Where irrationality creates opportunity
As a value investor, you would have a good idea of a company’s intrinsic value. When movements in the share price creates discrepancies between the market price and the investor’s estimate of value, this creates opportunity for the value investor to buy or sell.
At any time, for every stock, there is a market price, though it’s more accurate to say there are two prices: one the buyers are prepared to pay for shares and the price sellers are prepared to accept.
From the moment the Australian stock exchange opens for business at 10:00am, until the trading day closes at 4.10pm, shares in most of the 2,200 listed stocks are re-priced continuously. Some illiquid stocks remain un-traded and their prices do not change.
In theory, a company’s value on the share market reflects investors’ collective perception of its profit flow. If the sharemarket detects something that may harm its earnings, the share price falls. If the market hears good news, the share price rises.
Share prices react to supply and demand. The sellers are in charge of the supply and the buyers provide the demand. Both groups are driven by their expectations of future value.
In effect the sharemarket reacts in two ways:
- One which opens every day which is constantly reacting to news, sentiment, overseas market moves, economic data, commodity prices, exchange rates and company announcements; and
- Another which is longer-term in nature which works slowly to compound the value of profitable companies through the returns on the retained earnings.
The short-term, reactive, market is far more skittish and volatile, sometimes driven by automated algorithmic programs that buy or sell according to how the market is moving. It is a function of very short-term considerations, with quick profits the main aim.
In the other, longer-term market shares are not treated as trading chips in a casino but as units of ownership in companies. Long-term investors think and act like owners of a business.
As mentioned in ‘Value Investing’ this is where value investors operate, as share prices are pushed around by undisciplined or irrational market participants motivated by emotions, not considerations of value.
If a value investor has a good idea of a company’s intrinsic value, the movements of the share price in the short term can create large discrepancies between the price and the investor’s estimate of value. This creates opportunity for the value investor and widens their margin of safety when buying.
An old Wall Street saying holds that there are only ever two influences on the share market: fear and greed. These two emotions fight a daily battle for supremacy.
On a daily basis the market wavers between the two.
Of the two, fear is generally the friend of value investing. The stocks trading furthest below their intrinsic value are typically out of favour with other investors. Conversely, times when greed rules are not those when value investing flourishes. For example, in the technology boom of the late 1990’s most investors were prepared to pay much more than intrinsic value to buy into shares with perceived high growth. It was common to see companies worth nothing capitalised at hundreds of millions of dollars, or billions in the US.
Similarly, by the end of the 2002–07 bull market, which ended in the Global Financial Crisis (GFC), share prices in many markets had been pushed well past fair value by excessive optimism and belief that high P/E ratios would prove to be justified.
The trouble is markets get pushed to extremes of optimism, and then extremes of pessimism on the downside. This creates perverse outcomes and most often, it is the ‘retail’ or direct investor who suffers most.
For example, ahead of the GFC many retail investors accepted implausible buy recommendations on stocks – many from online trading platforms, incentivised to maximise trading volume, not investment returns – and then suffered the most when markets collapsed. After the collapse many of these same investors were sold low-returning, annuity-style structured products on the ‘fear’ of another crash when better investing opportunities actually existed! Ironically a large proportion of management fees for such products help fund further advertising centred on fear.
In all the sharemarket crashes we have seen, hindsight tells us the ‘contrarian’ strategy would have been the best: to sell when the market is making record highs and everyone else is most optimistic and buy after the inevitable slump, when everyone else is most gloomy. Or, to quote, Warren Buffett, “be fearful when everyone else is greedy, and greedy when everyone else is fearful”. After long experience with market cycles we would say the time to buy is not when the market thinks the world is about to end, but when you think the world is about to end.
Value investing can be the steady hand on the tiller of your portfolio that helps you take these contrarian positions. A disciplined value investor will have sold out of stocks as a rising market pushes them past intrinsic value; by definition this investor will not be able to find value situations in a generally overvalued market and will keep his powder dry in cash. Then, once the market has ‘corrected’ – or overcorrected, which is more likely – the emerging opportunities implied by many stocks now trading below their intrinsic value will tempt him back into the market.This is well demonstrated by the chart below, which compares the intrinsic value of the All Ordinaries, calculated by StocksInValue, against its actual price, the index price, at that time. Unsurprisingly prices ran well ahead of value ahead of the GFC in the immediate aftermath of the GFC, plunged well below true value.
Figure 2. All Ordinaries vs Intrinsic Value
Sources. ASX; Clime Asset Management
Time is on your side
Time is a critical part of the value investing equation. The value investor tries to profit from the tendency of gaps between a stock’s market price and its intrinsic value to close. Investors buys a stock when they believe the intrinsic value is meaningfully above the market price. There is no guarantee the gap between the two will not widen – in fact, in a bear market this is highly likely – but the value investor can take comfort in Graham’s reassurance, “Price eventually catches up with value”. This means value investors are by definition patient, long-term investors.
Discipline is crucial to the value investor, this is what brings us opportunity – the volatility of the market on the weathervane of investor sentiment – has to be ignored. The worst thing a value investor can do is to be panicked out of their stocks by the market’s mood swings. Remember, time is on your side.
From our Chief Investment Officer, John Abernethy, “It is a hard thing for investors to stay patient and take what they regard as sub-optimal returns in cash, but disciplined value investors are prepared to wait…”.
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