Inexperienced investors often confuse the share price of a company with its value. Let us understand this with an illustration. If an investor is given an option to buy either a stock priced at ₹ 10 or stock priced at ₹ 10,000, the possibility of such an investor buying the low-priced stock is quite high. As such, the typical retail investor suffers from a misconception that higher the price, lower are the chances of making serious money from a stock without taking into account other factors like valuation parameters such as price to earnings multiple, price to book value or dividend yield which is a serious fallacy.
There are several surveys in the market which have made it clear that individual investors continue to fancy low-priced stocks. The hope that fortunes would turn and a low-priced stock would become a multi-bagger makes many cling on to low-priced stocks. This hope is not baseless. Investors substantiate this hope with stories of ample gain in share price of a company which was available at extremely cheap price. Such stories regularly feature in the media. For instance, if you had bought Satyam Computers when its price was quoting in single digit when the scam broke out and held on to it, you had a multi-bagger. But most investors forget that for every such success story there are a hundred stories wherein the price of low-priced stocks has been stagnant.
A detailed study by the investment team at Alphaniti on stocks listed on the NSE also underscores the fact that the odds are stacked against investors to strike it big by investing in low-priced stocks. For e.g. in the past 5 and half years, returns from companies with share prices trading up to ₹ 50 grew at Compounded Annual Growth Rate (CAGR) of 6.6% over the same period. This is not all – Among this vast universe of companies, only 44% of such companies ended up giving positive returns. This shows that individual investors are not well-equipped to gauge multi-bagger potential of a low-priced stock. To deal with this, investors should follow a basic approach which is to go beyond the preference for low-priced stocks.
An important question investors need to ask themselves is: Why does a stock quote a particular price? A stock priced low is typically an outcome of lack of interest of serious investors. Institutional investors and analysts avoid buying stocks which do not have remarkable past or good earnings’ prospects. Share price of such companies typically follow the law of gravity and gyrate towards zero. Stocks quoting at low prices after a prolonged downtrend have reached those levels for a good reason.
Conversely, what are the odds of sticking to investing in Companies with high share prices? If the share price of a company is high, for starters, one can assume that there would very likely be some sound investment argument behind it. This could be due to various factors such as past performance, demand in the sector a company operates, balance sheet strength, and earnings’ prospects of a company vis-à-vis its peers. These factors trigger adequate interest of institutional investors and analysts. In a study undertaken by Alphaniti’s investment team, we find that returns of companies whose share price traded above ₹ 1500 in fact have grown at CAGR of 9% over the past 5 & half years and interestingly, among these companies, 57% gave positive returns. This shows that the percentage of companies outperforming their peers in high-priced stocks’ universe is higher than that in low-priced stocks’ universe.
This outperformance is also reflected in terms of indices. During the period of the above study, returns from Nifty 500 index has been a CAGR of just 5.9%. In the same period, the returns of the Nifty SmallCap 250 stood at an unimpressive 1% CAGR!
To sum up, it is important to understand the factors which determine the value of a company. Nuanced understanding of a company’s relative operational strengths and demand for its goods or services among others determines how valuable the company is in the eyes of astute investors. It has been observed that because of these factors a mid-sized company grows into a large-sized company. This approach will help investors in making sound investment decisions. However, investors must not forget this street’s wisdom: Even though buying stocks which are high-priced does not provide sure-shot investment success, avoiding low-priced stocks, generally, saves you from a never-ending falling value-trap.