In my last post, I started a discussion of Warren Buffett’s investing philosophy. If you haven’t read it yet, you might want to do so now. I am going to build on the concepts that I talked about previously.
In the short run, the market is a voting machine, but in the long run, it is a weighing machine.
According to Buffett’s mentor, Benjamin Graham, “In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.” This brings us back to the difference between price and value. In the short-run, price and value can be very different. Investors may get overexcited or overly concerned by a company’s prospects, and they may “vote” for a price that is either too high or too low. One of the reasons for this is because many investors aren’t even concerned about value. They are instead concerned with price trends on a chart or with market psychology or any number of things not related to value. Another reason for the difference between price and value is because investors often let their emotions get the best of them.
It was for these reasons that Yahoo’s stock price rose to a split-adjusted price of over $100 in 1999 compared to the current price almost nine years later of about $26. A good value investor – i.e. an investor who makes investing decisions by comparing price and value – should have been able to tell you that the prices in the late 1990s were insane, and a good value investor should have been able to easily avoid the ensuing market massacre. It didn’t take a rocket scientist to understand that many stocks, especially technology stocks, were overvalued. It just took a basic understanding of how to value a business.
In the short run, prices can differ widely from value, but in the long run, price and value tend to converge. This means that the market always comes to its senses at some point and eventually gets the price right. If the stock’s price is lower than its intrinsic value, investors will continue buying at higher prices until the stock price increases to intrinsic value. If the stock’s price is higher than its intrinsic value, investors will continue selling it at lower prices until the stock price declines to intrinsic value. In Yahoo’s case, investors finally figured out that the principles of economics were not suspended for technology companies after all, and they bid the stock down from over $100 to less than $5. Investors stopped “voting” for Yahoo and began to “weigh” its intrinsic value.
What does this mean for you as an investor? It means that you don’t need to concern yourself with market psychology, price charts, or anything else not related to the intrinsic value of the company whose stock you are interested in. If you can determine the intrinsic value per share, then you will know what is going to happen to the stock price, because intrinsic value exerts a “gravitational effect” on stock prices. The stock price might not move towards intrinsic value immediately, but it will do so eventually. As Warren Buffett wrote in his 1987 letter to shareholders:
“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.”
To be continued…
{ 1 trackback }
{ 0 comments… add one now }