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Price is a liar: take three steps before you dive in

Price is a liar’ is a bold proposition. Many might argue that it is also absurd. And I recognise that it needs careful consideration. But understanding price is vital to understanding financial markets. Let me explain.

Price pretends to be an objective measure, a metric as reliable as a centimetre, a kilogram and a second. But price is a liar because it has no link to the material world, the world of hard facts. It is no more accurate than a handshake. It is less a measure than an event.

Scientists define the kilogram based on physical constants. Its characteristics are precise regardless of time or place. A kilogram in Melbourne is no different to a kilogram in London or New York. A 2019 kilogram was not heavier than a kilogram today nor will it be heavier than a kilogram in 2025.

Price, on the other hand, has no scientific or mathematical definition. It is no more than when buyer meets seller, demand meets supply, and opinion meets money. People drive prices, and people, as behavioural economists like Tversky, Kahneman and Thaler have shown, are not rational.

Investors must guard against behavioural biases such as anchoring, confirmation and loss aversion. They should watch out for the Dunning Kruger effect, which refers to a cognitive bias whereby people with low ability or expertise in a particular topic tend to overestimate their ability or knowledge.

Bubble trouble

Historic examples of prices lying are infamous bubbles: Tulip Mania, the Mississippi Bubble, the South Sea Bubble, the bubble preceding the Wall Street Crash, Japan’s Financial Market Bubble, the Dotcom Bubble and the US Housing Bubble.

More recently there have been bubbles in tech, particularly profitless tech (ARKK), SPACS (special purpose acquisition companies), meme stocks (GameStop) and cryptocurrency.

All of these have been accompanied by acronyms like FOMO (fear of missing out) and YOLO (you only live once), and by ideas like greater fool theory (there’s always someone stupid enough to buy at a higher price). These are more lifestyle choices than investment processes.

Technicalities and patterns

There is a discipline that not only recognises price as behavioural but aims to profit solely from that knowledge.

Technical analysis, the study of historical patterns to generate targets, is hundreds of years old. Its idea that investors are buyers or sellers of an asset at predictable levels has fierce fans and caustic critics.

The old joke in financial markets that ‘charts are for sailors’ is at the expense of an approach that leans heavily on graphs of past prices and volumes for its predictions. Yet for it to be joked about means someone is taking it seriously.

For those not in the technical analysis club, price alone gives little information. There are stocks this year in the tech heavy US Nasdaq Composite index that are down 90% from their highs, but that gives no clue about their attractions as an investment. One definition of such stocks is a good reminder of the dangers of being enticed by shares that have collapsed:

“A stock down 90% is one that went down 80% and then halved.”

Lie detector

Valuation may be art not science, but it approximates the truth. More than this, it helps an investor understand how much a price is lying, both for good as well as ill. After all, prices can be too low as well as too high.

Valuation’s premise that an asset is worth the sum of its future cash flows still leaves plenty of room for blow-ups, after all that word ‘future’ is a minefield. But it also allows for a structured, repeatable process based on something resembling objectivity.

Valuation is a defence against behavioural biases. Terms that appear often in the stories of people trying to sell you something mean no more to valuation than the cash flows the words represent. Wonderful companies, beautiful cashflows, disruption, growth, moats, and the rest only matter to valuation as numbers.

Eyes wide open

Investing with reference to valuation is not the same as value investing. Value investing aims to work out an asset’s worth and then buy it at a discount. A value investor might only transact if they can buy a dollar for 80 cents, expecting that the price will move up to what is known as intrinsic value over time.

Another sort of investor might buy something at fair value or a premium because, having identified where they stand in relation to an asset’s value, they have reasons other than money to motivate them.

We have all bought or sold something at what is known in markets as the ‘wrong price’ out of clear-eyed choice, “I really wanted that house, car, ring etc even if I am over-paying”. This is a different sort of falling for it.

Investing while knowing when price is a liar

With many stock prices sinking, the temptation may be to dive in. If that is what you want to do, I would suggest bearing in mind three things.

Firstly, try to identify opportunities that do not rely on, let alone magnify, the market’s direction. Look for what are called low beta equities.

Secondly, favour shares with shorter rather than longer payback periods. This may be no more than saying favour good value.

Thirdly, hunt down income, especially in conjunction with my first and second suggestions. Income has been the poor relation over the last decade or more but anyone with an eye to history understands its integral role as a component of total return.

 

Hugh Selby-Smith is Co-Chief Investment Officer of Talaria Capital. Talaria’s listed funds are Global Equity (TLRA) and Global Equity Currency Hedged (TLRH). This article is general information and does not consider the circumstances of any investor.

 

6 Comments
Lisa Romano
July 31, 2022

Certainly now is a time to pause and examine an equity under the hood, check its price against its value, earnings and historical performance. Fools rush in where angels fear to tread.

Robert
July 30, 2022

Mass and weight are different things. Mass is the amount of matter that the object is made up of and weight is a force, the amount of gravitational force. So if your mass is 70kg on earth and you stand on the moon, your mass will still be 70kg on the moon, but your weight will be much lower on the moon.

Allan
July 29, 2022

I well remember an academic who pitched an article on 'The Conversation' a few years ago asking readers something akin to: "Which weighs heavier; a kilogram of cheese or a kilogram of Vegemite?...so I said: "My gut feeling says it will be the one that rests heavier on the stomach."

When I once wasn't absolutely sure what a 'cubic foot' was, I asked my doctor who, after reading right through several of his very thick books on medicine, said he wasn't 100%-sure either, but if he had to hazard a guess then he reckoned that a 'cubic foot' would have to be worth at least two weeks compo to any worker who had one if they could but feign a convincing limp when they hobbled into his surgery. This fits in nicely with what the author of this article says in his finale: "Thirdly, hunt down income,..."

Stan
July 28, 2022

It is always reassuring when some science creeps into the comments.

Jan H
July 28, 2022

"Mass or weight…what do we measure when “we weight in kg”? It is common, at day-to-day trading, to measure the weight of a product in kg. However, kilogram (kg) is the mass measuring unit at the International System of Units (ISU)."

Tony Reardon
July 28, 2022

Putting my pedant's hat on, the kilogram is not a unit of weight, it is a unit of mass. A kilogram can indeed weigh different amounts in different places.

 

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