Part Two: Supply and Demand

The 5 Major Forces Affecting Your Investment Performance

by: Ben Crowley

1.Population

2.Supply and Demand

3.Asset Allocation

4.Relative Strength

5.Timing 

Part 2: Supply and Demand

Econ 101 class was at 8:15 AM on Tuesday and Thursday and at the time, I wanted to be anywhere else in the world but in that classroom.  I had a great professor but the content of the material was brutal and boring.  I mean, who in their right mind wants to hear about Nash Game Theory and pricing strategies of an oligopoly first thing in the morning?  Ugh.  Because I am sensitive to the boredom levels of my readers I will do my best to keep it short and concise and get right to the point.  

You don’t have to be an economist to be a good investor but you should know that the price, or value, of all things is primarily shaped by the relationship between the availability of the thing (supply) and the willingness of a person to pay for that thing(demand).

Whether you are talking about a rare baseball card, common stock or a barrel of oil, the price is determined by how much someone is willing to pay for it.  Usually if you introduce more of the item into the known supply, the price will fall.  Conversely, if there is a hot item like a ‘Tickle Me Elmo’ doll, and my kid “HAS TO HAVE IT”, I will typically pay more for it.  This is the law of Supply and Demand at work.

Most people do not consider this force when it comes to investing, but it is most definitely in play.  Supply and Demand rears its head on both the Macro and Micro levels of investing and you have to consider it before pulling the trigger on an investment.

On the Macro level, in part one, I discussed Population.  Population is driver number one of demand.  If the majority of people need a product or service to survive, you better believe there will be a demand for it.  So from an investment standpoint, you better have a general idea of how much supply there is, or have a general understanding of who controls the supply before investing in it.  If the majority of people really want something or better yet, THINK they need something, you better have a good idea of how much it costs.  But most importantly, when it comes to investing, if you know how old the majority of people are in a given population and if you are clever enough to see trends on the horizon, you can invest in a product or service or commodity before the majority of people realize they need it or want it.  This is supply and demand investing on a Macro level.

On the Micro level it is a bit more complicated.  Always remember that a stock is not a company and a company is not a stock.  Two key examples are Microsoft and Apple.  Why has Apple stock gone on a very volatile ride from about $8 a share in 2001 to over $300 in 2011 and Microsoft has basically stayed flat at about $30 since 2001.  Both companies are leaders in the tech sector.   Both are extremely successful.  Both companies seemingly print billions and billions of dollars, quarter after quarter, year after year.  Both are extremely, “fundamentally” sounds companies with great cash flow and great balance sheets.  Both are about 65% to 70% held by institutions or mutual funds.  Why are their stock performances so drastically different? 

    

I believe that part of the reason has to do with the fact that there are 8.5 BILLION shares of Microsoft available to be traded everyday and there about only about 950 million apple shares.  In the case of Microsoft, many of these shares were bought before the end of the tech bubble in 2000 and have been held onto since.  There is just a much greater supply of individual ownership available for Microsoft and it takes a heck of a lot more activity to move the price of something when there is so much available.  The share of individual ownership of Microsoft are just too diluted to make any major price moves.  This is Supply and Demand at work on the stock price of an individual company.

If you must own individual stocks, it is important to know the percentage breakdown of institutional ownership and number of shares outstanding because it affects the supply and demand relationship.  When there is a massive flight to safer assets like cash and fixed income like we saw in 2008 and 2009, a perfectly good stock can take a real beating simply because it is widely held by institutions.  

Take Apple for example.  In July of 2008 it was trading over 200 dollars a share.  When the stock markets began to crumble and the financial world was collapsing, Apple was doing just fine.  In fact, it never missed on its earning expectations and continued to thrive.  But, by March of 2009 its stock price had plummeted to under 80 dollars.  The overall market was down only 45% but Apple was down over 60%.  

How can this be? Well, here is what happens.  Apple is 71% owned by institutions and mutual funds and is one of the top 5 holdings in just about every major stock market fund, load or no load.  So when you and I get defensive and I want to cash out and sit on the sidelines we enter a sell order for that mutual fund.  At the end of the trading day, that fund sells enough shares in proportionate amounts to liquidate our position and get us our cash.  So by selling our share of the fund, we are not only creating more supply of the fund’s shares, we are creating more supple of Apple shares.  Since Apple is so widely held across all types of mutual funds and institutions alike, it took a proportionately larger hit due to this forced selling.  Apple, in this case, decreased in price simply because people did not want to be invested in the stock market at all, fundamentals of the company be damned be damned.  

Remember, a stock is not a company and a company is not a stock.  

It is important to know, not only a company’s fundament financial info, but also its technical statistics if you are going to hold it in your portfolio.  What happened to Apple is another, but slightly different example of price changes as a result of supply and demand in the stock market.  The good news, however, is that is works the other way too.  Today, Apple’s share price is back up over 330 dollars since March of 2009 and inflows jut started coming back in to equity funds a few months ago.  So if you bought Apple back in the summer of ’09... well played.  

Remember, EVERYTHING that has a price, has that price because there is a perceived desire to have it and a known amount of that thing available to be purchased.  Stocks, bonds, products, real estate, art, baseball cards and cash and thousands of other things can be invested in.  Whether you are looking for cash flow or price appreciation from your investments it is crucial to keep the law of supply and demand in mind.  Please feel free to contact me with any specific questions about this topic or any other investing topic you might like to discuss.  

Happy Investing!