Friday, 22 April 2016

Why Studying Businesses Is of Limited Use in the Stock Market

The history of stock markets is full of investment wizards who picked wonderful stocks by studying their underlying businesses: what a company makes, what its market is, who its competitors are, where the industry is headed, how solid its financial strength is, and so on. True, such an approach can generate rewards, but what about the link between a real business and its stock? When you buy a company's stock, you are buying a piece in its business, but does the stock really mimic the business?

The unfortunate truth remains that a stock may not always follow its underlying business. Though the correlation between a business's performance and its stock performance is positive, there are a plethora of other factors that impact the stock. Since you buy the stock and not the real business itself, you become vulnerable to the eccentricities of the stock market.

Take for instance the market sentiment. Even if you have picked a good stock, it may not go anywhere (or rather go down) because of the sentiment prevailing in the market, even when the underlying business is doing just fine. Consider this fact: A stock starts racing in sheer optimism even before the underlying business has turned around. Further, talks of a buyback, a stake sale, a merger, etc., all drive stock prices, when the underlying business hasn't shown any improvement. A dilution in equity hits the stock, while the business remains unharmed.

You may want to take comfort in the stock-market adage that over the long term, a stock traces the course of its underlying business. And you are right. But over this “long” term many things will have changed for the business itself—for the worse. So, you can't really rely on the long-term theory. What's the message then? In the stock market, while it pays to keep an eye on the underlying business, that's not the only way to make money. What will work is a well-crafted strategy based on what moves stock prices. The strategy, what I call a model, will clearly tell you what and when to buy, how to track progress, and when to sell and take your profits home. 

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