In the previous chapter of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” we were shown different kinds of value by author Howard Marks (Trades, Portfolio).
Understanding the relationship between value and price came up next, in chapter four, “Establishing a healthy relationship between fundamentals—value—and price is at the core of successful investing.”
He went on to note no investment or even asset class is inherently more profitable than another. Profitability depends on pricing. To illustrate, he recalled the Nifty Fifty stocks of the 1960s and early 1970s, stocks with consistently high earnings—and high price-earnings ratios. They were large companies and offered stability as well as strong earnings growth. In other words, near-perfect investments.
At least until they weren’t anymore. In the early 1970s, the American economy slowed dramatically because of the oil embargo (which pushed up fuel costs) and inflation increased quickly. Marks noted that companies with price-earnings ratios of 80 or 90 dropped to single digits: 8 or 9. Investors who bought at the top had lost 90% of their money because they paid the wrong price.
So, Marks asked, “What are companies worth? Eventually, this is what it comes down to. It’s not enough to buy a share in a good idea, or even a good business. You must buy it at a reasonable (or, hopefully, a bargain) price.”
To buy at the right price, you must know what prices are based on. Fundamental value is a starting point—for the long term. This refers to the ability of a company to use shareholders’ capital to generate earnings (profits). But in the short term, price is more likely to be affected by psychology and technical factors.
By “technical” he means non-fundamental issues that influence supply and demand. For example, forced selling that occurs when the market crashes and margin calls must suddenly be closed. The second example is that of mutual fund managers who must buy as new capital comes in, even if there are no securities they like. Collectively, Marks refers to these situations as forced selling and forced buying.
Psychology is the second non-fundamental issue, and it refers to understanding what other investors are thinking. Marks said of psychology, “It’s impossible to overstate how important this is.”
This is an interesting statement. In chapter three, he dismissed technical analysis (but not technical factors), likening it to throwing darts or flipping coins. Yet, psychology underpins every technical indicator; price patterns do not exist in a vacuum, they exist because a majority of investors are thinking a certain way about a security’s past and future. To put it another way, technical analysis is a codified approach to understanding the psychology of investors.
In any case, Marks argued, “The discipline that is most important is not accounting or economics, but psychology.” Even value investors must deal with it because, “the psychological factors that weigh on other investors’ minds and influence their actions will weigh on yours as well.” This means value investors must commit time and energy to understanding market psychology.
Investors should try to have psychology and technical forces aligned with fundamental factors when buying and selling stocks.
Psychology comes to the fore again in discussing bubbles, when price becomes completely unattached from value. Marks pointed out that all bubbles start with a kernel of truth (“The internet is going to change the world.”). The first investors who grasp these truths capture above-average returns, and that attracts other investors who visualize easy money and disregard value altogether.
Between 2004 and 2006, houses and condos became popular investments because loans were cheap and tax deductible and, as everyone knew, “home prices only go up.” Those kernels of wisdom were soon exploded as we will all recall.
A few years earlier, the tech bubble produced the “can’t lose” idea. Again, price became unhinged from value, as buyers were sure someone else would pay them more for their stocks—the “greater fool” theory of investing. When the bubble burst, the market once again discovered value.
As Marks put it, “In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralizes any prudence that might otherwise hold sway.”
Riding a bubble, then, may be an investment strategy, but one of the riskiest approaches that exist. On the other hand, following a value approach is among the most reliable.
Marks laid out the various ways to profit from investments:
- An increase in an asset’s intrinsic value. A couple of negatives stand out with this tactic; first, the potential for an increase may already be factored into the price of the stock or security. Second, it may take many years for an increase to occur.
- Leverage, the double-edged sword. Using borrowed money does not increase or decrease the probability of success, it only magnifies gains or losses. In addition, it has also led to very large losses when brokers or lenders unexpectedly asked for their money back.
- Waiting for a greater fool, for someone else to overpay for your stock. Marks wrote, “Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable.”
- Buying an asset for less than its value is considered the most dependable approach. Waiting for an asset to rise to its fair value is the most logical, Marks said, “When the market’s functioning properly, value exerts a magnetic pull on price.”
Nevertheless, buying cheap stocks is no guarantee. As Marks noted, investors can be wrong about current value, external events may reduce value, market slippage may reduce value or price may not converge with value for a very long time. All in all, “Trying to buy below value isn’t infallible, but it’s the best chance we have.”
To sum up chapter four, value may be critical, but it is meaningless without the perspective of price.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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