Stock Market

Should a high price deter you from owning a company’s shares?

Ritesh Presswala/Nazim Khan

Every often, we come across share prices that optically look high in rupee terms and many investors perceive such stocks as those that would make for a bad investment choice.

The impicit rationalization for such investors is that either such stocks have run up too much, and hence such a run may not continue, or that they simply appear “expensive”.

Such beliefs, however, have little grounding in financial logic. Over the long run, stock prices are usually driven by earnings growth that a company witnesses and the earnings multiple (the price-to-earnings, or PE, ratio) that investors are willing to assign to a particular business. These, in turn, are driven by the company’s performance.

Companies can, and usually do, reduce their stock price by resorting to corporate actions such as a stock split, which increases the number of outstanding shares and brings down the price proprtionate to the split. (For instance, a 2-for-1 split will double the total number of shares in the market and halve the stock price.)

But beyond having an impact on liquidity that a trading counter can witness after a stock’s price comes down — or making it affordable for investors with very small investment amounts — stock splits, and even stock bonuses, have little impact on its future course.

However, even as the theory suggests minimal correlation, there seems to be some connection between high stock prices and future returns. If anything, the correlation appears to be opposite of what is generally percieved: stocks 

with high prices may actually produce better returns.

We ran a query for BSE 500 stocks whose per-share prices were over Rs 2,000 five years back and pulled up their returns since.

Out of 12 such stocks that turned up, eight stocks have handsomely beaten the Sensex’s 70 percent returns over the same period, with MRF topping the list with 492 percent gains (moving from Rs 6,863 to Rs 40,900).

As can be seen in the chart below, even the four that have trailed the Sensex have not posted negative returns.

We also ran a query for stock prices above Rs 1,000 and the results were similar: out of 33 stocks, 25 beat the Sensex while only one stock posted negative results.

Intuitively, the data makes some sense. Stock prices that have run a lot usually do so because of the business’ underlying performance. In many cases, companies that exhibit market leadership and do well over long periods may continue to perform well in future as well.

In fact, there is some evidence that the opposite of the theory — that a high share price carries high risk — is true. Penny stocks (stocks whose price is below Rs 10) generally carry the highest risk. Many are prone to reckless speculation while some can even be manipulated.