Many long-term investors aim to satisfy the “buy low, sell high” standard. The starting point evaluates an investment’s current value. This is the general approach taken by the traditional academic appeal to “intrinsic value,” a concept that cornerstones Graham and Dodd’s classic model for security analysis.[i]
Unfortunately, some investors skip many components of the discipline, and even experienced investors make a fatal error: They judge high or low compared to historical prices; but high and low are necessarily forward-looking.
The fatal error is partly attributable to the media’s compulsion to report analysts’ forecasts of the economy and markets. Unfortunately for investors who act on these forecasts, analyst opinions often fail to add value:
- Stock market analysts’ recommendations grossly favor buying over selling.[ii]
- Analysts’ stock recommendation changes correlate with recent stock prices: Positive change associates with an average 5% stock price increase and negative change associates with an average 11% stock price decrease.[iii]
- Stock market analyst recommendations reveal tendencies to “follow the herd.”[iv]
The misinformation stock analysts produce should come as no surprise because investment banking and broker-dealer firms employ many analysts…these are the firms that profit from trading volume.[v]
A Classic Buy Low Failure: Cisco (CSCO)
The retail investment industry’s emphasis on historical prices partly explains the fatal error. Figure 1 illustrates closing prices of Cisco (CSCO) during 2000, the year the “dot com” bubble burst.
CSCO was (and is) a leading communications and technology firm in 2000. Yet, in less than a year during 2000, CSCO’s stock lost half its value. Many investors around the end of 2000, familiar with CSCO’s sound financials and its technological and market dominance, figured CSCO’s stock price was low.
Next, look at Figure 2.
This graph displays closing CSCO prices from 2000 through 2017. Figure 1 ended at about where the red arrow points in Figure 2. Investors who decided CSCO’s 2000 year-end price was low compared to earlier prices were surely right. But “low” does not equal “bottom.”
CSCO ended 2000 at $38.25 per share. But the stock did not fall to its lowest close, $8.60, until October 8, 2002, 21 months later. An investor who decided to buy the stock at the end of 2000 would have lost 77.5% before the stock reached its bottom. The stock price did not recover to this year-end 2000 “low” price until late 2017, about 15 years later.
Nobody can argue with the principle. Investors are better off buying low and selling high. However, execution of the principle is often flawed because investors’ reference point for “high” or “low” is the current price compared to a past price. The past is the wrong reference point.
The correct reference point is future prices. But here lies the rub: Investors and stock analysts fail to consistently evaluate correctly whether current prices are high or low compared to future prices.
In our opinion, here’s the takeaway:
- Reject investment advice based on historical prices.
- Remain skeptical about analyst forecasts.
- Only use (if at all) “buy low, sell high” as a retrospective assessment of performance, not as a guide for timing purchases and sales.
Buying low and selling high might be suitable for speculators, but not for investors seeking to grow and preserve wealth.
[I] Graham, B., Dodd, D. L., Cottle, S., Murray, R. F., & Block, F. E. (1988). Graham and Dodd’s security analysis. New York: McGraw-Hill. Benjamin Graham and David Dodd published the original version of Security Analysis in 1934. The Graham and Dodd discipline and methods prevail today for security analysis and for value investors.
[ii] Barber, B., Lehavy, R., McNichols, M., and Trueman, B. (2001). Can investors profit from the prophets? Security analyst recommendations and stock returns. Journal of Finance, 56(2), 531-563.
[iii] Womack, K.L. (1996). Do brokerage analysts’ recommendations have investment value? Journal of Finance, 51(1), 137-167.
[iv] Jegadeesh, N., & Kim, W. (2009). Do analysts herd? An analysis of recommendations and market reactions. The Review of Financial Studies, 23(2), 901-937.
[v]The Securities and Exchange Commission offers a useful perspective on analyst recommendations including rule changes aimed at helping investors recognize sources of bias. https://www.sec.gov/tm/reportspubs/investor-publications/investorpubsanalystshtm.html
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