Lessons from a bloke called Benjamin
With unbelievable prices paid for stocks that have never made a dollar, here's a salutary lesson from an investor who's seen it all before.
The original masthead of this publication says a lot about our approach to investment. The Intelligent Investor is a classic work by Benjamin Graham. Graham, who lectured at Columbia Graduate Business School in New York, based this work and his other famous volume, Security Analysis, on his fundamental belief that investors who accurately calculate the intrinsic value of a company and buy shares below that value will make money.
Now, to Graham, the financial analysis of a company was not an exact science. While you can apply certain mathematical formulae and calculations to a company's books, other factors such as the ability of management and the nature of the firm's business have a big impact on its intrinsic value. Graham, a science graduate, never fully trusted this latter qualitative approach, however, and thought too much reliance on these elusive values invited investors to take risks - to allow emotion and over-optimism to cloud judgment.
While Graham's most famous disciple, Warren Buffett, the world's most successful investor, has proved time and again his genius in judging these qualitative features, there is no doubt that it is an extremely difficult craft. It is safer, said Graham, to start with net asset values and then your downside is limited to the liquidation value of those assets.
This is an extremely cautious approach, and one which, as experience grows, many investors depart from. Graham believed that there were good returns to be made by following his conservative approach and letting other investors do much of the work for him. He reasoned that the way to benefit from capital growth was to calculate a company's intrinsic value and buy it when the price was much lower than that figure. This could be either by reason of a bear market - where all stocks are trading at lower prices - or because individual stocks fall for another reason.
This happens most frequently, says Graham, because of the market's own essentially irrational view of life. This, he argued, is because people make markets and they find it difficult not to let emotion take the place of reason. While this approach is anathema to modern 'efficient market' analysts, who believe that markets rationally value stocks, taking into account all available information, it's a very attractive explanation of why the market can value some loss-making stocks so highly year after year.
Keep your cool
Graham illustrated his point of view with an entertaining anecdote. He suggested that you imagine having a business partner, Mr Market, who each day quotes a price at which he is prepared to buy you out or sell his interest to you. The problem is that Mr Market is a manic-depressive. Some days he is upbeat and quotes a high price for your interest. On other days he is impossibly gloomy about the future and is prepared to sell out his interest for a song. Mr Market is extremely thick-skinned. He doesn't care if you take his offer or not and tomorrow he'll be back with a new one. Because of this, you are put at a distinct advantage to earn good returns at his expense, providing the business is on secure economic foundations.
Beware the raging bulls
Even more important is that you do not fall into the trap of believing Mr Market's view of the future is necessarily the right one. This requires you to keep a cool, rational head. There is no place for emotion in stock investment and your attempt to look at the possibilities for the future in a dispassionate way are often going to be more realistic than the market's emotional rollercoaster. These wild rides may seem sustainable for a while, but in the long run, no stock can continue to trade at prices way above its intrinsic value.
This view provides a compass for investors in what at times seems like an uncharted sea. Unfortunately, this can be very difficult advice to follow. Human nature is such that it is hard to watch others making huge sums of money on a rapidly rising bull market and stand back because of a rational assessment of the underlying value of a company. But in the bad times it can be an extremely comforting doctrine to follow.
As with a raging bull market where prospects are seldom as good as they seem at the time, a bear market is rarely as bad and will often provide great opportunities for investors, who can keep their feet on the ground, to buy companies at prices often well below their value.
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