Let’s play a game. Ready? Open a financial newspaper like the Wall Street Journal, turn to the stock quote section, and pick any company at random, and look at the high and low from the past year.
Ok, let’s see here. We have GM. They make cars and trucks. Over the past 52 weeks, their stock traded as low as $28/share and as high as $39/share. They have 1.6 billion (bn) shares outstanding, so that means that the market value of GM was as low as $45bn and as high as $62bn. That’s a difference of $17bn dollars in value. Now the car business doesn’t really change that much — you sell plus or minus 5% more vehicles per year, a Chevy Silverado is a Chevy Silverado, they’re not figuring out how to replace gasoline for water, or how to fly to the moon. It’s basically the same business this year as it was last year. So how in the world could the value fluctuate by $17bn dollars? And more so, how could this be the same with every single company on the stock quote page?
Was last year an exceptional year of price swings? Nope
Is there something the market knows that we don’t know? No.
So, what’s the explanation? Well, it can be summed up into four short words: “THE MARKET GOES NUTS.”
Let me tell you a story. It’s a story that legendary investor Benjamin Graham told. It is about a business partner of yours, named Mr. Market. Imagine you own a business together. Now, Mr. Market is a good guy, but he suffers from wild mood swings. One day he wakes up, and the sky is blue and he’s feeling good and he is feeling really, really good. So he offers to buy out your stake in the business for way more than it is worth. Then the next day, he wakes up and it’s raining, he’s feeling desperate, and he is screaming that the world is going to end. He offers to sell you all of his stake in the company for half of what you paid for it. You take it! The next day, Mr. Market offers to pay a price that is neither extraordinarily high nor extraordinary low, so you just do nothing. Now the value of the business didn’t really change from day to day, what changed was the erratic moods of Mr. Market. In Short, Mr. Market is one moody dude.
So does this mean that we shouldn’t invest in the stock market, because of these wild swings in the short term? To the contrary! The fact that we are offered deals from time to time should make us very, very excited. Our goal is to 1) identify what the company is worth and then 2) to wait for Mr. Market to have a bad day and buy it at a large discount. Benjamin Graham called this giving ourselves a “margin of safety”. AKA Buying dollars for fifty cents.
Ok, you’re thinking. This is all well and good, wait for the market to go crazy and buy below the fair value, but one problem: How can we be sure that we can even come close to knowing the value of a company? How can we be sure that our forecasts (wild guesses) are even in the ballpark? Aren’t there a ton of smart people and computer programs waiting to scoop up a bargain as soon as it becomes available?
Now, I’ll be the first to tell you that I have been dead wrong on the value of companies on many many occasions. I’ll also admit that for over half of the companies on the market that frankly I have no idea what the true value of the company is. Why? Remember, the value of a company boils down to 1) how much these profits grow and 2) how long these profits can last. If you don’t know how long those profits will last, you can’t compute what the company is worth. With most companies it is a wild guess how long those profits can last because they don’t have any real defenses. They don’t have an economic moat. So we can’t really feel comfortable about the value. The good news is, there are some exceptional companies with a substantial moat around their castle, that we know can’t be competed away easily. By investing in these high-quality businesses we can have much more assurance that they will have a value today and a value tomorrow. These are ones that we can feel sure that we are at least in the ballpark of being able to calculate their long term value. So when Mr. Market comes to us in one of his bad moods, wanting to sell us shares at a discount, we say, “Sure! Give me all you got!”