Investors pay outrageous prices for stocks that never earn them a cent. Here’s what we can learn from an expert investor who has been around the block a few times…
When I refer to Benjamin, I am talking about Benjamin Graham, author of the classic (and probably most influential) value investing book, The Intelligent Investor.
Graham, a lecturer at the Columbia Graduate Business School in New York, held the belief that investors who make money are those who accurately determine the intrinsic value of a company and purchase shares below that value. Both The Intelligent Investor and Graham’s other well-known work, Security Analysis, are based upon this notion.
Graham acknowledged that a financial analysis of a company was not going to yield precise results. We know that mathematical calculations can be exact, however we also know that there are other factors at play that can be less quantifiable. For example, the nature of the company’s business and the capability of its management will have a large impact on the value of a company, but can’t be expressed in a single number.
Graham had a degree in science and as a scientist, he had less faith in the qualitative approach than he did in the quantifiable one. He felt that relying on abstract values encourages us to take risks and let our emotions and exaggerated optimism to affect our judgement.
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Limiting our downside
Warren Buffett, the most successful investor of all time and a disciple of Graham, proved himself to be a genius over and over again in judging the value of qualitative factors, despite Graham’s lack of faith in the accuracy of this method. However, let’s not be fooled, Buffett is a master and doing what he has done is no easy task. Graham tells us that it is far safer to begin with net asset values so that your downside is limited to the liquidation value of those assets.
Graham’s approach is very cautious and as we become more experienced investors, we often stray from it.
His idea was that his careful approach lets other investors do the work for us and this could lead to high returns. Graham thought that the best way for us to profit from capital growth is to calculate the intrinsic value of a company and buy when the price was significantly lower than that value. He felt that this could be the result of a bear market, where stocks are all trading at a lower cost, or for some other reason causing individual stocks to fall.
Graham tells us that most often, this happens because of the market’s irrational view of life. He said that this is because humans create the market and it is, therefore, hard for us to block out emotion when it comes to investing and it can take the place of rational thinking.
We know that modern ‘efficient market’ analysts believe that the market values stocks on rationality, weighing all available data. However, Graham’s theory provides us with a very plausible reason for why some losing stocks can be valued highly constantly.
Don’t lose your cool
Graham gives us an amusing story to illustrate his point.
He first asks us to imagine a business partner named Mr. Market. Mr. Market, Graham tells us, is bi-polar.
Part of the time, he is exceptionally optimistic and will quote us a high price for our interest. The rest of the time, Mr Market sees a dismal future and is ready to sell out his interest for almost nothing. He is also the type of person who lets nothing get to him.
Whether we decide to take his offer or decline it, he doesn’t really care. Mr. Market will just come up with a new offer the next day. It is because of this behaviour that we are positioned to earn good returns at his expense if the economic structure of the business is on solid ground.
Watch out for the raging bulls
The essential thing when dealing with Mr. Market is to not get sucked into believing that his perspective on the future is correct.
In order for us not to fall into this trap, we need to remain rational and keep our emotions at bay. Our view of the future market will be much more realistic and accurate when we look at investing in an emotionally detached way. Yes, it may seem that going along for a wild ride is sustainable, but when looking at it through rational eyes, we will see that it is impossible for a stock to trade at prices significantly higher than its intrinsic value for the long-term.
When we view it like this, it can help us find our way when we’re feeling lost. The problem however is that it’s easier said than done. Let’s face it, it is extremely difficult to sit back and just watch other investors hitting the jackpot in a quickly rising bull market, even if we have chosen to sit back based upon a rational analysis of the value of a company. Nevertheless, it can be very comforting to know that we have this approach to follow in difficult times.
Just as a bull market can trick us into believing that our future is better than we think, a bear market is often not as bad as we think. In fact, a bear market can open up a lot of terrific opportunities for us if we can remain grounded and buy stocks in companies that are significantly below their value.