Someone asked me the other day if he should sell his stock after a significant run up in the share price in a very short space of time. I get asked that a lot. My initial response is not to ask them what they bought but, instead, why they bought the stock in the first place. The answer to the “why” is always more telling than the “what”. The usual reply is because they thought that the stock was cheap. So what, I ask, has transpired between the time they bought the stock and now? Generally, all that has happened…
Someone asked me the other day if he should sell his stock after a significant run up in the share price in a very short space of time.
I get asked that a lot.
My initial response is not to ask them what they bought but, instead, why they bought the stock in the first place.
The answer to the “why” is always more telling than the “what”.
The usual reply is because they thought that the stock was cheap.
So what, I ask, has transpired between the time they bought the stock and now?
Generally, all that has happened is that the share is now trading at a higher price.
But what about the valuation?
Has the valuation changed significantly? If all that has happened is, say, a doubling of the share price and nothing else, then all we can say it is that the share is now twice as expensive as before.
But that still doesn’t quite tell the whole story.
A share can be more expensive but it might still be cheap. That might seem illogical but it isn’t.
It might, for instance, still be valued at a significant discount to its book value. In which case, it might not be expensive at all.
It might have a yield that is still higher than its peers and the market average. The dividend might even be very well covered by profits and cash flow.
So, again, we can probably conclude that the stock is not overly expensive.
Price is what you pay
Admittedly the price might have doubled. But the share might still be attractive, when compared to its profits or cash flow. In which case, we might conclude that it is not really that expensive at all.
The share might also be cheap when compared to, say, investments in other asset classes, such as bonds and cash.
So again, we might conclude that, whilst the share has risen in price, it is still not demanding in terms of its valuation.
Warren Buffett once said: “Price is what you pay, value is what you get.”
There is a world of difference between the price of a share and its value. Once you appreciate the difference, I can guarantee that you will never look at a share in quite the same way, ever again.
Double your money
At our Stock Advisor service we try to help you discern the difference between price and value. Let me give you a quick example.
At the turn of the Millennium I bought some shares in a consumer goods company at around £5 a pop.
The shares did remarkably well. They doubled in about 12 months.
That could easily have been a good time to sell. After all, a stock market investment, on average, takes about nine years to double. But my share did it in about a-tenth of the time.
So logic would suggest that I should have sold my holdings.
But guess what?
The share today cost around £50 a piece. In other words, they have gone up ten-fold. And that doesn’t even include the re-invested dividends.
So what the trick?
There is no trick. There are no short cuts. There are no secret formulas.
Point is, we should never become too fixated on the price that we have paid for a stock.
What’s more, we should never rush, impulsively, to grab a small profit.
Instead we should take some time out to monitor the story behind the company. Try and figure out what the company could look like in five, 10 or even 20 years from now.
If our reasoning leads us to conclude that the company could be significantly bigger in the future than today, then hang onto the share. We may even decide to buy more.
One day we might find that the company’s per-share earnings in a single year are more than the price that we paid for the stock.
That is when we know that we have a truly remarkable investment in our portfolios. Those are the kind of shares that we at Stock Advisor are looking for every day.
Take a look at what I mean here.
A version of this article first appeared in Take Stock Singapore. Click here now for your FREE subscription to Take Stock – Singapore, The Motley Fool’s free investing newsletter.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.