Portfolio management
Why Mr. Market offers bargains
Readers can try a small quiz. You are looking at putting some money to work in the stock market. You see shares of a fair company available at a great price. You also see shares of a great company available at a fair price. What do you do? Answer: nothing.
Neither of these investments should be made by the intelligent investor seeking superior returns.
We live in constant fear of missing out on opportunities. Day by day we see the price of stocks in ordinary companies moving up. It takes patience to sit back and watch them go. It takes tremendous discipline to wait for the right pitch. You get a free look at as many pitches as you like.
Well within our happy zone
Buffett writes: “Ted Williams, in The Story of My Life, explains the idea:
“‘My argument is, to be a good hitter, you’ve got to get a good ball to hit. It’s the first rule in the book. If I have to bite at stuff that is out of my happy zone, I’m not a .334 hitter. I might be only a .250 hitter.’ Charlie [Munger] and I agree and will try to wait for opportunities that are well within our own ‘happy zone.’” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America 1998) p208.
From theory to practice
The big question is why the stock market would ever offer a great stock and a bargain price. There are two answers; the how and the why.
First as to how it happens; remember you are dealing with Mr. Market. Mr. Market regularly offers the shares of superb companies for sale at bargain prices. Readers who know Mr. Market can skip the next couple of paragraphs.
Warren Buffett’s describes “Mr. Market” in the Berkshire Hathaway’s 1987 Annual Report.
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.”
“Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”
Think about the following statement: “Doing what everybody else is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all.” (Fisher, Common Stocks and Uncommon Profits and Other Writings 1958,1996) p32. Philip Fisher was one of the great influences on Warren Buffett’s investing style.
“Everybody else” is Mr. Market. He is part of a herd. He is subject to groupthink. He suffers from peer and client pressure. He has incurable behavioral problems.
Why Mr. Market would sell at a bargain price
The simple fact is that Mr. Market often can’t see past his nose. Mr. Market and sell side analysts are often fellow travellers. A term often used by sell side analysts is that they need ‘visibility’ before recommending the purchase of a stock. Of course, once everything is clear and visible, a stock can’t be bought at a very attractive price; all the good things are priced in.
Philip Fisher uses a number of examples of why the stock prices of superb companies can get depressed. Here is a typical one:
“…the company into which the investor should be buying is the company which is doing things under the guidance of exceptionally able management. A few of these things are bound to fail. Others will from time to time produce unexpected troubles before they succeed. The investor should be thoroughly sure in his own mind that these troubles are temporary rather than permanent. Then if these troubles have produced a significant decline in the price of the affected stock and give promise of being solved in a matter of months rather than years, he will probably be on pretty safe ground in considering that this is a time when the stock may be bought.” (Fisher, 1958,1996) p101.
John Train summarized Philip Fisher’s ideas on what to look for:
“First, buy when the start-up period of a substantial new plant- which sometimes lasts for months and includes a special sales effort for the new product involved – has depressed earnings and discouraged investors….
The second time to buy is on bad corporate news; a strike, a marketing error, or some other temporary misfortune. “
A third opportunity arises in capital intensive industries where engineers have figured out how to “increase their output substantially by spending a relatively modest amount of additional capital. This may produce a significant improvement in the company’s profits. Until the stock advances to reflect this prospect there should be a buying opportunity.” (Train, The Money Masters – Nine Great Investors: Their Winning Strategies and How You Can Apply Them 1980) p76.
This is obviously not an exhaustive list. It simply gives some realistic examples of the kind of opportunities the investor should be looking for.
Twenty plus reasons a stock would sell at a discount
Take a look at the list in the following post that sets out a whole bunch of reasons stocks can be bought at bargain prices. The joy of higher return with no more risk
Hold patiently for years
When you buy at a very attractive price or a bargain price, by definition you are buying when the stock price is depressed. The natural question is: what happens next?
John Templeton one of the 20th century’s investing greats said in a speech at the Empire Club in Toronto: “So we search for nations or industries where the stock prices are extremely low and they are only extremely low when there are good reasons for it. Things do not get very low for no good reason. They get low because other people are selling them. That’s the only thing that puts the price down. So, we search for those things that other people are selling and then if the problem or adverse outlook is temporary, we buy them and hold them patiently for years until the public changes its mind.” (Proctor & Phillips, The Templeton Touch, 1983, 2012) p.401.
Conclusion
We look only to buy superb companies, and then only at very attractive prices. Not all of our purchases will work out. That’s the nature of the game. It may take several years for Mr. Market’s adverse outlook to brighten. If after a reasonable time you decide that the superb company you bought is not so superb after all, it’s time to sell. But one has to be patient around that decision.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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