An old saw says that a cynic knows the price of everything and the value of nothing. Nowhere is this more true than in investing.
In the investment world, prices are everywhere. Stock prices combine to form indices; bond prices determine yield. Price-action is the main determinant of investment performance. Hundreds of millions of investors interact every day to buy and sell tens of thousands of securities and determine their prices.
But the price is not the value. The value of a stock or a bond is determined by its fundamentals—its balance sheet, revenue, income, and cash flow—present, and future. The key to generating returns that exceed the indices is distinguishing between price and value. So the most basic question an investor can ask is, how much of the future is reflected in the current price?
But this is really hard. Aristotle famously noted that people are by nature social animals, and it’s uncomfortable to be by yourself, either physically or in your actions. So when fundamentals are good, people want to buy and prices get pushed up, and when they’re bad people sell and prices go down. This herd-action causes price and value to diverge—sometimes dramatically—but also makes it hard to exploit. Buying into a falling market feels like catching a falling knife, and selling a booming market is like standing in front of a freight train.
That’s why finance professors are so smug when they condemn active management. The very thing that causes the market to be inefficient makes it hard to exploit. But it is possible. What it takes is an eye for value and the guts to stand alone.
Douglas R. Tengdin, CFA
Chief Investment Officer
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