Does your stock poke fun at economics?

Updated: Jan 03, 2012, 12:02 PM IST

Mainstream economics as it is practiced today, does have a lot of loose ends we believe. Little wonder, a lot of experts have begun to call it the dismal science. There are quite a bit of its principles that do not have universal validity. In other words, a principle that may work in one scenario may turn out to be a total disaster in the other.

What has the fact that economics is not the most perfect of sciences do with investing one may ask? Quite a lot we should say. In fact, we are of the opinion that for a stock to qualify as a good investment, it has to make a mockery of the one of the principles of economics. Failing this, there is a strong chance that the stock may not turn out to be a good long term investment.

Let us cut to the chase now. What according to you determines the price at which a product can be sold by the firm? Most people will have absolutely no hesitation in saying that the costs that go into making a product will ultimately determine the cost. No matter how conventional the view, it certainly flies in the face of a lot of everyday experience we think. If costs were the sole criterion in determining the price of a product, your bathing soap or for that matter, the can of aerated soda that you gulp down, wouldn`t have been priced at a multiple of the cost that would have gone into mass producing the same. A simple back of the envelope calculation will tell you that the economics of these everyday goods is skewed completely in favour of the producer. Yet, you wouldn`t think twice the next time you reach out for these products. Mind you, these are not isolated examples. On the contrary, there are plenty more examples that can prove that the final price of a product has absolutely no correlation to the cost of the inputs that were used in its production.

Thus, if input prices are not the key determinants of the final price of a product, what possibly could drive them? The answer perhaps lies in the value that we see in the product and our tendency to shell out a few extra bucks to obtain the same. Hence, if you have your favourite celebrity endorsing a soap brand or performing dare devil stunts after gulping down a can of soda, the value that you associate with the product does increase quite a bit. However, a celebrity endorsement is not the only thing that drives value. Value can also be had by means of having a reputation for superior quality. Products of the popular consumer electronics brand Apple could fit this description quite well according to us. The company is known for its ruthless focus on quality and hence, its products are able to command a much higher value and in turn, selling price that is far in excess of the cost of their production.

There could be other multitude of ways of acquiring value. Thus, the important thing is not how many ways but finding out if there is any value at all and whether the same is going to last for a long period of time. This last point is very important according to us. For even some commodity like product is likely to sell at a much higher price than the cost of its inputs due to favourable demand supply situation in the near term. But this does not mean that the product and thus, the stock has enduring value. No sooner will the demand supply situation turn adverse, the profitability is likely to come down and the value will prove to be only an illusion.

To conclude, the next time you try to invest in a stock, make an effort to find out whether the products of the company have an enduring value and its use gives a level of satisfaction that is higher than those of its peers. If you are successfully able to spot one, you would have taken a huge step towards making a successful investment.

Courtesy: Equitymaster