Simple Truths of Portfolio Strategy

For example, my calculations indicate that the minimum current business value of Commerce Bancorp(CBH Quote) is $80 per share. And I think Commerce's value will move north, toward $90 per share, over the next year. With Commerce's current share price around $60, taking a position is an easy decision.

Coca-Cola(KO Quote) has oscillated between $39 and the high $80s over the last few years. The business is worth at least $55 per share, in my opinion. A price near the current quote of $40 per share makes it a compelling buy. On the other hand, a stock quote anywhere near the old highs makes it a compelling sale.

Many investors buy a stock simply because they are enamored of the product or the service that the company renders. That's a wholly inadequate method for selecting stocks. Liking the coffee at Starbucks(SBUX Quote) or the shopping experience at Home Depot(HD Quote) can be a starting point in equity selection, but it's only a starting point. Much more important is a thorough understanding of the relationship between price (what is the price of the stock?) and value (what is the value of the business?).

All Stocks Are Mispriced

Forget the academic contention that stock prices are efficient. Look at the price oscillation of virtually any stock and compare it with the change in the underlying business, and you'll quickly conclude that prices change much more than businesses change.

This construct is useful for the investor in managing his or her portfolio: Every stock, without exception, is mispriced. Some are mispriced by a little, some are mispriced by a lot. But all are mispriced.

At their current prices, I think Starbucks (trading around $55) and Home Depot (around $43) are "mispriced by a little." But over the last couple of years, these two stocks have been "mispriced by a lot," as both have traded near $20, less than half of the current quote for each. For more on this, see my favorable column on Home Depot when it traded below $25.

Following the construct that every stock is mispriced forces an investor to evaluate critically each one of his portfolio positions. Because of factors such as taxes and (one hopes) a growing business value, it does not follow that an investor should liquidate a stock simply because it is "mispriced by a little" or slightly overvalued. But it does follow that portfolios containing companies that are very undervalued offer high potential return coincident with low relative risk.