an experiment: Call your broker and ask him how much any stock is trading for. If he gives you a price, hang up and then close your account. And don't open a new account until the financial adviser responds to your query with a PE. If he quotes a price, he's just a salesman. That's what salesmen do. If he gives you intelligent information, he is an adviser and a quite possibly a mensch.

Low PE ratios do not mean a stock is a good investment. High PE ratios don't mean a stock is a bad investment -- Apple and Google, for instance, have done pretty well. And it's important to note that some companies that have hit a rough patch might not have any earnings at all and thus have no PE ratio to even look at. Some value investors, like me, might consider some companies like that to be truly excellent investments.

That's where the second number comes in. The PE ratio, like price, also should be balanced against another number or even a series of numbers. We'll get to that tomorrow.

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