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What not to do with stock prices

There are as many misconceptions about stock prices as there are about mutual fund NAVs

What not to do with stock prices

Last week, I discussed how an illusory idea of the 'price' of a mutual fund created problems for investors. Investors think of the NAV of a fund as its price, which leads to flawed concepts in the way they choose funds. The worst aspect is to compare two funds on the basis of NAV and think that in some sense, funds with the same NAV must be similar.

Are equity investors immune to this problem? After all, while mutual funds don't actually have anything called price, stocks do. The price of a stock legitimately plays a central role in investing, so one would expect equity investors not to have any misconceptions about price.

Unfortunately, this is not true. Stock investors are prone to the exact same flawed mental model about the price of a stock as mutual fund investors are about NAV. Many believe that a stock with a low price is somehow cheaper and therefore, a better buy than one with a high price. In fact, the situation is potentially much more confusing than mutual fund NAVs. Think of the concept carefully. To put it simply, the low price of a stock is a legitimate reason for buying it and a high price is a legitimate reason for not buying it or indeed for selling it. This concept is central to almost all equity investing.

However, this 'high' or 'low' is not an absolute level. It's high or low compared to what you have independently concluded is a reasonable price for that particular stock. It could be compared to the past of the stock or the future you anticipate or something else like that. However, the important thing is that the reference point of the comparison is to the stock itself and not to anything else. A stock that is at Rs 15 is not cheaper in any meaningful sense of the word than another one which is Rs 500. The 15 rupee stock could be an expensive buy at that price, while the Rs 500 one could be a bargain. Or vice versa. The two prices are simply not comparable.

In the case of mutual funds, I'd said that this flawed mental model was actually encouraged by fund salespeople. For years, new funds have been sold to investors with the pitch that it would be available at Rs 10 so would be cheap. Salespeople would specifically say that buy a Rs 10 fund so that there is plenty of scope for rising. Such a statement was tantamount to fraud.

Curiously, a similar pitch is made for cheap stocks. There is an entire investing subculture (for want of a better word) based on buying cheap stocks and it's there all over the world. They are called rupee stocks in India and penny stocks in the US. Once upon a time, they were called cigar butt stocks in the US which was a more picturesque term. The idea was that you picked up a cigar butt from the pavement and got a few free puffs out of it. There are even equity 'research' tools and websites which enable you to filter for rupee stocks.

The price idea in stocks is perpetuated by the fact that comparing ratios derived from stocks is a standard and very useful technique. Ratios like price-to-earnings, price-to-book value are the bread and butter of fundamental stock research. Since these are ratios, they are perfectly comparable across different companies and with a general standard of what such values should be. As all investors know, such comparisons are a centrepiece of fundamental equity research. However, extending the ratio idea to raw price numbers is a fundamental mistake. I guess it's true of many areas but investors dabbling by copy-pasting tips and tricks rather than understanding how things work is not a great way to build a sustainably profitable investment portfolio.