MARKET RULES: BUY LOW AND SELL HIGH

Searching the Universe for Investment Theories

In the earliest days of Wall Street's Robber Barron Era, Rothschilds was said to have uttered the immortal words: 'Buy that which is cheap and sell that which is dear.' Charles Dow, one of the founding fathers of Dow Jones & Company (of Dow Index fame) and the first editor of The Wall Street Journal, might have put it this way: 'Buy a stock that has value in earnings and value in the dividend paid out. As this stock rises in price and the value of earnings and dividends declines, sell the stock.'

The idea of 'buy low, sell high' is as old as trading ownership of properties. It is the basis of all business. Buy a property at one price and sell it at a higher price. The difference between the buy and sell price is your profit (or loss). To make a profit is the reason to buy and the reason to sell. The lower you can buy, and the higher you can sell, the greater and more sure your eventual profit will be.

Ironically, 'buy low, sell high' is an old market axiom that most people clearly understand, but forever have trouble implementing. The average stock goes unnoticed at a low price, sometimes for years, as its fundamental performance gradually improves. Only when a prominent analyst or media journalist features the stock does it draw a bit of attention from very savvy retail investors. This makes the price move higher. The price rise itself attracts the attention of less savvy retail investors and possibly institutional investors, who buy and push the price even higher. This much higher price catches the attention of the least savvy retail investors, who finally decide to buy and push the price to perhaps ridiculous and assuredly dangerous levels. At this peak price the institutions sell out for a small profit, and the price falls. The falling price scares the less savvy investors, who sell and push the price even lower. At some very low price only the few very savvy investors begin to buy again... and on goes the process, completely counter to our 'buy low, sell high' theory.

Buy low, sell high becomes a contrarian strategy, because buying stocks that are priced low (and usually low PE ratios and low P/BV) means buying that which is shunned by most other investors--out of favor stocks, stocks in the down portion of their business cycles, and stocks not drawing much attention from media and analysts. You will be buying contrary to the crowd, which is always psychologically demanding. It is a very strange phenomenon, but most of us prefer to 'buy high, sell low'... buying what others are buying (those stocks perceived to be 'good', 'promising' and 'exciting') and selling stocks that fall to low prices fearing they will fall lower and lower and wipe out our portfolio value (assuming others know more than we do in dumping the shares).

During bull markets there is a common corrollary to this market theory that arises called 'buy high, sell higher'. It is also called the 'Greater Fool Theory'... buying at an obviously high price in the hope that an even greater fool comes along and buys from you at some even higher (ridiculous) price. There were an almost endless supply of greater fools during the Great Bubble in 1999, but they are hard to find today... and many of their favorite fool stocks in 1999 are traded at less than 10% of their peak value today. It is a most dangerous and speculative activity to buy shares of a business well above the intrinsic value of the underlying firm.

So, how can you better implement the 'buy low, sell high' theory? For starters, perfect a method of determining the true value of any business. Once you have this foundation value, you can begin to make an independent assessment of what is 'high' and what is 'low' without depending on the market to answer that question. Next, you need to develop a discipline in order to only buy stocks at times when the value is well below your calculated intrinsic value (even when few others agree with you), and sell them when they rise far above your intrinsic value (even when everyone else remains very excited about the company's prospects). It won't be easy, and you might need to develop an entirely new 'comfort zone'... but it will be safe and probably very profitable!

Sage@wallstraits.com