I cringe every time I read an article by a value investor that says something like, “You should buy stocks that are on sale, just like you buy [pick your consumer item] on sale.” In the financial markets that can be dangerous.
In a great essay titled, I Want to Buy Losers, Clay Allen of Market Dynamics discusses the problems with this analogy. [You've got to read the whole essay to really appreciate it.]
Many investors buy stocks the way many consumers buy paper towels or any other staple. They are attracted to a sale and loss leaders are a proven method for a retailer to increase the traffic in their store. The value of the item is well known and a sale price gets the attention of potential buyers.
Mr. Allen explains brilliantly and succinctly why this analogy is bunk:
But stocks are not like paper towels. Paper towels can be used to satisfy a need and this is what gives the item its value to the consumer. What gives a stock its value? A stock cannot be used to satisfy a need or accomplish a task. The value of a stock is derived from the financial performance of the company, either actual or expected. The fact that the stock is down in price is usually a sure sign that the financial performance of the company is declining.
…if the value of the stock was constant, then buying bargain stocks would be the correct way to invest in stocks. But stock values are constantly changing as business conditions change for the company and the expectations of investors change.
All in all, it seems to me that relative strength often more closely reflects what the expectations of investors are–and the expectations are what counts. Let’s face it: strong stocks are usually strong because business conditions or fundamentals are good, and weak stocks are usually weak for a reason.
—-this article was originally published 3/26/2010. In the intervening years, my friend Clay Allen has passed away. His wisdom, however, is still with us. His point that a stock is not a paper towel is absolutely correct. The only purpose of an equity investment is to make money.