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Making the Fluctuations Pay

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Sep 15, 2009
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Warren Buffett has continuously given credit for his approach to stock investing to his mentor and friend, Ben Graham. To be more specific, Buffett points to Graham’s The Intelligent Investor, the book Buffett read in 1950, when he was 19-years old. And for more than 50 years, Buffett’s approach hasn’t changed.

When Buffett wrote the preface to the 4 th edition (1973), he said,

If you follow the behavioral and business principles that Graham advocates—and if you pay special attention to the invaluable advice in Chapters 8 and 20—you will not get a poor result from your investments. (That represents more of an accomplishment than you might think.)

I find myself reading Chapter 8 (“The Investor and Market Fluctuations”) and Chapter 20 (“‘Margin of Safety’ as the Central Concept of Investment”) several times a year. In Chapter 8, Graham introduces the reader to his famous “Mr. Market” metaphor to explain how and why stock prices fluctuate. More than 50 years later, there is no better way of understanding how stocks are priced than by using Graham’s Mr. Market.

Mr. Market

Graham explained Mr. Market by way of a parable. He said that an investor should imagine that in a private business of which he owns a small share, he has a partner named Mr. Market.

Each day, Mr. Market tells you what he thinks your interests are worth and offers to either buy or sell your interest for that price. On some days, Mr. Market is spot-on and his price is justified by the underlying worth of the business.

However, on other days, Mr. Market lets his emotions get the better of him. When euphoric, he offers you sky-high prices for your interests. But when depressed, he offers you very low prices for those same interests. Mr. Market doesn’t care if you sell to him when he offers you a very high price or buy from him when he offers you a very low price. It is better to form your own ideas on the value of your interests based on the underlying worth of the business than to allow Mr. Market to determine those values for you. In other words, Mr. Market is there to serve you, not to guide you.

Wild swings

While I’m sure you know that nothing is certain but death and taxes, I would like to add another certainty: fluctuating stock prices. Graham was telling intelligent investors that they needed to be prepared both financially and psychologically for price volatility, because the swings could be huge. He went on to say that these wide pendulum swings in prices should be taken advantage of and not be a cause of concern for the intelligent investor.

Buffett got the point about fluctuating stock prices, cautioning investors, “Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.” If one needed to have the point driven home, the volatility in the stock market that occurred in the closing months of 2008 was nothing short of spectacular.

Since 1950 there have been only 68 trading days (0.40% of the time) that saw the stock market rise or fall 4% or more; I’m sure you would agree that it is a pretty rare event. Yet 28 of those rare 68 days (nearly 4 out of 10 days) happened in the last three months of 2008! Most investors panicked and sold stocks as quickly as they could. Stock prices were trading at valuations to the underlying businesses at levels not seen in decades. Volatility has increased dramatically in the past decade as access to information has become almost instantaneous.

Events that took days to influence prices now happen in mere seconds. It is said that the basis for the Rothschild fortune was set toward the end of the Napoleonic Wars. Having a network of agents across Europe, the four Rothschild brothers were able to capitalize on the news of Wellington’s victory at the Battle of Waterloo (June 16–19, 1815) a full day ahead of the government's official messengers. That is how Nathan, living in England, knew it was safe to invest heavily in the London economy a full day ahead of most businessmen.

Knowing that stocks will fluctuate, as sure as the sun will rise in the East, how then can an investor profit from these extreme gyrations? Graham mentions two ways:
Timing or forecasting price movementsPricing: buy when prices are below intrinsic value and sell when they are above

Crystal ball

Let’s first take a look at timing or forecasting price movements. It doesn’t matter if I’m being interviewed on CNBC or a local radio station, the interviewer always asks for a prediction: where do I see the stock market going over the next month, six months, year, or longer? Each time I’m asked I give the same answer: I have no clue.

Wall Street and the media have done an excellent job persuading the public that it’s important to have some kind of opinion on events that are unknown and unknowable and to focus on market forecasts. It’s hard not to be persuaded, considering these analysts are backed by billions of dollars in assets, tuned in to government sources for information, have titans of industry whispering in their ears, and are watching customer order flow as it crosses their trading desks.

However, the track record of long-range predictions is not that good, even when done by the best in the business. Each year, Barron’s interviews Wall Street strategists on their 12-month predictions on stocks, bonds, and profits, as well as the industry sectors they favor and those they would avoid in the coming year. If there were any year that investors would have wanted to use a crystal ball to peer into the future, it was in 2008—the worst year for the S&P 500 since 1931. How accurate were the analysts’ predictions?

S&P 500-2008 Projection*

Not one analyst predicted a lower S&P 500 in 2008

S&P 500
Wall Street Firm 2008 Target
Merrill Lynch 1525
Morgan Stanley 1525
J.P. Morgan 1590
B of A Securities 1625
Lehman Bros. 1630
Deutsche Bank 1640
Credit Suisse 1650
Goldman Sachs 1675
Citigroup 1675
UBS Securities 1700
Bear Stearns 1700
ISI Group 1750

*12-month projection from 11/30/07 Source: Barron’s 12/17/07

Unfortunately, they all missed the mark by a mile. On the day the analysts made their predictions (11/30/07), the S&P 500 closed at 1481. The most “bearish” analyst predicted a 3% rise and the most “bullish” forecast an 18% rise for the S&P 500 in 12 months. The S&P 500 closed on 11/28/08 at 896, a 12-month decline of 39.5%. Not one analyst forecast that the S&P 500 would even be lower one year later!

Trying to figure out how corporate America will fare over 12 months is an almost impossible task. Perhaps these analysts were better at predicting interest rates, which rely more on economic fundamentals.

2008 Forecast 10-Year Treasury Yield

Only one analyst got the direction (lower) right!

Wall Street Firm Treasury Yield
Merrill Lynch 3.7%
UBS Securities 4.0%
Goldman Sachs 4.0%
ISI Group 4.0%
Lehman Bros. 4.2%
Credit Suisse 4.3%
Citigroup 4.4%
Morgan Stanley 4.5%
Deutsche Bank 4.8%
Bear Stearns 5.0%
J.P. Morgan 5.0%
BofA Securities 5.0%

They didn’t do that much better forecasting interest rates. Once again, they got it all wrong. On the day the analysts made their prediction, the 10-year Treasury yield was 3.97%. The analysts with the lowest yield predicted that yields would fall a mere 27 basis points (bp), while the most aggressive prediction saw yields soaring to 5%, a rise of 103 bp.

One year later on 11/28/08, the yield actually dropped to 2.93%, 77 bp lower than the lowest prediction and 207 bp lower than the highest predictions. Only one analyst got the direction (lower) right!

I wouldn’t trade places with those analysts for all the tea in China; they have a very hard job. Predicting the future is a very difficult way to make a living and an even harder way to invest. If these folks with all the resources behind them can’t get it right in the worst year in market history since the Great Depression, what chance does the average investor have?

While some investors can and do make money forecasting price movements, the record shows that the average investor stands little chance investing in this manner. Even if investors use a formula or system that has been back-tested over decades and shows excellent results, that is no guarantee of success. Market conditions change and old formulas can’t adapt, resulting in losses. In addition, many popular systems based on market behavior, such as investing on certain days of the month, eventually fail due to their popularity.

Value and price

While most investors see stocks as nothing more than symbols that are bought and sold in fractions of a second, there is another group that sees things in a totally different light.

Viewing stocks for what they really are, pieces of a business, makes all the sense in the world. By valuing the whole business, you can then figure out how much a piece of the business (its stock) is worth. The factors that affect a business are its financial condition and future prospects. The value of most large-cap businesses in stable industries doesn’t radically change over short periods of time; instead, it chugs along at a consistent rate year after year.

If a private business had earnings that were 2% lower than the previous quarter, would the business now be valued at 20% or 30% lower than it was the day before?

Imagine you own a private business that is worth $1 billion and your most recent quarterly earnings were $50 million, which is $1 million lower than the previous quarter. Let’s assume there was a perfectly good explanation for the decrease in earnings and it appears to be a onetime event. Now imagine getting a call from a business broker offering to buy your business, which was valued yesterday at $1 billion (based on comparable businesses in your industry), for $700 million. How fast would you hang up the phone? It seems ludicrous that someone would have the nerve to make an offer that is so disconnected from the value of the business. But that is exactly what happens in the stock market when investors have no idea of the relationship between the value of a business and the price of a stock.

Think of the advantage you would have if a minority partner in your business offered you his shares based on the “emotional” valuation of $700 million. How fast would you buy those shares back from him?

If you think this doesn’t happen on Wall Street, think again. The table below shows the percentage change from the highest stock price over the past 52 weeks on businesses in The Inevitable Wealth Portfolio. Keep in mind that these are not small-cap or penny- stock companies but large-cap, multibillion-dollar global giants.

Declines from 52-week highs

Stock prices disconnect from the value of the business

52-Week 52-Week 52-Week Decline
Name Symbol High Low from High
The Mosaic Company MOS $163.25 $21.94 87%
Leucadia National Corp. LUK $56.90 $10.26 82%
Tyco Electronics Ltd. TEL $40.34 $7.40 82%
National Oilwell Varco, Inc. NOV $92.70 $17.60 81%
CF Industries Holdings CF $172.99 $37.71 78%
Southern Copper Corp. PCU $40.42 $9.12 77%
Western Digital Corp. WDC $40.00 $9.48 76%
Garmin Ltd. GRMN $55.50 $14.40 74%
Corning Inc.* GLW $28.07 $7.36 74%
Noble Corporation NE $68.99 $19.23 72%
Autodesk, Inc. ADSK $41.68 $11.70 72%
Nucor Corporation NUE $83.56 $25.25 70%
Devon Energy Corp. DVN $127.43 $38.55 70%
Coach, Inc.* COH $37.64 $11.41 70%
eBay Inc. EBAY $32.10 $9.91 69%
EOG Resources, Inc. EOG $144.99 $45.03 69%
Schlumberger Limited SLB $111.95 $35.05 69%
Tiffany & Co. TIF $49.98 $16.70 67%
Apache Corp. APA $149.23 $51.03 66%
Carnival Corp. CCL $42.71 $14.85 65%
ConocoPhillips COP $95.96 $34.12 64%
Precision Castparts Corp. PCP $131.38 $47.08 64%
Diamond Offshore Drilling DO $147.77 $53.30 64%
Occidental Petroleum Corp. OXY $100.04 $39.93 60%
Zimmer Holdings, Inc. ZMH $76.22 $30.67 60%
Texas Instruments Inc. TXN $33.00 $13.38 59%
The Walt Disney Co. DIS $35.02 $15.14 57%
Northrop Grumman NOC $77.45 $33.81 56%
Gap Inc. GPS $20.80 $9.41 55%
Forest Laboratories, Inc. FRX $39.02 $18.37 53%
Microsoft Corp. MSFT $30.53 $14.87 51%
Chevron Corp. CVX $104.63 $55.50 47%

* Removed from portfolio after reaching profit target of 50% or greater

Stock prices as of April 30, 2009

The companies that make up our portfolio had seen their stock prices fall on average 70% from their 52-week highs during the past year. In most if not all cases, there was nothing in the fundamentals of the business to justify a loss of market value to such magnitude. In fact, as stock prices went down, the fundamentals of the businesses became even stronger.

Being able to differentiate between the value of the business and the price of the stock, we were able to purchase these companies at a large discount to their underlying values. In just the past four weeks, both Corning (GLW, Financial) and Coach (COH, Financial) were removed from the portfolio after rising more than 50% in under 90 days.

Graham saw wide price fluctuations as an advantage and cautioned those who become nervous and do silly things when stock prices fell:

Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks have no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.


The stock market offers the intelligent investor the benefit of liquidity. It’s much easier for you to sell $10 million worth of Microsoft Corp., a $180 billion company, than it is to sell your minority interest in a Dunkin’ Donuts store.

You can increase or decrease your position at your discretion. The only time you should make a purchase or sale is when you have an advantage. That is when you are able to value your interests better and more accurately than can Mr. Market.

The Inevitable Wealth Portfolio comprises businesses that Mr. Market offered us at very low prices. Since the fundamentals of the businesses are strong and the balance sheets rock solid, his loss is our gain. And we will continually take advantage of Mr. Market’s wild emotional swings all the way to the bank.

Charles Mizrahi is editor of Hidden Values Alert and The Inevitable Wealth Portfolio. He is also the author of Getting Started in Value Investing (Wiley).
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