Market volatility obscures true value

Investing in the stock market is a roller coaster ride. People should know what to expect before getting on. Once we are on, it can take us from dizzying highs to stomach-turning lows.  The difference with the stock market is that we can choose to get off at any point. People are more frightened by a quick drop than by a steep climb, so it’s not uncommon to see people getting out at the bottom.  How can that be a form of investing and not outright gambling?

Legendary investor Benjamin Graham, the mentor of Warren Buffet, explained that price does not always equal value. That’s sometimes difficult to see because we are not used to negotiating prices.  In the grocery store, the price on the tag is the price we pay.  The same applies to almost all shopping, with the most common exceptions of cars and houses.  But price does not always equal value.  Think, for example, of sales.  The price is lowered, but has the value changed? What is the true value: the sale price, or the original price? In the stock market, the changes in price are more common and more extreme, further obscuring value.

Ben Graham offered an analogy to investing in the market. Imagine you work in a business partnership with a manic depressive called Mr. Market. Every day he comes in to work and, depending on how he’s feeling, names a price at which he’s willing to buy your portion of the business or sell you his portion of the business. Some days he’s manic, and willing to pay a high price to buy your shares. Other days, he’s depressive and willing to sell you his shares at a low price. What would you do? I would try to determine, within a reasonable range, a fair value for the business, so that I could buy from him when he’s depressive and sell to him when he’s manic.

That is a very fair comparison to what goes on in the stock market. Just because the price varies daily and hourly, the value of the company doesn’t necessarily. If you read financial media (which I don’t advise), you’ll see that the market price of a company supposedly rises and falls due to global economic outlook, local investor outlook and sometimes because of reasons that aren’t even related. It comes down to investor sentiment, and people will pay higher prices when they’re optimistic, and offer only lower prices when they’re pessimistic.

Determining value doesn’t require an advanced education. Investing means buying cash flow, so the value of a company depends on the profits they are expected to earn and the dependability of future earnings. We can do this by looking at past earnings to find how profitable the company has been, and how consistent the earnings have been. Unless there’s a real event that will cause lower (or higher) profitability in future, it’s normal to pay around 15 times earnings. This is the P/E (price/earnings) ratio. Around 15 is seen as normal, over 20 is seen as high and under 10 is seen as low.

When I walk into a grocery store, and I see soup on sale, I don’t think: “It’s going to zero, time to sell all my canned soup!” Buying low means buying on sale. Companies whose stock price is cheap relative to earnings are more likely to offer good value for money. Later, there are two reasons I may sell. If someone is willing to pay me more than my shares are worth, there’s an opportunity to profit. On the other hand, if there’s a real reason to think the company will be less profitable in future and the value has broken down, selling is usually the best option.

Not everyone has the confidence and patience to invest in the stock market. Wild fluctuations are normal and distracting. Finding the true value is not a science and is prone to error. However, if I can determine the likely value of a company (within a reasonable range) and buy it cheaper, I can have confidence that I’ll profit over time. How do you stay calm during days, weeks or months when stock markets fall? How do you decide when to buy and when to sell?

3 thoughts on “Market volatility obscures true value”

  1. When I had my big losses in 2001, I wasn’t paying attention to the market at all (yes, completely ostrich-like – I was following the Wealthy Barber strategy). Had I been doing so, I think I may have lost much less. I promised myself then that I would never again invest in a company unless I knew A LOT about it, not just what regular investors get to see.

    I’m still somewhat reactive (though not enough to do anything stupid like buy or sell) when I see sharp fluctuations. My only saving grace and calming agent has been familiarity with the business operations of the companies that I’m directly invested in or the big components of the mutual funds that I’m invested in. I think it hits closer to home now since I’m looking at the market making or breaking my retirement, but at least I’m only 44 and wouldn’t mind going back to work. If I were 65 and had the market drop on me, I would probably completely freak out. Hopefully by then I’ll have learned the patience that comes with more experience.

    I think I would like to be like some retirees and have some cash put aside in something very liquid so that I had the opportunity to stock up when the soup sale comes along once in awhile.

  2. For selling, I set a target price and a mental stop loss (e.g. it’s not an order to my broker).

    My target price depends on how little I paid and the company’s prior history and is flexible depending on news and market movements… typically ends up being 15-20% above the purchase price and I don’t sell the entire holding.

    The stop loss is whatever represents 0.8% of my total portfolio value (rather than a specific % of my purchase price) and then I sell half of the holding. Reset the stop loss and sell the rest of the holding if the stock continues to drop. This is the market’s way of hinting that you don’t know enough about the company!

    I also sell when there is significant bad news: missing earnings projection more than usual, safety violations, lowered expectations (particulary when announced mid-FY), underlying economics for this business are souring, etc.

  3. Jacq and George, thank you for sharing. Investing is very difficult to teach because part of it comes with experience. Seeing what you do helps me know what works (mentally) and what doesn’t. Hopefully, it also helps other readers get a glimpse of how to think about it.

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