“Nobody knows if the stock is going to go up, down, sideways or in circles.” While The Wolf of Wall Street should by no means be a guide for behavior in the world of investing, Matthew McConaughey got it right when he pointed out that no investor, professional or otherwise, can predict how a stock’s price will fluctuate from day-to-day or week-to-week. The temptation of “fast money” and “get rich quick” schemes can frequently lure intelligent individuals into doing ill-advised things with their hard earned money, potentially resulting in a total loss of capital. Salespeople and “advisors” who purport to know how a security is going to move over a short period of time either misunderstand securities markets or are acting solely in their own best interest. Stocks have long proven to be highly unpredictable when considered over short periods of time; however, the purchase of interests in high-quality businesses at appropriate prices should yield strong results over the long term.
While much of the framework to be presented here can apply to all kinds of investments (real estate, fixed income, private equity, venture capital), we will focus on stocks for the sake of discussion. So what exactly is a stock? Quite literally, a stock is a partial ownership interest in a business. Just like being an investor in a local business, stockholders are entitled to their proportionate share of a company’s assets and earnings, less what is owed to creditors. The main difference between purchasing a stock and an interest in a private business is that stocks are available for purchase and sale on public exchanges known collectively as the “stock market.” Thousands of companies are available for instantaneous purchase on these exchanges, leaving investors charged with the daunting task of deciding which are worth owning and which are not.
There are countless ways market participants have attempted to identify the best investments, and success has been achieved in more than one way. The investment philosophy that I practice and find the most sensible is known as “value investing.” Value investing is centered around developing a keen understanding of the fundamentals and valuation of the business that underlies a stock. Introduced by Benjamin Graham, and later refined and popularized by his protege Warren Buffett, value investing focuses on identifying investment opportunities that are available for purchase at prices that are less than their intrinsic value. Intrinsic value is the present value of all future cash flows that the asset can be expected to generate over its life. While it may seem intuitive for investors to primarily focus on acquiring assets for less than they are worth, the market frequently does not behave accordingly. Benjamin Graham once noted that “in the short run, the market is a voting machine but in the long run, it is a weighing machine.”
In practice, value investing requires taking advantage of disconnects between the “voting machine” and the “weighing machine” to identify opportunities that are undervalued. Graham represented this best with a comparison of the stock market to an individual he called “Mr. Market.” Imagine you own a working 5-acre farm that directly abuts a similar 5-acre farm which is owned by your friend, Mr. Market. Mr. Market has manic tendencies, and he frequently offers to buy pieces of your farm or sell you pieces of his based on things such as the weather of the day, how busy the grocery store was that morning or rumors he has heard from other farmers. Most days the prices he offers are fairly reasonable given the production value of each of the farms, but on certain days he is overcome with either euphoria or misery. One these days, Mr. Market provides opportunities to purchase land at prices far below what they are worth or sell pieces of land for far more than they should yield. Either way, however, Mr. Markets offers do not change the actual value of the farmland in question.
The stock market is much like Graham’s character Mr. Market. Prices are constantly changing, and sentiment, rather than value, tends to drive these changes in the short term. When the market becomes euphoric about a business’ prospects, investors tend to bid the prices up far beyond what they are worth, and when bad news is received, the market tends to drive prices down beyond what is appropriate. These wild swings in price can be capitalized on because the market price has no bearing on the actual value of the underlying security. Over time, however, the market tends to converge to the appropriate valuation, creating strong opportunities for disciplined investors.
Rather than attempting to predict the short term price movements that stocks will make, history has shown that focusing on the long-term business prospects and corresponding valuation of a business increases the probability of achieving adequate investment outcomes over time. Warren Buffett said it best when he pointed out that “it’s pretty easy to get well-to-do slowly. But it’s not easy to get rich quick.”