August 20, 2018
"In the short run, the market is a voting machine but in the long run it is a weighing machine." —Benjamin Graham
After an eventful first quarter of 2018, in which the S&P 500 Index first surged over 5% in January and subsequently briefly tumbled as the calendar progressed from January to February, the stock market quickly recovered and returns have been relatively flat since. Concerns over tariffs, trade wars, and rising interest rates have dominated news headlines and resulted in a somewhat bumpy ride, but have not been enough to move the market significantly. Of course, ups and downs in the stock market are nothing new—swings in stock prices have been around since stocks began trading on an exchange. The recent market gyrations provide us with an opportunity to explore an old parable about stock price fluctuations popularized by Benjamin Graham, who is widely regarded as the father of value investing. Value investors generally make buy or sell decisions by comparing price against the intrinsic, fundamental value of a security.
Benjamin Graham was born in 1894 and graduated from Columbia University in 1914. Mr. Graham went on to work on Wall Street, started an investment partnership, and taught investment courses at Columbia Business School. He later published two seminal books on investments, Security Analysis and The Intelligent Investor, in which he drew a clear distinction between investment and speculation. He defined the difference as “an investment is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculation.” He advocated valuing companies as if they are private businesses, without any timeframe or sale price in mind. He supported having a willingness to hold investments indefinitely as long as one continues to expect the business to increase its intrinsic value at a satisfactory rate. In our current environment, where investors trade stocks daily and many on Wall Street consider a long-term investment to be mere months, this approach might seem like a breath of fresh air.
"As the long-term owner, you have witnessed the ups and downs of the economic cycle and understand the long-term value of your operation."
The legendary investor and businessperson Warren Buffett, a student of Graham’s, has described The Intelligent Investor as the best book on investing ever written. In the book, Mr. Graham described a helpful mental attitude with which to view the stock market’s ups and downs, which Mr. Buffett has adhered to throughout his investing career and still resonates today. In his parable of the market, Graham explains the concept of Mr. Market, who is a fictional individual. In his example, you imagine you are one of the owners in a successful private business—perhaps a stable manufacturing operation that has successfully operated for decades. One of your partners, named Mr. Market, gives you a daily quote for what your interest in the business is worth and furthermore offers to either buy your interest or sell you his interest. Occasionally the valuation from this individual appears plausible when you take into account the current cash flow of your business and its outlook. Other times enthusiasm or fear get the better of this person and the value proposed appears quite silly. The swings between optimism, euphoria, pessimism, and depression occur frequently and can last for months at a time. As the long-term owner, you have witnessed the ups and downs of the economic cycle and understand the long-term value of your operation. As a prudent, sensible businessperson, you should act upon these daily valuations only if it is to your advantage to do so. You may be quite happy to sell your interest when you are quoted an unreasonably high price and thrilled when you can buy more when the price is low. The remaining time you can sit back, amused by the daily communication and listen only when, based on your own idea of the value of your business, the price looks attractive. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them.
"Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them."
Viewing the stock market through this lens, according to Buffett and Graham, is highly important for successful long-term investing. The fluctuations in the stock prices have only one significant meaning for the true investor. They provide the opportunity to buy wisely when prices fall sharply or sell wisely when they advance greatly. The daily market quotations are provided for your convenience, either to be taken advantage of or ignored. The best part of this situation is that Mr. Market does not care how many times you take advantage of him. No matter what, he will arrive the next day ready to do business. In the short-term, returns are subject to the emotions and whims of Mr. Market and his friends; business success is confirmed (or disproved) in the long run.
"In the short-term, returns are subject to the emotions and whims of Mr. Market and his friends; business success is confirmed (or disproved) in the long run."
Here at Clifford Swan, our security selection methodology centers around valuing companies like private businesses in which we anticipate buying an interest and owning for a long period of time. Our focus is on companies with a long-term record of profitability, a capable management team, strong balance sheets, and a sustainable competitive advantage, among other metrics. Over time, we expect many of our investments to grow their intrinsic value at a satisfactory rate. Our attitude toward stock market movements differs greatly from those of a speculator, who profits from correctly predicting the timing and direction of stock price movements. The fluctuations in the price of a company are important to us in that they provide an opportunity to buy when the price gets low and to sell (or refrain from buying) when the price gets too high.
"At the moment, Mr. Market’s attention is particularly focused on trade wars and rising interest rates, which has translated into some fluctuations in stock quotes."
At the moment, Mr. Market’s attention is particularly focused on trade wars and rising interest rates, which has translated into some fluctuations in stock quotes. We are assessing whether these factors change our calculation of a company’s intrinsic value. If we determine that Mr. Market’s latest concerns have little impact, we will remain disciplined and only use the market fluctuations to our advantage. On the other hand, if our analysis indicates that Mr. Market’s concerns have long-term merit, we will adjust our calculations of intrinsic value accordingly. Our behavior is guided by our conviction that time reveals the true measure, or value of a company. In the short-term, we evaluate whether contemporary factors will ultimately affect companies. Our long-term capital preservation approach allows us to let Mr. Market serve us, not direct us. Through Mr. Graham’s intellectual framework, we can take price volatility in stride and patiently wait for our next opportunity to pick his pocket.
Download Article: How to Invest in a Temperamental Market
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.