HH A Universal Theory Of Stock Market Investing

This piece attempts to encapsulate my conclusions after several years of investigating stock-market conundrums. It is, in essence, a grand unified theory of stock market investing. It is in ten succinct points. After laying out each point, I will offer some further thoughts and elucidations, and link to my previous articles on the subject in question.

Tenet 1: The price of a stock is completely determined by investor expectations.

Because a stock’s price is determined entirely by the willingness of investors to buy or sell it, it is exactly equal to the aggregate of investors’ confidence that the price will rise or fall in the future plus the expectations of dividends to be received and of the price of a potential acquisition. This investor confidence can be influenced by any number of things, from a Twitter recommendation to a careful discounted-cash-flow analysis; these things are called “factors,” and they are almost infinite in number. Some of them are based on rigorous accounting principles, some are based on investor beliefs (many of them incorrect), and a few seem to have no basis whatsoever.

Because the price of a stock is completely a function of investor behavior, stocks cannot be said to be “mispriced,” and there is no such thing as “luck” or “randomness” in the stock market. Many stock-market theorists try to separate the price of a stock into two components: value and noise. Others hold to the Efficient Market Hypothesis, that the price of a stock fully reflects all available information about it. But, as George Soros puts it, “The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong.” Or, as I wrote here, “The stock market is a badly oiled contraption, stuck together with cellophane tape and staples, and full of rust spots and leaks and broken parts. Its pricing mechanism is terrible and inefficient, and it runs a crazy, circuitous, and illogical course. Why? Because many of the price movements in stocks are based on the quirks of human behavior rather than on sound financial sense.”

Tenet 2: Stock prices have only a very tenuous relationship to a company’s intrinsic value (if such a thing even exists).

Because a stock’s price is determined by millions of different investors’ confidence levels, most of which are the result of an almost infinite number of different factors, the complexity of the system that sets stock prices is beyond rational calculation. It is therefore impossible to rationally assign a “value” or a “target price” to a stock. When people talk about the “intrinsic value” of a stock, they are looking at the “intrinsic value” of the company of which the stock is technically a portion, and base that value on the company’s earnings, free cash flow, dividend payout, book value, enterprise value, and/or similar numbers. But while this may make some sense for a privately held company, once a company goes public, the equity portion of it becomes more or less unmoored from its intrinsic value and its value instead becomes whatever investors as an aggregate think it should be.

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Disclosure: My top ten holdings right now: ZIXI, ARC, GSB, CTEK, KTCC, PERI, HALL, OSIR, CRNT, NTWK.

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