A graph of the stock market’s latest ups and downs doesn’t really tell the whole story.
If you are one who believes that stocks are nothing more than wiggles and giggles on a chart, then I suggest you stop reading here. Nothing I say further will matter. Investors who base their decision on whether to buy or sell on stock charts don’t really care too much about the company behind the stock.
But if you believe, as I’m confident you do, that stocks are pieces of businesses and represent products and services, customers, employees and managers — then continue reading. You’re going to like what I have to say.
Let’s take a look how chartists might’ve interpreted the stock market activity this past summer. Chartists see market activity based on high and low points. They try to establish trends based on past price movements that they believe can be extended to predict future points of support and resistance.
They see the price movements in terms of the DJIA’s intraday high of July 21 (12,751), its intraday low of August 10 (10,686), and its recent bounce higher to an intraday high on August 15 (11,484). To sum it up: the DJIA fell 2,065 points, or 16.2% and has now retraced 39% of its decline by rising 798 points or 7.5% from the low. They may even conclude that the stock market is in a bearish trend with brief short covering rallies. Chartists like to let the “trend be their friend” and conclude that stock prices are heading lower.
Another type of investor would look at the stock market’s recent gyrations in a totally different light. By viewing stocks as pieces of a business, value investors might ask themselves: Did something in the fundamentals of businesses change that caused them to be worth 16.2% less?
If we go a step further, the question becomes sharper. The Wilshire 5000 Total Market Index, which is an index of total market capitalization of all U.S. equity securities, on July 21 was valued at $14.3 trillion. Less than three weeks later, the index fell to $11.8 trillion. What fundamental change occurred that caused a loss of $2.5 trillion in 5,000 publicly traded companies?
And then five days later, on August 15, what happened to increase the value of the index by $900 billion to $12.7 trillion?
There is no other asset class that swings from high to low like equities do. The readily available platform to trade makes it so easy to buy and sell stocks that it’s easy to forget we’re talking about real businesses.
Imagine if you were looking to buy a coffee shop on Main Street in Anytown, USA, and your business broker called you one month ago and said, “The owners are looking to sell their business for $100,000.” Then three weeks later he called you back and said, “They’d let the business go for $86,000.” And less than a week later he called to say they changed their minds and “It’s now on the market for $92,000.”
I think you’d either switch brokers or decide that the owners of the coffee shop are not playing with a full deck. When looking at a private business, the value of the business, most of the time, moves by a few percentages either way. But in the world of publicly traded companies, multibillion-dollar businesses can see their market values increase or decrease by more than 50% in one year! While all the while the fundamentals of the business continue to move at a snail’s pace.
Explaining the gyrations
The media provided many explanations for the wild price movements of the stock market: the debt crisis, the European financial crisis, the U.S. debt downgrade by Standard and Poor’s — but very few explanations, if any, concluded that the decrease in market value was justified based on the fundamentals of the business.
I wonder how many fewer hamburgers people will eat at McDonald’s over the next year because of Standard & Poor’s downgrade. Or how many people will stop brushing their teeth with Colgate toothpaste because of Italy’s fiscal problems.
When you really think about it, allowing the stock market to value a business based on the last stock price doesn’t make that much sense.
We’ll probably find out a few months from now that the wild gyrations might have happened because several large hedge funds needed to raise cash. Or perhaps several overleveraged funds had large margin calls. Whatever the reason, we need to keep in mind what Warren Buffett said: “The stock market is there to serve us, not guide us.”
If you know the value of a business, you don’t need to depend on Mr. Market to value your business. In fact, you welcome periods like the one we just went through because during times of fear, stock prices disconnect from the value of the business. In fact, those are the times when the greatest opportunity presents itself.
Fortune managing editor Andy Serwer asked Warren Buffett what he was doing during the summer melt down. Buffett said, “The lower things go, the more I buy. We are in the business of buying, [both securities and, if he can find them, big companies].”
And just a few weeks ago, we found out that during third-quarter 2011, Buffett bought $4 billion of common stock, to add to the $4 billion he bought in the first half of 2011. He also started to buy back, for the first time in history, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) stock.
Buffett was looking to buy while most investors who look to the stock market to guide them were selling. And buying seems to be what most intelligent investors should be doing during downturns. There is, however, one caveat: You need to know the value of the business before you determine if the stock market is accurately reflecting that value. Knowing the value better than the market at times when emotion runs high is the difference between average investors and great ones.
We were buyers
During the market downturn we added several stocks to our portfolios. In the Prime Time portfolio, the market decline gave us the opportunity to buy Leucadia National (NYSE:LUK), recommended in the June 2011 issue, and Texas Instruments (NASDAQ:TXN), recommended in the July 2011 issue. Both stocks hit their trigger price during the market sell off during the first week of August.
We also trimmed some of our positions in both the Prime Time and Special Situation portfolios to make room for future purchases. We sold Mednax Inc. (NYSE:MD)(+31.3%), Cass Information (NASDAQ:CASS)(+23.0%) and Multi-Color (NASDAQ:LABL)(+4.2%). All were purchased close to three years ago, and were trading slightly above their intrinsic value.