How Stock Market Operates (Part II)

When for a long period of time a particular stock has been selling in a certain price range, say from a low of 25 to a high of 30, there is almost an irresistible tendency to attribute true value to this price range. Giving in to this urge can be very costly. This is because the genuinely worthwhile profits in stock investing come from holding the surprisingly large number of stocks that have gone up many times from its original costs. The only true test of whether a stock is "cheap" or "expensive" is not its current price in relation to some former price, but whether future cashflows realized are significantly more or less favorable than the current appraisal of that stock.

Taking from a Graham parable, the market is not a weighing machine on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather it is more like a voting machine, whereon countless individuals register their choices which are the product partly of reason and partly of emotion.

This is an important principle because despite the laws and regulations in place today, pools of manipulation of shares still exist. The methods of all these pools are fundamentally similar. The members would sell stocks back and forth amongst themselves at gradually rising or constant prices. All this activity on the stock price would attract attention of others who would then start buying shares and take a portion of the shares off these pools' hands at still higher prices. These highly skilled manipulators were quite experienced and able practitioners of this rather questionable art.

The conservative investor must be aware of the nature of the current appraisal by the financial community of any industry he is interested in. Determining whether at that moment the price of a stock is attractive, unattractive or somewhere in between depends on most part how far off these appraisals deviate from reality. However, to the extent that the general level of stock prices affects the total picture, it also depends somewhat on correctly estimating coming changes in purely financial factors, of which interest rates are by far the most important.

Allow me to close this chapter with a simple summary, prices have only one significant meaning for the investor. They provide him with an opportunity to buy wisely when prices fall sharply below its calculated intrinsic value. Throughout the investment process, he will be better off ignoring market prices and pay attention to his calculated range of future cashflows lest he gets anchored by some misleading price conditioned into his mental memory.