Overheard a seductive stock tip? Saw a story about a cool product or a hot stock? Quick payoffs are fool’s gold. To make money in the market, you need to think about stocks differently, not as get-rich-quick schemes, but as Money Machines.
Investing in the stock market doesn’t have to be reckless speculation—gambling on guesses about zigs and zags in stock prices. You can become a value investor by forming your own opinions about what stocks are really worth, and taking advantage of the market’s fickle nature. Where others see risks, you can see opportunities.
Value investing is the secret to the success of Benjamin Graham, Warren Buffett, and other legendary investors. It can be your secret, too.
It’s all about the cash. Resist the temptation to base your investment decisions on guesses about Mr. Market’s prices. Don’t buy stocks foolishly at inflated prices, hoping to sell to even bigger fools at still higher prices.
Instead, think of investments as money machines and think about what you would be willing to pay for the cash they generate over an indefinite horizon. If you are right about the cash, you will be happy with the investment, no matter what Mr. Market says.
Get-rich-quick schemes are inherently suspect. If they worked, the promoter would be using the scheme instead of peddling it. Be skeptical of hot tips. They are usually false or, if true, already reflected in the price.
The efficient market hypothesis says that market prices take into account all relevant information so that no investor can take advantage of other people’s ignorance. There is wisdom in the observation that it will never be clear that a stock’s price is about to surge or collapse—for if it were obvious, there would not be a balance between buyers and sellers.
Stock prices reflect investor expectations and will not rise or fall when things that are expected to happen do happen. Stock prices will change if the unexpected happens. However, by definition, it is impossible to predict the unexpected. Therefore, the argument goes, it is impossible to predict changes in stock prices. Value investors do not try to predict blips and dips in stock prices, but we all should remember that what everyone knows isn’t worth knowing. The true benchmark for gauging your investment ideas is not how today differs from yesterday or how tomorrow will differ from today, but how tomorrow will differ from what others expect.
Some efficient-market enthusiasts argue that the fact that changes in stock prices are difficult to predict proves that the stock market always sets the correct prices, the prices that God herself would set. However, stock prices may be difficult to predict because of unpredictable, sometimes irrational, revisions in investor expectations—as if God determined stock prices by flipping a coin. If so, market prices are hard to predict, but are not good estimates of intrinsic value.
Stock prices are sometimes wacky. During speculative booms and financial crises, the stock market leaves suitcases full of $100 bills on the sidewalk. Still, when you think you have found an easy way to make money, ask yourself if other investors have overlooked a $100 bill on the sidewalk or if you have overlooked a logical explanation.
If a stock’s price goes down after you buy it, think about whether there is a good reason for this dip or if it is just noise. If there is a good reason, consider harvesting the tax benefits by selling the stock. If the price drop is noise, this is an opportunity to buy more shares at an even better price.
Possessing information is knowing something that others do not know. Processing information is thinking more clearly about things that are well known. This distinction is important because even if stock prices take into account sales, profits, interest rates, and other relevant facts, prices may be distorted by common human errors in processing information. The stock market is only semi-efficient. Three examples are confusing a great company with a great stock, hot tips, and chasing trends.
Some investors are more skilled than lucky. However, the pervasive unpredictability of stock prices makes it hard to separate the truly talented from the lucky and the liars. The stock market is not all luck, but it is more luck than nervous investors want to hear or successful investors want to admit.
It is tempting to think that, as in any profession, good training, hard work, and a skilled mind will yield superior results. It is tempting to think that you are one of the gifted. You are not alone! Very few investors think they are below average, even though half are. After all, who would sell one stock and buy another if they thought they would be wrong more often than right? Being human, we count every profitable decision as a confirmation of our wisdom. We blame every mistake on bad luck or the irrationality of other investors.
This overconfidence is why so many investors jump in and out of stocks, believing they know more than investors on the other side of their trades. It is why so many investors hold so few stocks, believing that their picks are destined to succeed. It is why so many investors won’t sell their losers, despite the tax benefits, believing that other investors will eventually agree that these are great stocks.
In any set of data, even randomly generated data, it is possible to find patterns if one looks long enough. Ransacking data for patterns demonstrates little more than persistence: “If you torture the data long enough, it will confess.”
It is not surprising that investors and computers can discover rules that explain the past remarkably well, but are unsuccessful in predicting the future. If there is no underlying reason for the discovered pattern, there is no reason for the pattern to persist. Value investors do not try to predict stock prices, so they do not waste time looking for patterns and they are not tempted by patterns they happen to notice.
In a Ponzi scheme, money from new investors is paid to earlier ones. The insurmountable problem is that the number of new investors needed to keep a Ponzi scheme going multiplies too rapidly to be sustained. Ponzi schemes are an example of the useful principle that investments that sound too good to be true probably aren’t true.
Speculative bubbles are like Ponzi schemes in that they are fueled by wishful thinking that cannot continue indefinitely. Prices climb higher and higher, beyond reason, in that nothing justifies the rising prices except the hope that prices will keep going up. Then the bubble pops, buyers vanish, and prices collapse.
Some people do not think that bubbles are possible. Since markets always set the correct prices, whatever prices markets set must be correct. It is hard to take this circular argument seriously. A bubble exists when rising prices cannot be justified by an asset’s intrinsic value. This is clearly true of collectibles like Beanie Babies that have no intrinsic value. It is also true of stocks that do not generate enough cash to justify their market prices, but are instead being bought so that they can be sold.
Value investors resist bubbles because they are not counting on selling their stocks at higher prices. Value investors are sellers, not buyers, during speculative bubbles (and buyers during panics).
A stock’s intrinsic value is the present value of its dividends if the stock were held forever. Even though we don’t live forever, let alone hold stocks forever, this perspective forces us to think about the cash that companies generate instead of guessing whether the market price tomorrow will be higher or lower than today’s price.
The two main economic drivers of the stock market are the profits that companies generate and the interest rates used to discount these profits. Remember that if you are trying to predict which direction stock prices are headed based on predictions about the economy and interest rates, what matters is how your predictions differ from the predictions already embedded in stock prices. For example, it is not enough to predict that profits will increase; you need to predict whether profits will increase by more or less than the market expects. Value investors do not play this game because they are not trying to predict stock prices.
Instead of trying to predict short-term zigs and zags in stock prices, value investors evaluate individual stocks and the market as a whole by looking for good companies that have low stock prices relative to their dividends, earnings, and assets.
Such comparisons are often implicitly a contrarian strategy, doing the opposite of what the herd is doing. Stock prices are most likely to be low relative to dividends, earnings, and assets when most investors are gloomy and are most likely to be high when most investors are ebullient. Thus value investors tend to buy in the midst of gloom and sell in the midst of euphoria, effectively following Warren Buffett’s advice: “Be fearful when others are greedy and greedy when others are fearful.”
One appealing metric is the John Burr Williams (JBW) equation based on the dividend yield and an assumption about the long-run growth of dividends, perhaps the economy’s long-run growth rate. This total return estimate—the dividend yield plus the dividend growth rate—can be compared to the current interest rate on Treasury bonds plus whatever risk premium satisfies you.
Another appealing metric is a comparison of Robert Shiller’s cyclically adjusted earnings yield to the inflation-adjusted ten-year Treasury rate. Another is the Bogle model for estimating stock returns over a ten-year horizon:
These models can be applied to the market as a whole (as gauged by the S&P 500, for example) or to individual stocks. There is no guarantee it will work in the future, but the top-10 companies on Fortune’s annual list of the most-admired companies have beaten the S&P 500 soundly. An appealing value strategy is to focus on the most-admired companies and use the JBW, Bogle, and Shiller models to assess whether these stocks are attractively priced.
It is risky to extrapolate a few years of a company’s earnings several decades into the future. In addition, growth per se is not valuable. A company that reduces its dividends in order to expand the company always increases the firm’s growth (as long as profits are positive) but doesn’t increase the value of its stock unless the profit is larger than the shareholders’ required return. Firms can also create an illusion of growth by acquiring companies with relatively low price-earnings ratios.
The Law of the Conservation of Investment Value says that the value of a firm depends on the cash it generates, regardless of how that cash is packaged or labeled. Nothing is gained or lost by combining two income streams or by splitting income in two and calling one part one thing and the rest something else. This principle helps us understand why mergers, stock splits, stock dividends, cash dividends, share repurchases, and stock sales do not directly help or hurt shareholders.
Don’t worship earnings per share. There are lots of ways that companies can increase earnings per share without benefiting shareholders: investing in marginally profitable ventures; acquiring companies with low price-earnings ratios; doing a reverse stock split. Value investors don’t drink the Kool-Aid because they compare a stock’s intrinsic value to its market price.
Anchoring is a general human tendency to rely on a reference point; for example, judging the value of something by the price that was paid for it. A stock isn’t worth $50 because you bought it for $50. A house isn’t worth $400,000 because you paid $400,000 for it. Just because mortgage rates were 6 percent in the past doesn’t mean they will be 6 percent in the future.
The price you paid for a stock is a sunk cost that you cannot go back and change. Yet many investors are reluctant to sell losers, despite the tax benefit, because selling for a loss is an admission that they made a mistake buying the stock in the first place. Think about whether a stock is cheap or expensive at its current price, not whether the price is higher or lower than the price you paid. Don’t make foolish wagers trying to recoup your losses. Get over them and move on.
A company whose earnings are up dramatically this year (or over the past few years) is more likely to have experienced good luck than bad luck and, most likely, will regress toward the mean in the future, disappointing overly optimistic investors. Don’t be among them.
The most optimistic earnings predictions are likely to be overly optimistic, which is why the stocks of companies with the most optimistic earnings forecasts usually do worse than stocks with relatively pessimistic forecasts. Similarly, because of regression, stocks that are deleted from the Dow Jones Industrial Average generally outperform the stocks that replace them.
The bottom line is simple and sweet: Mr. Market’s mistakes create opportunities for sensible value investors. Form your own opinion about what stocks are really worth and, remember, stocks are money machines.