From 1981 until very recently the key strategy of equity investors was 'buy and hold'. It just worked. From a very low base the valuations of equities rose and rose, fuelled by falling interest rates, a wave of cheap credit and an investment boom in technology companies. Those conditions were ripe for a bull market to prosper but perhaps not to the nosebleed PE multiples that were seen at the top. Perhaps naively investors have been hoping for such a bull run ever since, but the current reality is very different from those anomalous conditions bearing some resemblance to the kinds of markets witnessed earlier in the last century, an era in which the guru of the market was Benjamin Graham.
Graham, tutor of Warren Buffett and father of value investing, lived through some of the most turbulent bull and bear cycles in market history. It was in this environment that he forged his investing philosophy by shunning vulnerable high multiple growth stocks in favour of the many more asset backed bargain investments he found available. But one of his key insights was in the behaviour of market prices, insights that he wrote about in Chapter 8 of his famous book for the layman '*The Intelligent Investor*'. It is this chapter with its famous parable of 'Mr Market' that Warren Buffett has long referred to as being one of the most profitable readings any stock market investor can make.
Market Fluctuations and Portfolio Management
Graham starts by discussing the two ways an investor can profit from market fluctuations - by either the way of 'pricing' (buying stocks below fair value and selling above) or the way of timing (anticipating future price movements). He makes it very clear that the way to 'satisfactory results' is the former rather than the latter - "if he places his emphasis on timing he will end up as a speculator with a speculators results". This belief echoes modern research into the folly of forecasting that shows most stockbrokers have no insight at all into the future course of price movements - in fact quite the reverse.
But Graham does say that on occasion one can profit from market timing but only after price movements have occurred not before. But while certain volatile market environments work well for this strategy of 'buying low, selling high', others such as the bull markets of the 1920s, 1950s and 1980/90s never give investors a bear market of substance in which to go long. Given that one can only know which market you are in with hindsight he advises a form of 'tactical asset allocation', to 'weight' your portfolio between stocks and bonds, decreasing the weight of stocks as markets rise, and increasing them when they fall. Graham suggests that this kind of 'mechanical' method for portfolio management can 'give an investor something to do' during times when the market makes men emotional, "providing him with some outlet for his pent up energies".
On the tyranny of stock quotations
Graham insists that investors remind themselves constantly that by buying a share they are taking a part ownership of a business. In any normal private business an investor will figure out his stake's worth by looking at the company's accounts each year and calculating his share of book value and profits. By floating a company on the stock market the shareholder becomes quite cursed with the free availability of the stock quote.
"That man would be better off if his stocks had no market quotation at all for he would then be spared the mental anguish caused him by other person's mistakes of judgement."
A stock quote from day to day is fathomably not the worth of a business. It is how much just the few shareholders who bother to trade that day decide their investment is worth. Just because someone is selling a part of a business for a silly price, doesn't mean that is what your stake is worth nor that the whole company should sell for that price. On that note Graham suggests investors should beware of the most successful stocks in that market as they can paradoxically end up being the most speculative. Investors bid their prices far above book value making them vulnerable to the wild impact of investor mood swings on the share price - anyone who follows ASOS (LON:ASC) today will understand this truism very well.
"The investor should always remember that market quotations are there for his convenience either to be taken advantage of or to be ignored."
The Parable of Mr Market
Graham takes these idea further with his now famous parable of Mr Market. He asks the investor to imagine that he owns a small share of a business where one of the partners is a man named Mr Market. He's a very accommodating man who tells you every day what he thinks your shares are worth while simultaneously offering to buy you out or sell you more shares on that basis. But Mr Market is something of a manic depressive whose quotes often bear no relation to the state of the underlying business - swinging from the wild enthusiasm of high prices to the pitiful gloom of valuing the company for a dime.
"You may be happy sell out to him when he quotes you a ridiculously high price and equally happy to buy from him when his price is 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."
While some may say the markets today are a very different beast to those in which Ben Graham lived due to the dominance of algorithmic trading and risk on/risk off mentalities, the extremes of sentiment in stocks and markets are still evident for all to see. Given the excesses of the credit bubble will need paid off for a long time to come and that interest rates have nowhere to go but up investors can likely expect extreme year to year volatility in shares for some time. In this environment Graham's thoughts on market prices hold extremely valuable lessons for investors to take to heart.