One of the most famous quotes from the father of value investing, Benjamin Graham, is:
"In the short run, the market is a voting machine but in the long run it is a weighing machine."
It is questionable whether Graham actually said this. Indeed, the first time the quote appeared, based on my research (if any readers have evidence to the contrary, please feel free to post it in the comments), was in Berkshire Hathaway's 1987 letter to investors, where Warren Buffett (Trades, Portfolio) wrote:
"Following Ben’s teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: 'In the short run, the market is a voting machine but in the long run it is a weighing machine.' The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price."
Graham did say something similar, though not as catchy, in the 1940 edition of "Security Analysis":
"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, where on countless individuals register choices which are the product partly of reason and partly of emotion."
While it is irrelevant whether or not Graham said the exact Buffett quote, the logic behind the statement remains the same. The market value of securities is not determined regularly using a precise formula. Rather, it is determined by a herd of unruly voters and investors who are all chasing different goals and using different strategies to calculate their estimate of intrinsic value.
It is very easy to make a statement about how things are or should be done, but putting it into practice is much harder. The quote does not define what "short run' is, probably because it is impossible to know. As investors, we will never know if or when the market will change its opinion toward a security, re-rating the stock to a level we think reflects its intrinsic value. At the same time, we cannot define "the long run." It is impossible to tell when a stock is fully valued.
Another, and arguably better, way of viewing the market is through Seth Klarman (Trades, Portfolio)'s time arbitrage lense.
"Value investing is a large-scale arbitrage between security prices and underlying business value."Ă‚
This is very similar in principle to Graham's way of viewing the market, but it also draws a line between security prices and underlying business value. Graham's quote concentrates on equity prices alone.
While different, both quotes have the same underlying message. Stock markets are inefficient, and value investors with a long-term outlook profit from this discrepancy by taking advantage of other participants' short-term focus.
Even though Graham first discussed this principle more than 80 years ago, it remains relevant to this day despite the tremendous advancement in technology and market transparency.
In some respects, the idea of time arbitrage is possibly even more critical today than it has ever been before thanks to the impact quantitative hedge funds and high-frequency traders have on stock prices.
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