Friday, November 21, 2014

Mr. Market

Roughly 15 years ago, Warren Buffett was asked to speak at Sun Valley not long before the tech bubble burst.*

Here's how an article on CNBC described the reaction:

"Many of the people in the room had amassed vast paper profits from stocks shooting ever higher in the Internet boom. Buffett wasn't playing that game, and some of the younger people in the audience thought he was stuck in the past, unable to understand that this time it would be 'different.'"

His message to the audience was rather straightforward:

"There was no new paradigm..."

Despite his long-term investing track record, many chose to discount or ignore what Buffett was saying back in 1999. There was, in a similar way, a fair amount of skepticism toward his favorable views of stocks during the financial crisis and even more recently (in both cases the market overall was substantially lower than it is now).

It's not that Buffett gets the timing right. In fact, Buffett doesn't try to guess where prices are going or to get the timing right.

"...we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future." - From the 1986 Berkshire Hathaway (BRKa) Shareholder Letter

Predicting, in a reliable manner, where prices will be going is close to impossible and mostly a waste of energy.

Fortunately, being a successful long-term investor doesn't require brilliant timing.

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two. 

But I think it is very easy to see what is likely to happen over the long term." - Warren Buffett in Fortune, December 2001

Trying to guess where prices are going in the coming weeks, months, or even over several years ends up best case being a distraction and, more likely, is just a plain foolish thing to do. Investing is (or should be) about how price compares to intrinsic value and how that value is likely to change over a longer time horizon. The emphasis is long-term effects instead of some unusual acuity for jumping in and out at just the right time.

Attempting to time things is a great way to make unnecessary mistakes and incur unnecessary frictional costs. The emphasis on what market prices might do next can end up being a big contributor to unsatisfactory investment outcomes (or worse).

In 1999, it was all about the upside. At the time there was lots of enthusiastic buying of stocks that offered incredibly high risk of permanent capital loss. For too many, those losses indeed became very real and very permanent.

Errors of commission.

In 2008, when the world was a real economic mess -- with compelling and scary headlines everywhere -- buying seemed dangerous and the enthusiasm for stocks all but disappeared. At that time many stocks were unusually undervalued. The risk of permanent capital loss -- especially for those with a long-term investment time horizon -- was rather low. Those missed gains were also very real and very permanent.

Errors of omission.

With the benefit of hindsight, these outcomes may seem obvious, but being correct and decisive in real time while keeping emotions in check just isn't the easiest thing to do.

Errors of commission might be more plain to see but that doesn't mean errors of omission don't matter a whole bunch.

They certainly do.

These days, many stocks have become rather, at the very least, not at all cheap. The risk of permanent loss -- or, at least, subpar returns considering the risks -- is now much higher and getting worse as the rally continues. Margin of safety is, in many cases, way too low for incremental purchases as far as I'm concerned.

Unfortunately, some will make of mistake of getting interested in stocks now after having mostly missed the chance to buy when prices were attractive.

"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffett

Prices may continue to go up, of course. What's already not cheap goes on to become plainly expensive.

There's no way to know this beforehand.

There's also no need to know it.

"Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game." - From the 1987 Berkshire Letter

For those with a long investing time horizon, if prices do continue to rise in the near-term or intermediate-term, it's not a good thing at all.

To me, while there are naturally always individual exceptions, the chance to buy part of a good business at a really substantial discount is, at least until the next bear market or substantial market correction, mostly in the rear-view mirror.

Investing well inevitably involves lots of waiting for a good opportunity to present itself; it inevitably involves lots of preparation. Ultimately, it requires sound business judgment and price discipline. So energy should be spent trying to better understand existing or potential investments. In combination, this makes it possible to act decisively while others -- those caught up in the emotions of the moment and less prepared -- simply cannot.

In the end, how the business performs is what mostly matters while price action does not.

"...Charlie [Munger] 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." - From the 1987 Berkshire Letter

These days, while most things are far from cheap, it is still nothing like 1999. Back then valuations became completely nonsensical for way too many assets. That doesn't mean right now is a wonderful time to be buying stocks.

Far from it.

Those who think results over the next five years are likely to be as attractive as the past five years are likely to be disappointed. Put another way, the only way for stocks to produce similar results is if prices run far ahead of increases to per share intrinsic value.

That can happen, of course, but I certainly hope it does not. Bubbles do real damage. Some of it subtle; some of it not.

In fact, a good chunk of the returns these past five years have been, in many cases, driven by a closing of the discount to value gap. It's not that per share intrinsic value didn't increase somewhat. For good businesses they did and will continue to do so. It just that the increases were far less than the returns would imply.

In the very long run, as long as the purchase price was reasonable in the first place, what matters is whether a business can increase per share intrinsic value at attractive rate. The bonus returns in recent years resulted from the big discounts to value that existed for a time.

The crisis created those big discounts and, for the most part, they are now gone. So price has caught up -- and in some instances no doubt now has even exceeded  -- per share intrinsic value.

So total return expectations -- even for very high quality businesses -- should be more modest going forward (at least until the market goes meaningfully south again).

Otherwise, allow the market to serve.


Long position in BRKb established at much lower than recent market prices

* The 1999 Sun Valley speech by Buffett that I mentioned above was covered in Chapter 2 of 'The Snowball'. It was also covered in a 1999 Fortune article where he said the following: "Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss."
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.