Investing III - Lesson still being learned

In my last post I spent a certain amount of time talking about stock fundamentals, notably Price/Book. I also disclosed that a couple of the stocks I own just now have a P/B of less than 1. Today's follow-up post, then, addresses the question of how it is possible for a stock to have a P/B of less than 1.

It comes down to this: Speculation.

The stock market, at its most fundamental level, is not about assigning value to companies and stocks as they exist today through the invisible hand of the marketplace. If it was then every company would have a P/B of roughly 1.

No, instead the stock market is really about assigning value to companies and stocks as they MIGHT exist TOMORROW through the invisible hand of the marketplace.

When you buy a stock today that you think will be worth more in the future, then your action of buying the stock will probably cause that stock's value to go up, slightly. Especially if a lot of other people come to the same conclusion at the same time and you're all trying to buy the same stock. As you bid against each other the stock rises in price, until you collectively decide what the maximum is that you're willing to pay today for a stock that, hopefully, will still be worth more tomorrow.

It's the same when you sell. If you decide today that a stock you own has reached its maximum value (or its maximum value for the near future, anyway) then you try to sell it. And your action of selling the stock will probably cause that stock's value to go down, slightly. And again, if a lot of other people come to the same conclusion at the same time and you're all trying to sell the same stock, then as you bid against each other the stock lowers in price, until you collectively decide what the minimum is that you're willing to accept today for a stock that may not be worth as much tomorrow.

It's a lot like lemmings, sometimes. The wisdom of crowds can be replaced with the madness of crowds very quickly.

What does this have to do with Price/Book? Again, it's speculation. Basically, there are stocks out there that buyers and sellers speculate will be worth significantly less or significantly more tomorrow than they are today. And when this happens the P/B begins to drift significantly away from 1. Effectively, they're speculating that the Book value is going to change - that the company is going to have a net worth Tomorrow that is greater or less than its net worth today.

It's still odd to see the P/B drift too far away from 1, but it happens.

How often does this happen? Well, it depends on the industry.

Cleantech stocks are all the buzz right now, so it's not uncommon to see them with a P/B of 5 or more. It's the same with internet stocks - last decade's buzz - but to a lesser degree. Still, in both cases investors seem to think the net worth is going to go up. A lot.

What about more mainstream stocks? Well, let's look at Dow Jones.

The Dow Jones Composite Index is comprised of 65 stocks. I've checked the fundamentals of every 5th of those 65 stocks in order to come up with 13 representative (hopefully) P/B ratios. Of those 13 stocks, one of them had a P/B of more than 5. Another had a P/B of less than 1. The other eleven, obviously, each had a P/B between 1 and 5.

Let's break it down further:

P/B between 0 and 1: 1
P/B between 1 and 2: 3
P/B between 2 and 3: 4
P/B between 3 and 4: 2
P/B between 4 and 5: 2
P/B between 5 and 6: 0
P/B between 6 and 7: 1

I think I can safely say in a bell-curve kinda way that stocks with a P/B of less than 1 or more than 5 are outliers.

I'm still trying to figure out how to use this knowledge. As the title suggests, this is a lesson still being learned. In my previous post, though, I've shown one application for this knowledge: Showing when a stock is over-valued.

Can it be used the other way? Can the P/B be used to show when a stock is under-valued?

And if a stock is under-valued, shouldn't one buy it?

Maybe not. I'm in the midst of finding out, though.

Operating on the theory that an under-valued stock is maybe worth buying, I have purchased a few shares in a couple of stocks with P/B ratios of less than 1. One has a P/B of 0.86 and the other has a P/B of 0.21.

If these stocks are simply under-valued then one day - hopefully a day in the near future - their value will rise until their P/B approaches 1. When that happens I will stand to make a profit should I choose to sell.

The problem is this: Maybe they're under-valued for a reason. And if they're under-valued for a reason then they very well may continue to decline in value.

That being said, I'm sticking to my investment rules. I'm not investing money I can't afford to lose, I've looked at the fundamentals (Both of the stocks in question have positive balance sheets and more cash than debt), and I'm reasonably diversified (These aren't the only stocks I own).

If these stocks go the way of the dodo then I'll still have some other investments, and I'll have learned something. The fundamentals seem to indicate that these stocks are not on the brink of extinction, though.

The worry is that the other people trading these stocks know more than I do - which is almost certainly the case. These stocks are under-valued for a reason, probably. They can't have been driven down in price purely by speculation.

The madness of crowds is a strange thing, though. Maybe my stocks have been dragged down when they shouldn't have been.

Whatever the outcome, I'll let you know.