Why Studying Businesses Is of Limited Use in the Stock Market

The history of stock markets is full of investment wizards who picked wonderful stocks by studying their underlying businesses: what a company makes, what its market is, who its competitors are, where the industry is headed, how solid its financial strength is, and so on. True, such an approach can generate rewards, but what about the link between a real business and its stock? When you buy a company's stock, you are buying a piece in its business, but does the stock really mimic the business?

The unfortunate truth remains that a stock may not always follow its underlying business. Though the correlation between a business's performance and its stock performance is positive, there are a plethora of other factors that impact the stock. Since you buy the stock and not the real business itself, you become vulnerable to the eccentricities of the stock market.

Take for instance the market sentiment. Even if you have picked a good stock, it may not go anywhere (or rather go down) because of the sentiment prevailing in the market, even when the underlying business is doing just fine. Consider this fact: A stock starts racing in sheer optimism even before the underlying business has turned around. Further, talks of a buyback, a stake sale, a merger, etc., all drive stock prices, when the underlying business hasn't shown any improvement. A dilution in equity hits the stock, while the business remains unharmed.

You may want to take comfort in the stock-market adage that over the long term, a stock traces the course of its underlying business. And you are right. But over this “long” term many things will have changed for the business itself—for the worse. So, you can't really rely on the long-term theory. What's the message then? In the stock market, while it pays to keep an eye on the underlying business, that's not the only way to make money. What will work is a well-crafted strategy based on what moves stock prices. The strategy, what I call a model, will clearly tell you what and when to buy, how to track progress, and when to sell and take your profits home. 

Don't Disregard Your Profits

The one aspect of stock investing which surprises me the most is that money loses its significance in the stock market. What I mean by this is that investors behave differently toward money in the stock market than they do in their daily lives. In daily life, many of us have a cautious approach toward money (which is good); we tend to think twice before spending it. And surely we don't want to lose it.

In the stock market, investors frequently show a complete disregard to profits. The other day someone told me that she wasn't selling a stock that was showing a huge gain just because she didn't need the money. Another “fundamental” analyst said he preferred to keep stocks for the long term, even if it meant losing on the profits the market was offering him. Further, one bright fellow stayed invested because he didn't know any other stock to invest in. I bet the same people would behave differently outside the stock market.

I am not saying that just because your stock shows some profit, you should sell out. Selling a stock should follow a strategy, but it must be sold at some point because you make no money unless you sell it. Many times stocks become expensive in terms of valuations and it is prudent to sell them rather than blindly follow “long-term” investing principles. It's indeed wise to take money out of a stock and wait on the sidelines rather than say that you don't need the money or you don't know any other stock to invest in. You can always act later, but your stock-market profits may not always be there. The bear can quickly gobble them, while you preen yourself for being faithful to the investing principles given by your investment icon.

The profit that the market offers is real money. If you spend it, it will work in the same manner as your hard-earned money does. There's no difference. The need is to give your profits the top priority and do anything to protect them, even if it entails breaking any cherished principles of investment science.