Don’t worry about why a stock is cheap. Don’t think of your investment in a stock as a bet for or against the prevailing view that some product, industry, technology, CEO or societal trend will prove good or bad – durable or temporary.
That isn’t your job. Knowing why other people are betting against a stock is knowledge you don’t need.
The only knowledge you need is the knowledge that you are buying a piece of a business for less than its value to a private owner.
The stock market is not a racetrack pooling bets on the future. It is a store selling pieces of businesses. Some of the merchandise is priced very high. Some very low. Most is priced about the level a reasonably well-informed shopper would pay.
But that doesn’t mean you should assume the listed price has any relationship to the product’s actual value.
You are a bargain hunter. Your job is to find the best merchandise at the lowest price.
Mr. Market
Everybody has heard the story of Mr. Market. At least second hand. Here is the actual tale as told by Ben Graham:
That’s the whole point of Ben Graham’s Mr. Market metaphor. Mr. Market has mood swings. Our job is to take advantage of those mood swings. It is not our job to use Mr. Market’s moods as possible evidence of some actual condition of the business.
Seeing Wal-Mart (WMT, Financial) has a P/E of 13 and Costco (COST, Financial) has a P/E of 26 and then setting off to prove that Wal-Mart’s prospects are every bit as good as Costco’s is a terrible idea. If you want to buy Wal-Mart stock you need only prove that Wal-Mart is selling for less than the business is worth. You don’t need to know why Wal-Mart sells for less than Costco or Dollar General (DG, Financial). In fact, you don’t even need to know how high or low Wal-Mart’s P/E is compared to those businesses. You only need to know one price and understand the value of one business.
And yet, many of the value investing blogs and articles I read start their discussion of why some stock is such a great investment by explaining what the market’s consensus view is and why that conventional wisdom is wrong.
This is a terrible idea because:
1. Market prices are complex. Buy and sell decisions are complex. Comparing your view of the future with the market’s view of the future assumes we can offer a distinct reason for why people buy and sell stocks. Can we really be more specific than people sell stocks because they don’t want to hold them and they buy stocks because they do want to hold them?
I’m skeptical about the idea of understanding the reasons for people’s buy and sell decisions. People are attracted to certain stocks and repulsed by others. These feelings aren’t totally unexplainable. I’m sure we can partially explain why certain celebrities are found especially attractive or repulsive by the general public. We could probably do the same for why certain stocks are found especially attractive or repulsive by the investing public. Beyond laying down some general principles of what investors do and don’t find attractive in a stock – I think we’d mostly just be entertaining ourselves making up stories about stocks instead of just valuing stocks.
2. We intend to take advantage of the market price. If we let the market price influence our opinion of the company we are taking an input and letting it pass through us as an output. This is dangerous. And risks creating feedback where we do not isolate our thinking from the market’s thinking but instead allow ourselves to regurgitate some of what the market is telling us without analyzing it. If you head down this path, you are venturing into more and more reactive behavior. It’s a bad idea to be “in tune with the market.” Isolation is best.
3. I don’t think knowing the reasons why people are selling a stock has much practical use.
Here are my own experiences in this regard.
I don’t worry about why investors stay away from a stock, because I’ve found it isn’t helpful in my investing process. Trying to find the issue on which I and other investors disagree has never helped me. Knowing why others aren’t buying a stock hasn’t helped me. Some of my best purchases have been in situations where it was rather unclear to me why the stock persistently traded as low as it did.
J&J Snack Foods
For example, J&J Snack Foods (JJSF, Financial) in 2000.
At the time, these were the company’s last five years of (diluted) earnings per share:
1995: $0.61
1996: $0.65
1997: $0.91
1998: $1.26
1999: $1.50
You can read the CEO’s 1999 letter to shareholders. The company was already 28 years old. Its long-term growth record was fine. The founder had been running it for 28 years. The business was simple to understand. And the discussion of it in the annual report was adequate. The CEO had a simple, clear vision for the company. He communicated it well. And the company had delivered on that vision for close to three decades. It didn’t sound like the CEO was leaving any time soon. So the future would probably look a lot like the past. And It was not a difficult company to value based on the past.
In 2000, the stock price of J&J Snack Foods ranged from $12.50 to $22.75. In every quarter, it sold below $17 a share at least once.
So, you could buy JJSF in 2000 at a P/E of anywhere from 8.3 to 15.2 just by picking a random day to buy the stock. If you were choosy, you were given the opportunity to buy the stock at under 12 times earnings at least once in every quarter.
You may remember, back in 2000, the S&P 500’s price-to-earnings ratio was quite a bit higher than 12.
What happened to J&J Snack Foods?
Earnings dipped right after 1999, but J&J Snack Foods went on to grow by more than 11% a year for the next decade.
If you bought the stock in 2000 and held it until today, you experienced annual stock price appreciation of somewhere between 13% and 19% a year (depending on whether you bought closer to a P/E of 8 or a P/E of 15). You also received cash dividends of $5.10 (split adjusted for 2000 stock purchase) which is anywhere from a 20% to 40% return of your original investment within 12 years. Not bad considering the company didn’t pay a dividend in 2000. Had never paid a cash dividend in the past. And had no intention of paying a cash dividend in the future.
I’m still not clear why the stock often traded for a high single-digit to low double-digit P/E ratio back in 2000. It didn’t make sense to me when I bought the stock at age 14. Today, at age 26, I still don’t know why that happened. But it did happen. And all you had to do was notice the stock and buy it. You didn’t need to know why it was cheap. You just had to recognize JJSF was a perfectly fine business selling for less than its value to a private owner. That’s the lesson of Ben Graham’s Mr. Market metaphor.
Village Supermarket
Next example: same year (2000), same state (New Jersey), same product (food), different company – Village Supermarket (VLGEA, Financial).
At the time, these were the company’s last five years of (diluted) earnings per share:
1995: $0.20
1996: $0.69
1997: $0.71
1998: $1.34
1999: $1.55
Same store sales:
1995: (0.7%)
1996: 1.7%
1997: 1.0%
1998: 2.4%
1999: 6.0%
Sales per square foot:
1995: $803
1996: $809
1997: $803
1998: $811
1999: $866
Tangible book value (July 1999): $18.45 a share.
In fiscal year 2000, Village Supermarket’s shares traded between $12.13 a share and $15.75 a share.
That means if you bought the stock on a random day in 2000, you got it at a P/E ratio of anywhere from 7.8 to 10.2.
The price-to-book ratio was anywhere from 0.66 to 0.85.
The letter to shareholders from Village Supermarket was even better. It didn’t explain how the company was simply chugging along as it had for more than a quarter century – like J&J Snack Food’s letter did – instead it explained how the company had turned itself around in the last four years and was committed to continuing down that very simple path.
You can read the shareholder letter here (it’s part of the 10-K).
As you can see, Village was selling more per square foot, increasing the amount of square feet of selling space per store, and adding higher margin specialty items in those extra square feet (see discussion of the “Power Alley” for example).
The whole thing was very obvious (remember, this was a grocer with a 6% jump in same store sales). And yet none of it was reflected in the stock’s P/E ratio (which was basically 8-10 throughout the following year) or the price-to-book ratio (which was around 0.7 to 0.9).
I’m not sure why the stock traded at those prices. The company had debt. But it also had land offsetting much of that debt. It had built up a lot of retained earnings over the years. It wasn’t some speculative business. To the extent the financial position was not spotless it was basically what you would find with any grocery store.
About five years before, Village posted an operating loss. At that time, it violated some bank covenants. This is not unusual for a grocery store. Generally, they aren’t built to post even an occasional operating loss. If you own a grocer or a railroad or something like that and you see operating earnings go into the red – you know operations need to get turned around fast or your stock is going to go to zero. That’s the nature of leverage. So, that could’ve been a concern here. Although (operating and financial) leverage works both ways. So a sustained improvement in operations at a grocer can lead to really big returns (the same is true at a railroad).
Now, maybe some people had a preference for a grocer with more of a national presence. Though it’s unclear to me why smaller stores spread over a larger region and operated under different brand names is better than big stores clustered in a small area using the same brand name.
Yes, in 2000, there was some talk of online groceries. The web was changing everything. And it was going to change the way we bought our food too. Maybe that had something to do with it.
Personally, I kind of doubt it. I actually think the web did have something to do with the stock price of Village Supermarket – but not in the way you might think.
I think both J&J Snack Foods and Village Supermarket had two strikes against them in 2000:
1. They weren’t tech companies
2. They weren’t mega caps
If you look at stocks in 2000, people were interested in the world’s newest public companies and the world’s biggest public companies. That’s what investors found attractive back then: new and big.
Old and small was repulsive.
And this trend had been happening for a few years. So, if in 1996 or so you were some company that wasn’t a global giant or on the Internet, you were neglected. And if you were that kind of company and you were growing the value of your business quarter after quarter in the late 1990s, you got no credit for that growth. So by around 2000 or so we were in a situation where some public companies had increased their intrinsic value quite a bit without any parallel increase in their market cap. In an odd way, you had some stocks get cheaper during a bull market.
Beyond that, I can’t offer a good explanation for why these stocks traded at the prices they did back in 2000. It didn’t make sense to me then. And it doesn’t make sense to me now.
The fact that I never understood why either stock was cheap is irrelevant.
You don’t need to know why something is cheap to know it is cheap.
In each case, all you had to do was look at the business and look at the market cap. They were both perfectly fine businesses selling for less than their value to a private owner.
That’s the only requirement for a value investment.
Worrying about why a stock is cheap is doing exactly the opposite of what Ben Graham taught. And yet it’s something I see included in a lot of articles and blog posts written by value investors. They always feel they have to explain why investors hate the stock.
That often makes for a more entertaining article. It certainly gives the piece more of the flavor of a narrative. And people love hearing stories. People love thinking in stories.
But it’s not necessary for the actual investments you make. It’s okay to have no clue why a stock is so cheap.
It’s enough just to understand how the value of the business is higher than the stock price. You don’t need to know why the stock price is what it is.
That’s not your business.
Your business is buying cheap stocks. Not worrying about why a stock is cheap.
Ask Geoff a Question about Ben Graham’s Mr. Market Metaphor
Check out the Ben Graham: Net-Net Newsletter
Check out the Buffett/Munger Bargain Newsletter
That isn’t your job. Knowing why other people are betting against a stock is knowledge you don’t need.
The only knowledge you need is the knowledge that you are buying a piece of a business for less than its value to a private owner.
The stock market is not a racetrack pooling bets on the future. It is a store selling pieces of businesses. Some of the merchandise is priced very high. Some very low. Most is priced about the level a reasonably well-informed shopper would pay.
But that doesn’t mean you should assume the listed price has any relationship to the product’s actual value.
You are a bargain hunter. Your job is to find the best merchandise at the lowest price.
Mr. Market
Everybody has heard the story of Mr. Market. At least second hand. Here is the actual tale as told by Ben Graham:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in that enterprise? Only, in case 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 happy to buy from him when his price is low…price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.It doesn’t matter what other people are doing – and it certainly doesn’t matter why they are doing it. All you and I need to do is buy a stock when it sells for less than its value to a private owner.
That’s the whole point of Ben Graham’s Mr. Market metaphor. Mr. Market has mood swings. Our job is to take advantage of those mood swings. It is not our job to use Mr. Market’s moods as possible evidence of some actual condition of the business.
Seeing Wal-Mart (WMT, Financial) has a P/E of 13 and Costco (COST, Financial) has a P/E of 26 and then setting off to prove that Wal-Mart’s prospects are every bit as good as Costco’s is a terrible idea. If you want to buy Wal-Mart stock you need only prove that Wal-Mart is selling for less than the business is worth. You don’t need to know why Wal-Mart sells for less than Costco or Dollar General (DG, Financial). In fact, you don’t even need to know how high or low Wal-Mart’s P/E is compared to those businesses. You only need to know one price and understand the value of one business.
And yet, many of the value investing blogs and articles I read start their discussion of why some stock is such a great investment by explaining what the market’s consensus view is and why that conventional wisdom is wrong.
This is a terrible idea because:
1. Market prices are complex. Buy and sell decisions are complex. Comparing your view of the future with the market’s view of the future assumes we can offer a distinct reason for why people buy and sell stocks. Can we really be more specific than people sell stocks because they don’t want to hold them and they buy stocks because they do want to hold them?
I’m skeptical about the idea of understanding the reasons for people’s buy and sell decisions. People are attracted to certain stocks and repulsed by others. These feelings aren’t totally unexplainable. I’m sure we can partially explain why certain celebrities are found especially attractive or repulsive by the general public. We could probably do the same for why certain stocks are found especially attractive or repulsive by the investing public. Beyond laying down some general principles of what investors do and don’t find attractive in a stock – I think we’d mostly just be entertaining ourselves making up stories about stocks instead of just valuing stocks.
2. We intend to take advantage of the market price. If we let the market price influence our opinion of the company we are taking an input and letting it pass through us as an output. This is dangerous. And risks creating feedback where we do not isolate our thinking from the market’s thinking but instead allow ourselves to regurgitate some of what the market is telling us without analyzing it. If you head down this path, you are venturing into more and more reactive behavior. It’s a bad idea to be “in tune with the market.” Isolation is best.
3. I don’t think knowing the reasons why people are selling a stock has much practical use.
Here are my own experiences in this regard.
I don’t worry about why investors stay away from a stock, because I’ve found it isn’t helpful in my investing process. Trying to find the issue on which I and other investors disagree has never helped me. Knowing why others aren’t buying a stock hasn’t helped me. Some of my best purchases have been in situations where it was rather unclear to me why the stock persistently traded as low as it did.
J&J Snack Foods
For example, J&J Snack Foods (JJSF, Financial) in 2000.
At the time, these were the company’s last five years of (diluted) earnings per share:
1995: $0.61
1996: $0.65
1997: $0.91
1998: $1.26
1999: $1.50
You can read the CEO’s 1999 letter to shareholders. The company was already 28 years old. Its long-term growth record was fine. The founder had been running it for 28 years. The business was simple to understand. And the discussion of it in the annual report was adequate. The CEO had a simple, clear vision for the company. He communicated it well. And the company had delivered on that vision for close to three decades. It didn’t sound like the CEO was leaving any time soon. So the future would probably look a lot like the past. And It was not a difficult company to value based on the past.
In 2000, the stock price of J&J Snack Foods ranged from $12.50 to $22.75. In every quarter, it sold below $17 a share at least once.
So, you could buy JJSF in 2000 at a P/E of anywhere from 8.3 to 15.2 just by picking a random day to buy the stock. If you were choosy, you were given the opportunity to buy the stock at under 12 times earnings at least once in every quarter.
You may remember, back in 2000, the S&P 500’s price-to-earnings ratio was quite a bit higher than 12.
What happened to J&J Snack Foods?
Earnings dipped right after 1999, but J&J Snack Foods went on to grow by more than 11% a year for the next decade.
If you bought the stock in 2000 and held it until today, you experienced annual stock price appreciation of somewhere between 13% and 19% a year (depending on whether you bought closer to a P/E of 8 or a P/E of 15). You also received cash dividends of $5.10 (split adjusted for 2000 stock purchase) which is anywhere from a 20% to 40% return of your original investment within 12 years. Not bad considering the company didn’t pay a dividend in 2000. Had never paid a cash dividend in the past. And had no intention of paying a cash dividend in the future.
I’m still not clear why the stock often traded for a high single-digit to low double-digit P/E ratio back in 2000. It didn’t make sense to me when I bought the stock at age 14. Today, at age 26, I still don’t know why that happened. But it did happen. And all you had to do was notice the stock and buy it. You didn’t need to know why it was cheap. You just had to recognize JJSF was a perfectly fine business selling for less than its value to a private owner. That’s the lesson of Ben Graham’s Mr. Market metaphor.
Village Supermarket
Next example: same year (2000), same state (New Jersey), same product (food), different company – Village Supermarket (VLGEA, Financial).
At the time, these were the company’s last five years of (diluted) earnings per share:
1995: $0.20
1996: $0.69
1997: $0.71
1998: $1.34
1999: $1.55
Same store sales:
1995: (0.7%)
1996: 1.7%
1997: 1.0%
1998: 2.4%
1999: 6.0%
Sales per square foot:
1995: $803
1996: $809
1997: $803
1998: $811
1999: $866
Tangible book value (July 1999): $18.45 a share.
In fiscal year 2000, Village Supermarket’s shares traded between $12.13 a share and $15.75 a share.
That means if you bought the stock on a random day in 2000, you got it at a P/E ratio of anywhere from 7.8 to 10.2.
The price-to-book ratio was anywhere from 0.66 to 0.85.
The letter to shareholders from Village Supermarket was even better. It didn’t explain how the company was simply chugging along as it had for more than a quarter century – like J&J Snack Food’s letter did – instead it explained how the company had turned itself around in the last four years and was committed to continuing down that very simple path.
You can read the shareholder letter here (it’s part of the 10-K).
As you can see, Village was selling more per square foot, increasing the amount of square feet of selling space per store, and adding higher margin specialty items in those extra square feet (see discussion of the “Power Alley” for example).
The whole thing was very obvious (remember, this was a grocer with a 6% jump in same store sales). And yet none of it was reflected in the stock’s P/E ratio (which was basically 8-10 throughout the following year) or the price-to-book ratio (which was around 0.7 to 0.9).
I’m not sure why the stock traded at those prices. The company had debt. But it also had land offsetting much of that debt. It had built up a lot of retained earnings over the years. It wasn’t some speculative business. To the extent the financial position was not spotless it was basically what you would find with any grocery store.
About five years before, Village posted an operating loss. At that time, it violated some bank covenants. This is not unusual for a grocery store. Generally, they aren’t built to post even an occasional operating loss. If you own a grocer or a railroad or something like that and you see operating earnings go into the red – you know operations need to get turned around fast or your stock is going to go to zero. That’s the nature of leverage. So, that could’ve been a concern here. Although (operating and financial) leverage works both ways. So a sustained improvement in operations at a grocer can lead to really big returns (the same is true at a railroad).
Now, maybe some people had a preference for a grocer with more of a national presence. Though it’s unclear to me why smaller stores spread over a larger region and operated under different brand names is better than big stores clustered in a small area using the same brand name.
Yes, in 2000, there was some talk of online groceries. The web was changing everything. And it was going to change the way we bought our food too. Maybe that had something to do with it.
Personally, I kind of doubt it. I actually think the web did have something to do with the stock price of Village Supermarket – but not in the way you might think.
I think both J&J Snack Foods and Village Supermarket had two strikes against them in 2000:
1. They weren’t tech companies
2. They weren’t mega caps
If you look at stocks in 2000, people were interested in the world’s newest public companies and the world’s biggest public companies. That’s what investors found attractive back then: new and big.
Old and small was repulsive.
And this trend had been happening for a few years. So, if in 1996 or so you were some company that wasn’t a global giant or on the Internet, you were neglected. And if you were that kind of company and you were growing the value of your business quarter after quarter in the late 1990s, you got no credit for that growth. So by around 2000 or so we were in a situation where some public companies had increased their intrinsic value quite a bit without any parallel increase in their market cap. In an odd way, you had some stocks get cheaper during a bull market.
Beyond that, I can’t offer a good explanation for why these stocks traded at the prices they did back in 2000. It didn’t make sense to me then. And it doesn’t make sense to me now.
The fact that I never understood why either stock was cheap is irrelevant.
You don’t need to know why something is cheap to know it is cheap.
In each case, all you had to do was look at the business and look at the market cap. They were both perfectly fine businesses selling for less than their value to a private owner.
That’s the only requirement for a value investment.
Worrying about why a stock is cheap is doing exactly the opposite of what Ben Graham taught. And yet it’s something I see included in a lot of articles and blog posts written by value investors. They always feel they have to explain why investors hate the stock.
That often makes for a more entertaining article. It certainly gives the piece more of the flavor of a narrative. And people love hearing stories. People love thinking in stories.
But it’s not necessary for the actual investments you make. It’s okay to have no clue why a stock is so cheap.
It’s enough just to understand how the value of the business is higher than the stock price. You don’t need to know why the stock price is what it is.
That’s not your business.
Your business is buying cheap stocks. Not worrying about why a stock is cheap.
Ask Geoff a Question about Ben Graham’s Mr. Market Metaphor
Check out the Ben Graham: Net-Net Newsletter
Check out the Buffett/Munger Bargain Newsletter
