This is by far the most important thing I will ever write about investing and it is essentially mandatory reading for anyone looking to become a client and partner of this firm. If you're not with me on this you likely won't be a good fit for us (or for proper investing in general). What I will explain is extremely simple and in my opinion the most important thing to understand and follow in order to achieve excess returns but for whatever reason, it is difficult for most investors to implement in their practice.
Let's start with a riddle. If you could choose between equity markets rising to a very high point or dropping to a very low point and staying at that point permanently, which would you choose? This would mean that the price of all stocks worldwide would move to that point and stay there forever. Think about it for a second.
Good?
Unless if you are about to retire and don't care about money beyond that which is necessary to pay for your basic retirement expenses, you should have picked the second choice- let prices drop to a low point and remain there forever. If you are okay with never purchasing a stock again, the first option of high prices might work out well. If you wanted to become wealthy beyond belief however, you would choose the second option of permanently low prices.
With low stock prices, it wouldn't matter how much earnings grow or how high dividend payments are- you would still be able to purchase at that low price permanently. You'd be able to purchase basically any publicly traded company and achieve incredible annual returns. With stock prices flat, your only returns would come from dividends. Of course, in the very long-run, dividends are the only reason investors own companies and is what valuation depends upon.
In the first option of rising prices, you would receive a nice gain but your future returns would be horrendous for a long period of time. It is possible you would have no reason to ever purchase a stock again because the returns would be so low.
Let's say the market cap of Apple Inc dropped from its current level of around $830 billion down to $100 billion. It currently pays out around $10 billion a year in dividends, so you would get a 10% total return with flat prices- not impressive. Apple has $260 billion in cash on its books though, and it generates over $50 billion in free cash flow a year. If it were to pay out $200 billion of its cash and investment reserves, investors could buy up stock at that market cap of $100 billion and receive the $200 billion dividend for a 200% instant return. If Apple wanted, it could pay out $20-$30 billion a year for a 20-30% annual return on that low price.
Think about 10 years from now, when the prices of all those good companies that are now much larger and have better dividend paying potential are still low. Think about a smaller company growing earnings at 20% a year- in 10 years it would have earnings 600% higher than they were at the beginning of that period and yet have the same stock price. Think about 20 years from now, when the size of these companies dwarfs their stock prices, so that investors could receive returns upwards of 1,000% a year simply from dividend payments. Your capital would multiply itself by 10x a year with a simple dividend payment. Think about 30-50 years from now, when companies have compounded at decent rates over that period- prices would be unimaginably low relative to business values and dividends. Compounding at such rates in this theoretical vacuum would lead you to be richer than the entire world economy rather quickly.
Those who took the first option of getting that initial boost from price increases would be stuck with permanently high prices and would have to wait a while to ever receive a decent return. What if their salary and net worth has grown over that time, so that they have a much larger base of capital that cannot compound at any decent rate because stock prices are too high? If you are a young person who would like to purchase stocks in the future this is your worst nightmare. The retiree would be okay but younger people would have to wait at least a few decades before receiving a return that could affect their net worth.
As this example illustrates, if you are a long-term investor, you would be perfectly satisfied if stock prices never increased again, or even if they permanently decreased. Low stock prices are always your friend- you can purchase more of a business for each dollar you invest.
This is why stock price decreases make me happy. For whatever reason, people don't like paying high prices for groceries, rent, cars, or anything else- but they seem to want to pay high prices for companies. Most investors seem to like it when the cost of ownership of their companies increases. If you plan on ever buying stock again, you should rather wish the price to drop- frankly your optimum price of ownership would be $0- you could get ownership for free.
I would say the main problem here is the assumption that swings in stock prices indicate swings in business values. For so many reasons that I have summarized in previous blog posts, this cannot be the case, and every day I come to believe that markets are more and more inefficient. Once you realize this simple fact and notice it on display on a daily basis, it is as if you have left the matrix or gone to Hogwarts to join some small and unusual group of people- it is astounding that the vast majority of investors, mainstream commentators, and academic theorists can be so wrong about this and that stock prices can be so inaccurate so frequently.
The vast majority of investors are not accurately estimating (or even trying to estimate) the present value of all future free cash flows of the companies they own, and the herd mentality and group think are truly difficult for many to circumvent. Most investors feel as if they are losing money if their stock prices decline- they feel scared, worried and they believe they need to save what they have and sell out.
This is exactly how wise investors make money- by purchasing companies from the fearful and emotionally weak. As Buffett says, "the stock market is a device for transferring money from the impatient to the patient". I believe the processes through which this occurs are fear, group-think and short-term thinking.
Further, as Munger says, "in fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations".
How would you feel about the price of your rent payments decreasing 50%, or 90%? Awesome, right? How would you feel if the only stock you held dropped in price 50%, or 90%? Most people would become an emotional train-wreck and feel as if their net-worth has been crushed permanently. If the value of that business has not changed, you should be buying hand-over-fist in such an occurrence. The investor who understands the nature of markets would see it as a massive opportunity. Price declines look bad on paper, but they are the best thing you can ask for as a real investor if business values haven't changed and you if you haven't let your irrational fear affect your ability to purchase stock moving forward.
This is exactly why volatility works to your advantage as an investor. Changes in stock prices are simply changes in public sentiment of a business.
Let's say you own a small tool-shop. The shop's earnings are stable, it has a strong balance sheet, and you manage to take it public. Its stock now trades between investors on this secondary equities market and somehow the price of your business changes every day- but the business itself isn't changing much. Would you as an owner really care if the company was de-listed for a decade? Would a wise and formerly private owner really care if the price of ownership dropped 50%? It is all irrelevant- none of that affects the business. It is just part of the game of capitalism and a wise investor uses it to their advantage.
I'm going to summarize Ben Graham's Mr. Market metaphor here as simply as possible:
Lets say you and a friend own a private business with stable earnings and prospects. Your friend has bi-polar disorder and his mood changes every day- one day he is very happy and optimistic, the next he is depressed and pessimistic about the future. Every day he offers to sell you his half of the business and his condition affects his opinion of the future of the business. Some days when he is optimistic, he thinks the business will do great and will only sell his half to you at high prices when he thinks it is worth more. On his bad days, he is down on the firm and will sell you his 50% at almost any price because he thinks it is worth less. Do his mood changes and ask prices affect your opinion of the business? Would you believe that the value of the business depends on his ask price on a given day? If you were smart (and willing to take advantage of this person) you would buy his 50% when he is depressed and sell to him when he is optimistic. You wouldn't worry when his ask price drops; you would be stupid to believe your 50% is now worth less based on his opinion.
The exact same mechanism is at play in the stock market as a whole. For whatever reason, with massive wealth at risk, many people are highly vulnerable to fear, group-think and the typical lemming-like behavior that leads to buying at high points and selling at low points. When you hold a stock and you see it drop from $50 to $40 to $30 then to $15 most people believe they are being left out, are losing money, and are prone to follow the group and sell. I believe it is a simply overwhelming feeling for the typical investor, even if they can rationalize why its a bad idea they do it anyways.
You should not see the stock market as some collective of rational observers making decisions based on logic. You should picture a bunch of potential buyers and sellers constantly waving around bid and ask prices. I usually picture the large boards in the 1800's-1900's whereby trades were made by shouting out offers as the current price is noted on the board in chalk as seen in the picture below. When a buyer and seller yell out and agree on a price, the stock then trades at that price. The changes in price are just a result of the most recent trades and changes in sentiment. The same thing is happening now electronically at a much quicker pace and higher volume.
Now it should be said that fluctuations only matter in relation to business values. If the company you own is overpriced, holding through a big price drop won't necessarily help you if you purchased at that high price. If the business you own is worth $200 and the price drops from $500 to $300, that's not going to cut it. Depending on the quality of the business, the price would have to drop to anywhere from $100-200 for there to be a buying opportunity. This is why you must be certain you are purchasing companies at fair or cheap prices. In the case above, the price drop of 40% from $500 to $300 hasn't presented a buying opportunity but you have suffered a likely permanent loss of capital. Obviously, a buying opportunity is only present if the price is equal to or lower than the value of the business- the lower the quality of the business, the higher the discount to fair value you must demand.
This is the reason that volatility must be embraced in any proper investment operation. For a stock that isn't cheap to become cheap, a 10-20% drop won't do- it will typically need to be more. Of course, you'd prefer this price drop to occur before purchase but that is not always possible- cheap companies sometimes become cheaper based on short-term sentiment. In any case, it should elate investors as price drops in general are a positive thing for future returns.
If one purchases cheap companies, it reduces the potential for price decreases. If you are purchasing companies at half of their fair value, it is going to be difficult for them to become any cheaper, which is why purchasing companies at a discount to intrinsic value both reduces the risk of permanent loss and maximizes returns- it would be difficult for them to get cheaper and if they reach fair value one will experience dramatic returns. Purchasing at large discounts to fair value is both extremely conservative and will bring high returns to the investor. It is the exact opposite of the typical 'risk/reward' paradigm- the higher the discount to fair value, the lower the risk of permanent loss and the higher the potential returns. Of course, risk is usually seen as volatility which is an improper and superficial definition- risk is the chance permanent loss.
I think one of the main reasons investors succumb to fear in times of volatility is because they don't have a sense of the values of their companies. They may have purchased at a high price during a time of euphoria and if they have not assessed the value of the firm, they will react to price fluctuations as if they are indicative of changes in value. To act on price fluctuations makes you a speculator and a gambler. You must always have in mind the value of the business and see prices relative to values. When you are confident in what the business is worth, price changes don't affect your opinion or emotions, and it is only in this case that you are comfortable buying when the stock price drops and the company becomes cheaper.
"Buy low and sell high" is thrown around a lot and for some reason people think it is difficult to do. It is really quite simple, it just requires a high level of emotional tolerance, a disassociation from price changes, confidence in one's analysis, and a bit of contrarianism. Although it seems to be every investor's goal, it is the rare breed that truly buys low and sells high.