Revisiting the Relationship Between Intrinsic Value and Market Price

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Sep 03, 2014
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“The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”

-Ben Graham and Dave Dodd

One of the questions that I have spent a lot of time thinking about is the relationship between intrinsic value and market price, especially when my intrinsic value calculation for a security remains much higher than the market price of the security for an extended period of time. After all, shouldn’t sound analysis produce successful results in a reasonably long period, say 3 to 5 years? Such is the case for IBM. I don’t know whether Mr. Buffett is surprised by the performance of IBM’s stock since Berkshire Hathaway acquired a major position in 2011, although three-years is arguably too short to judge the correctness of Mr. Buffett’s decision. What I can reasonably infer is that Mr. Buffett thought that the intrinsic value of IBM was much higher than what it traded back then.

While I don’t know the exact answers to the questions posed above, I was able to glean some insight when re-reading the bible of value investing – Security Analysis. In Chapter One, Graham and Dodd laid out a chart, which traces the various steps culminating in the market price. Below is a snapshot of this very important chart:

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Graham and Dodd then shrewdly observed that “it will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.

Looking at the chart above, again, we can be reasonably sure that Mr. Buffett had done sound analysis regarding future value factors and intrinsic value factors. So should a long-term IBM shareholder. If the analysis is right, then it must be the market factors that have been preventing the unlocking of IBM’s value proposition since 2011. Graham and Dodd pointed out that “undervaluations caused by neglect or prejudice may persist for an inconveniently long time. The particular danger to the analyst is that, because of such delay, new determining factors may supervene before the market price adjusts itself to the value as he found it. In other words, by the time the price finally does reflect the value, this value may have changed considerably and the facts and reasoning on which his decision was based may no longer be applicable.

The antidote, according to Graham and Dodd, is “by dealing with those situations preferably which are not subject to sudden change; in part, by favoring securities in which the popular interest is keen enough to promise a fairly swift response to value elements which he is first to recognize……

Now the question becomes:

1.Is IBM truly not subject to sudden change?

2.Is the popular interest in IBM keen enough to promise a fairly swift response to value elements which he is first to recognize?

I don’t know enough about IBM’s business to answer those questions although I was tempted to. But you can tell how the answers to these two questions will determine whether the assumed undervaluation will persist for an inconveniently long time or not. And let’s not forget that “the particular danger to the analyst is that, because of such delay, new determining factors may supervene before the market price adjusts itself to the value as he found it. In other words, by the time the price finally does reflect the value, this value may have changed considerably and the facts and reasoning on which his decision was based may no longer be applicable.

You may ask, what exactly is your point? I am not suggesting that IBM is undervalued. Nor am I suggesting that Mr.Buffett’s analysis on IBM was wrong.

First of all, IBM is just a case study for Ben and Dave’s timeless investment wisdom: there are three broad categories of factors that influence the market price of a security. Too often value investors focus on the latter two categories (future value factors and intrinsic value) while ignoring the first category (market). It seems to me that truly extraordinary investors ought to pay an adequate amount of attention to the market factors, although he may be wrong from time to time.

Secondly, an intelligent investor should be diligent about whether the facts and reasoning on which his decision was based are still applicable. In this regards, comparing facts with the theses you laid out a couple years ago will be helpful.

Similar to that of most of my previous articles, my intention is not to inform, but to remind.