Intelligent Investor Ch.8 - The Investor and Mr. Market

The Investor and Market Fluctuations

Both bonds (including high-grade) and common stocks will swing widely in price over a period. Every Investor has to be prepared for that both financially and psychologically.
"The Investor want to benefit from changes in market levels"

A big danger when you see these swings on the market is that it can lead you to speculate attitudes and activities.  It is easy to say that you do not want to speculate, but the hard thing is to take your hands off!

Market Fluctuations as a Guide to Investment Decisions

As common stocks fluctuate widely in their prices, an investor should take advantage of that. The book describes two ways to do it:

1. The way of timing
2. The way of pricing

Timing means to anticipate the future and by that decide when to buy and when to sell. Pricing is to buy common stocks when they trade below their intrinsic value (or fair value) and to sell them when they are priced above that value. Pricing is the way to go for the Intelligent Investor as timing will lead you into the way of speculating about forecasting the future!

Buy-Low-Sell-High Approach

"The average investor cannot deal successfully with price movements by trying to forecast them". 

Graham mentioned that it is not even good enough to invest after the market has declined a lot. If the market has declined 50% and you start to invest at these lower levels, you do not know if it continues down an additional 40% and stays down there another 10 years!

There are several criteria's that bull markets had in common:

• Historically High Price levels
• High Price/Earnings ratios
• Low Dividend Yields compared to Bond Yields
• Much speculation on margin (borrowed money)
• Many offerings of new common-stock issues of poor quality (e.g. IPOs)

But even if you recognize these criteria, it is very unsure if they play out in a similar way, so it seems unrealistic for the investor to base his policy on buying and selling common stocks. The only recommendation Graham discusses only the changes to be performed of the holding ratio by the amount of common-stock versus bonds (75-25, 50/50, or 25-75)! 

Market Fluctuations of the Investor's Portfolio

Every investor who owns must see them fluctuate in price over the holding period. There is a good note in the book from Graham: 

"It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price - regardless of which stock you own or whether the market as a whole goes up or down. If you can't live with that - or you think your portfolio is somehow magically exempt from it - then you are not yet entitled to call yourself an investor" (Graham refers to a 33% decline as the "equivalent one-third" because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started)

A serious investor should not believe that the day-to-day or month-to-month fluctuations make him richer or poorer. The important question to ask is, what the business valuation is compared to what the market is valuing your investment

Business Valuations versus Stock-Market Valuation

Remember from the first posts, you are a part-owner of a business. The result of the business value is based on (1) profits from the enterprise or (2) change in the underlying value of the assets! So consider yourself as part of the business owner and by that part of the assets and not an owner of a piece of a paper that trades in seconds up and down, and by that determine what value the business has! 

Successful companies sell almost constantly at prices well above their net asset value (or book value, or "balance-sheet value")

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Net asset value, book value, balance-sheet value, and tangible-asset value are all synonym for net worth or the total value of a company's physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company's annual and quarterly reports; from total shareholders' equity, subtract all "soft" assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.

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The market normally puts a premium price on successful companies, so you have to expect that the price in comparison to the book value might a lot of times be higher. The conservative investor does not want to overpay for an enterprise and be close to a company's tangible-asset value and at not more than one-third above that figure. This is only the view or value on the assets, but you want as well to know what you pay for the earnings and a satisfactory ratio of these earnings to the price, that the company has a strong financial position and that these earnings will be maintained over the next coming years!

Mr. Market

I cite this directly from the book (with simplifications):

"Imagine that in some private business you own a small share that cost you $1000! One of your partners, Mr. Market, is very helpful indeed. Every day he tells you what he thinks your part of the business is worth and furthermore offers either to buy you out or to sell you an additional share. Sometimes his idea of value appears believable and correct y the business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his passion or his fears run away with him, and the value he proposes seems to you a little short of silly!"

"If you are a careful investor or a business, will you let Mr. Market's daily communication decide your view of the value of a $1000 part in a business? Only in cases, 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 to buy fro 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 part-ownership, based on full reports from the company about its operations and financial position."

To summarize Mr. Market and his behavior is that you as an investor should expect fluctuations (up and downs) in your portfolio. More importantly, though, remember to take advantage of Mr. Market when he offers you ridiculously low prices compared to the business value or ridiculously high prices!

Fluctuations in Bond Prices

Even though bonds have higher safety due to its principal and interest you collect every month, you can see wide swings in prices and yields! Bond yields move inversely to prices, low yields meant that prices are high! Grahams calls this "the rule of opposites"! If you buy bonds when the prices are high, your future returns are almost always to be low! The safeties bet here is to choose U.S. saving bonds, as the market values will not decrease and probably have the lowest fluctuations.

Price fluctuations of convertible bonds and preferred stocks are based on three factors:

• Variations of the price of the common-stocks
• Change in the credit standing of the company (Moody's or S&P's Aaa or AAA down to D)
• Changes in interest rates

Normally convertible issues have been sold by companies that have credit ratings well below the best. The investor has normally difficulties to find convertible issues with the combination of high-grade bond and price protection plus a chance to benefit from an advance in the price of the common!