Have you ever felt like you were missing out on a stock that was rising and wanted to buy it? Or worse, after watching it go up for a few days or even a few weeks in a row, couldn’t take it anymore and decided to actually buy it before it went up even more? You’re not alone. That’s just how we humans are hardwired.
The large majority of people end up making poor decisions in financial markets for numerous emotional-related reasons. Excitement causes us to “buy high” and fear causes us to “sell low” – which, as we know, is the exact opposite of what we’re supposed to do when investing. I’m certainly not perfect. I’ve done it many times and only after years of reading about the psychological nuances of investing/trading and actually applying them in real trading have I been able to transform my thinking by short-circuiting the initial, innate reaction which is so often wrong.
When it comes to investing in stocks, I think many people get it wrong because they think of stocks like stocks and not as actual companies. By this I mean that many people see stocks as something that goes up and down every day, and they’re hope is that it will go up after they buy it. They often forget that what they’re actually buying are shares of the equity ownership of a company which give them the right to act like an owner. You get to vote on all proxy votes and you’re entitled to future profits, dividends, etc. so it’s important to think about the company as a whole from an owner’s perspective and determine what you’re willing to pay to become an owner. That answer is largely determined by what you feel future profits will be:
- Step 1 – determine expected profits moving forward (the value of the company)
- Step 2 – determine how much to pay for those profits (the price you’re willing to buy the stock)
The lesson here is that there is often a large disconnect between the underlying value of the company and its stock.
Let’s use a simple example to illustrate: let’s say you were talking to the owner of a local, private company about buying it. After doing your research on the prospects of the business, you both agree on a price of $1 million (the value of the company) and you say “great, give me a few days to think about it and make sure I have the money ready to go.” You come back next week and the owner says “The price went up – it will now cost you $1,050,000 (a 5% increase).” Would you say “Oh boy, the price is going up! I better buy now before it goes up even more!”? Probably not… You’d probably say something more like “What!? We just agreed to $1 million last week. Why the increase? I’m not paying an extra $50,000.”
Notice how crazy it seems now to buy stocks after they’ve been rising in price? The difference is viewing a stock as a security that will hopefully go up vs. viewing it as buying an entire company and thinking about what that company is worth based on the business’s financials and outlook. This is how value investors like Warren Buffett think about investing. I’ll admit it’s easy for Warren Buffett to think about companies like this because he does buy the entire company, but it’s pretty much exactly the same for all of us. We’re just taking the value of the whole company and buying a percentage of it. The value divided by the number of shares outstanding equals the price per share.
Admittedly, the tough part is coming up with a value that you think the company is worth. There are many different approaches to valuing a company but we’ll leave that for future blog posts. Just keep this example in mind next time you feel the need to chase a stock and buy it after it’s been rising. I say this now because most of the major stock indexes continue to make new all-time highs and I’ve definitely been more of a seller lately than buyer.
Portfolio Update
Another company we own stock in is being taken over. This morning it was announced that UnitedHealth Group is buying Catamaran Corp (CTRX) for $12.8 billion in cash, expected to close in the fourth quarter of this year. We’ve been owners of Catamaran the past two years or so. The stock was in a major consolidation phase after big gains in 2011 and 2012 but I thought it was undervalued and kept buying on dips. We were rewarded today with a nice 24% rise above Friday’s closing price.
The stock is trading about 2.5% below the takeover price of $61.50 but I usually don’t like to wait around another 6 months for the deal to close since these things can fall apart. Also, since it will be settled in cash (no stock of the new company) it’s simply a question of selling now or later. I sold the stock for everyone that owned it in tax-deferred accounts (IRA’s, Roth IRA’s, etc.) and sold shares owned at long-term capital gains in all taxable accounts. I’ll be selling the remaining shares for a handful of clients over the coming weeks after the shares pass the 1-year mark to make them long-term capital gains as well.
I hope everyone has a great week!
-Nick