"If a business does well, the stock eventually follows" is another one of those often trotted out quotes from Warren Buffett which seems almost too obvious to take any note of. But in the world of investing we often see common sense take a back seat to more primitive responses such as fear and greed, and when the price of a share is dancing around seductively before our eyes for several hours each working day it is all too easy to lose sight of what really matters, namely business progress. Focusing on the price chart instead of the business is putting the cart before the horse.
When deciding upon a share purchase I generally proceed on the assumption that I will hold the share forever, or certainly for a very long period of time. That doesn’t necessarily mean I will never sell the share under certain circumstances, but the mindset it creates forms the basis for proper due diligence. The prospect of having a reasonable proportion of your net worth invested in a share for many years certainly justifies the few hours’ research I believe is important for successful investing. Sadly, I often get the impression that some investors spend more time monitoring share price movements than they do selecting their shares in the first place, just waiting for the stock market to make them some money. No, investors should not try to make money from the stock market, they should try to make money from the businesses in which they invest.
When price matters the most
Fundamentally, there are two primary objectives that need to be achieved for successful investing:
(1) finding good businesses which have the ability to create shareholder value over the long term; and
(2) purchasing those businesses at a fair or bargain price.
Both of those objectives need to be satisfied, and only one by itself will not do. There will always be plenty of fantastic businesses to find, yet some of them will not make fantastic investments if they are not acquired at the right price. The time when price matters the most is at the point of acquisition and this is where investors should concentrate their efforts. Conversely, some businesses can be acquired at what appears to be a bargain price but if their economics or management are such that shareholder value isn’t created then such bargains will prove to be illusory under the scrutiny of time.
And when price matters the least
Once we have satisfied the above two principal objectives, then investors would do well to ignore short term price fluctuations. I often hear regrets from investors who are lamenting a share price fall of a few percent the day after they bought and it is probably human nature to feel some kind of notional loss when that happens, although it is not at all rational. Now that the share has been acquired the success of the investment will largely depend on how the business performs over the long term relative to any assumptions made prior to acquisition. That is something which can only be proved right or wrong with the passage of time and not by what happens to the stock market on any one day. Neither can we expect to time the bottom of the market: just because the price got cheaper doesn’t make it a bad purchase, and decent returns don’t rely on always buying at the bottom which is fortunate because it’s almost impossible to achieve.
So instead of obsessing over daily price movements investors should retain a focus on the business fundamentals which means doing very little other than monitoring the occasional results announcement from the company. Doing very little can be more difficult than it sounds though as our instinct is to do better by taking action; but with investing being active is an attribute best left behind as the temptation to over-trade can be dangerous. It has been said that the stock market transfers wealth from the active to the patient, and time and patience is one of the private investor’s greatest advantages.
Instead of us taking action, we let the businesses in which we invest take action for us by letting their good economics work for us over a period of time. Those companies which show a material progress in per share earnings and dividends over many years will create value for their shareholders which, provided those shares were acquired at a reasonable price, will eventually be recognised by the market. A share which was purchased on a 5% yield and whose dividend doubles over 10 years is unlikely to be on a 10% yield at the end of that period unless there are specific business concerns. The business will grab the market by the scruff of its neck and drag it along in the same direction even if it wriggles like crazy along the way. That is the horse pulling the cart.
With a long term business based approach to investing the stock market loses its relevance other than as a platform to buy pieces of good businesses. Think of your shares like a private business owner might think of their business. Does the owner, or part owner, of a private company start worrying what everyone else thinks his business is worth at 8am every morning? Or is his primary focus on whether the company continues to invest its capital well in order to grow its revenues, profits and cash flows so that he can share in the business success via increasing dividend payments or business value?
Mr Market Parable
The best way to approach changes in market prices is best summed up by Benjamin Graham’s now legendary parable of Mr Market in Chapter 20 of his book The Intelligent Investor. Whilst Mr Market has since become a ubiquitous phrase in investing parlance, the original passage from the book can sometimes liberate investors from a certain way of thinking and so it is worth repeating here:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman, will you let Mr Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is too low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”
The clear message from Graham was to form your own ideas about the value of the business from its fundamentals and don’t let Mr Market’s constant price chatter let you lose focus on what really matters. Yes, of course the company’s trading position can and will get worse or better than you expected and so you will have to occasionally reappraise your view of the merits of the investment. But that is done by objectively assessing the annual reports and results announcements, not by letting the market sway your thinking. Otherwise you may be panicked into selling after a price fall – even though you are convinced the fundamentals are still sound – and that is likely to be disastrous to your returns.
I did mention at the beginning of the article that there are occasions when I would sell notwithstanding a long term buy and hold approach. The important thing here though is to ensure you are selling for the right reasons: as Graham said above, you may be happy to sell when the market is offering you a ridiculously high price relative to your assessment of the company’s value.
The relevance to dividend investing
When building an income portfolio for the long term, we should patiently go about accumulating good quality businesses when they are offered to us at an attractive price by the market. We need to satisfy the dual objective of (a) finding good businesses which are likely to deliver a growing income stream over the long term; and (b) buying only when offered at an attractive price relative to that expected income stream. Carry out research on each potential company as though you are going to hold the share forever as this will create the correct mindset.
Once acquired, forget about capital fluctuations as they will only serve to distract you from what really drives long term capital growth, and that is business progress. As long as the dividends keep increasing each year then over the long term the capital will take care of itself and so only pay attention to company updates which will allow you to ensure that the company is staying on the right path. The rest is just noise.
Don’t be panicked into selling low. Only consider selling if you believe Mr Market is offering you a ridiculously high price, and I mean a genuinely high price, not just a small blip which will mean very little in the long term since the insidious temptation to over-trade must be avoided. Don’t try to make money from the stock market; make money from the combination of good business economics and time. Don’t put the chart before the horse.
Filed Under: Value Investing,