How Markets Set Prices, Part III

We began this series by showing how the market for betting on sporting events sets prices through the metric known as the point spread. We ended Part I by explaining that in economic terms, a market in which it is difficult to persistently exploit mispricings after the expenses of the effort is called an efficient market. In Part II, we also showed that the sports betting market was highly efficient. We now turn to demonstrating that valuation metrics for stocks are the equivalent of the point spread.

Battle of the Discount Retailers

As an investor, you are faced with the decision to purchase the shares of either Walmart (WMT) or Kohl’s (KSS). Walmart is generally considered to be one of the top retailers. It has great management, the best store locations, an outstanding inventory management system, a strong balance sheet, a strong online business, etc. Because of its great prospects, Walmart is considered a growth stock. Kohl’s, on the other hand, is a relatively weaker company. It has lower return on assets, lower return on equity, and a weaker balance sheet with a higher debt-to-equity ratio. Because of its relatively weaker prospects, Kohl’s is considered a value stock. Just as it was easy to identify the better team in Duke versus Army (in our running example from this series), it is easy to identify the better company when faced with choosing between Walmart and Kohl’s. Most individuals faced with having to buy one or the other would not even have to think about the decision – they would rush to buy Walmart. But is that the right choice?

As we saw in the sports betting story, being able to identify the better team did not help us make the decision as to which one was the better bet. Let’s see if the ability to identify the better company helps us make an investment decision. Before reading on, think about which company is Duke and which one is Army.

Imagine that both Walmart and Kohl’s have earnings of $1 per share. That is certainly possible even though Walmart generates far more profits. Walmart might have 1 billion shares outstanding, and Kohl’s might only have 100 million shares outstanding. Now imagine a world where Walmart and Kohl’s both traded at a price of $10. Which stock would you buy in that world? Clearly, you would rush to buy Walmart. The problem is that Walmart is Duke and Kohl’s is Army. And Walmart and Kohl’s trading at the same price is analogous to the zero point spread set by the bookies in the Duke versus Army game. Hell will freeze over before either happens. Just as sports fans would rush in to bet on Duke, driving up the point spread until the odds of winning the bet were equal, investors would drive up the price of Walmart relative to the price of Kohl’s until the risk-adjusted expected returns from investing in either stock were equal. Let’s see how that might look in terms of prices for the shares of Walmart and Kohl’s.

Being a weaker company with relatively poorer prospects, investors might be willing to pay just 10 times earnings for the stock of Kohl’s. Thus, with earnings of $1 per share, the stock would trade at $10. The company might also have a book value of $10 per share. Thus, the book-to-market (BtM) ratio would be 1 ($10 book value divided by its $10 market price). On the other hand, Walmart is not only a safer investment due to its stronger balance sheet, but it has stronger growth prospects. Thus, investors might be willing to pay 20 times earnings for Walmart stock. With $1 per share in earnings, the stock would trade at $20. The company might also have a book value of just $4 per share. Thus, the BtM would be 0.2 ($4 book value divided by its $20 market price). Walmart is trading at a price-to-earnings (P/E) ratio that is twice that of the P/E ratio of Kohl’s. It is also trading at a BtM that is only one-fifth that of Kohl’s. Walmart is Duke having to give Army 40 points to make Army an equally good bet.

The Financial Equivalent of the Point Spread

The P/E and the BtM ratios act just like point spreads. The only difference is that instead of having to give away a lot of points to bet on a great team to win, you have to pay a higher price relative to earnings and book value for a great glamour company than for a distressed value company. If you bet on the underdog (Army), you get the point spread in your favor. Similarly, if you invest in a value company (Kohl’s), you pay a low price relative to earnings and book value. The great sports team (Duke) has to overcome large point spreads to win the bet. The great company (Walmart) has to overcome the high price you pay in order to produce above-market returns. In gambling, the middlemen who always win as long as you play are the bookies. In investing, the middlemen who always win as long as you play (try to pick mutual funds or stocks that will outperform) are the active fund managers and the stockbrokers.

Let’s again consider the analogy between sports betting and investing in stocks. First, in sports betting, sometimes it is easy to identify the better team (Duke versus Army) and sometimes it is more difficult (Duke versus North Carolina). The same is true of stocks. It is easy to identify which company, Walmart or Kohl’s, is the superior one. On the other hand, it is harder when our choices are Walmart and Costco (COST).

Second, in sports betting, we don’t have to bet on all the games. We can choose to bet only on the games in which we can easily identify the better team. Similarly, we don’t have to invest in all stocks. We can choose to invest only in the stocks of the superior companies.

Third, in sports, the problem with betting on the good teams is that the rest of the market also knows they are superior, and you have to give away lots of points. The point spread eliminates any advantage gained by betting on the superior team. The same is true with investing. The price you have to pay for investing in superior companies is a higher P/E ratio (offsetting the more rapid growth in earnings that are expected) and a lower BtM (offsetting the lesser risk of the greater company). In sports, the pricing mechanism in place would make betting on either team an equally good bet. The same applies for investing: Either stock would make an equally good investment. Thus, while being able to identify the better team (company) is a necessary condition of success, it is not a sufficient one.

Fourth, when a bet is placed between friends, it is a zero-sum game. However, when the bet is placed with a bookie, the game becomes a negative-sum one because of the costs involved (the bookies win). Since we cannot trade stocks between friends, trading stocks must be a negative-sum game because of the costs involved (the market makers earn the bid-offer spread, the stockbrokers charge commissions, the active managers charge large fees, and Uncle Sam collects taxes).

Fifth, in the world of sports betting, it should be relatively easy to exploit mispricing because amateurs are the competition setting prices. In the world of investing, the competition is tougher because it is mostly large institutional investors, not amateurs like you and me.

Sixth, in sports betting, it is legal to trade on inside information. Yet, even with such an advantage, it is likely you don’t know anyone who has become rich by exploiting this type of knowledge. On the other hand, it is illegal to trade on inside information regarding stocks. Thus, it must be even more difficult to win that game.

The evidence from the world of investing supports the logic of the above arguments. Study after study demonstrates that the majority of both individual and institutional investors who attempt to beat the market by either picking stocks or timing the market fail miserably, and do so with great persistence. All one has to do is read the semiannual SPIVA reports published by Standard & Poor’s. In Part IV, we will review the evidence.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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