It’s Priced In!

One of the biggest mistakes I see novice investors make is buying a stock based on the fact that a company is doing something “special”. This includes introducing a new product, adding a “rock star” manager to its management team, or simply growing quickly. None of these things makes a stock particularly appealing, and that’s a hard fact to swallow. The reason is simple, you will find out about this “special” thing that’s happening at the same time or, more likely, after most of the rest of the market has found out. Therefore, the price of the stock will adjust to reflect the markets expectation of the impact of the news. In other words, whatever “special” thing you think the company is doing is already priced into the current stock price. This “special” thing is no longer a bonus for investors, but an expectation that if not achieved will actually hurt the stock price.

To illustrate, let’s take the example of Wal-Mart Stores. In 2000, Wal-Mart had annual sales of $191 Billion and earnings of $1.40/share. By 2010 sales had more than doubled to $400 Billion and earnings tripled to $4.18/share. Yet Wal-Mart stock closed at about $41/share in 2000 and $48/share in 2010, including the affect of dividends. How is it possible for a company to double sales and triple earnings, yet have it’s stock remain almost unchanged? The answer is that the growth was expected and, had it not occurred, the stock price would have actually gone down. In other words, those buying Wal-Mart in 2000 because they expected the company to grow were making an investment decision based on a false premise, the premise that Wal-Mart stock would rise if the company grew. The correct premise would be to buy Wal-Mart stock because they expect the company to grow more than what the rest of what the market expects. Or perhaps not buy Wal-Mart at all if they think that growth expectations are overblown (in hindsight, the correct decision).

WMT Graph

When you’re tempted to buy a stock based on something “special” you see ask yourself what you know that others don’t. If it’s a product or industry that your very familiar with (more familiar than 99% of other investors) then perhaps your hunch can pay off. If not, then you should accept the fact that you have no advantage over other investors and that the investment holds no special appeal.