“The stock market is filled with individuals who know the price of everything, but the value of nothing.” – Phillip Fisher
“Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to…the operating results of his companies.”
—Ben Graham, The Intelligent Investor,
At Investing 501, Gregg and I try to help others improve their investment process by sharing our experiences on Seeking Alpha. One of our more popular articles was entitled, The Illusion of Control, which discussed how investors could improve their investment process by focusing on understanding businesses and how to value them and by not constantly trying to find that “new” piece of information that would bring more clarity to an investment idea. The stark reality is that we have significantly less control over our investment outcomes than we want to believe. We also posted an article on our blog entitled, “What are you hoping to gain by checking that stock price right now?” We consider the act of frequently checking stock quotes and looking at price charts to be part of the pursuit of trying to find “new” information and doing so can be detrimental to the performance of a long-term investor. In this article I will expand on the previous articles.
Next time you feel compelled to look up a stock quote, write down why you want to know what the stock is doing. After you know the quote, write down what you think you gained by doing so. How does that revelation help you in your long-term investment thesis on the company? If you truly believe that you are going to hold a stock for a few years, how does knowing what the stock is doing today add value to that thesis? There might even be some proximate news item (earnings perhaps) that is apparently driving the change in the stock price. If you are buying stocks with low valuations, the company is usually struggling from an operational standpoint. Turnaround results are not linear. The chances you bought the stock right before turnaround happens and therefore all stock price reactions to “new news” is positive is very low. My guess is there will be more negative stock price reactions to “new news” initially. Stop looking for validation of your long-term investment premise in the daily, mostly random, movements in stock prices.
If you consider yourself an investor or analyst with a long-term investment horizon, you should be spending almost none of your time looking at stock prices of your investments or potential investments as part of your investment process. Considering that news outlets, bloggers and other websites devote a significant amount of their time attempting to explain the proximate cause of a stock (or market’s) price movement (ex post of course) this advice seems contrary to what is popular today. The explanation of the price movement is usually tied to some macro information (i.e e.g.?? oil stocks are down x% today because oil prices declined x% because investors are worried about slowing growth in China) or something company specific (company ABC is up/down xx% because of an earnings beat/miss or an analyst upgrade/downgrade). WE BELIEVE ATTEMPTING TO ASSIGN ANY LONG-TERM INFORMATIONAL MEANING TO THE DAILY VOLATILITY IN A STOCK PRICE IS A WASTE OF YOUR VALUABLE TIME.
“It’s Alright, She Moves In Mysterious Ways” Mysterious Ways, U2
Investors worry about lots of things. One of the things they should stop worrying about is what the ubiquitous “They” are doing. One of the things investors and analysts need to do is stop looking for that one piece of “unknown” information that either validates or invalidates their investment thesis. How often does the thought “I wonder what the new news is that “They” have discovered that I am unaware of” cross your mind when a stock moves a few percentage points more than the overall market with “no apparent news” being reported?
Some may argue that this apparent “new information” is extremely relevant to reassessing their investment thesis on a particular company (because others appear to be acting on something and the magnitude of the stock price movement dictates its importance). Many times these apparently inexplicable (at the time) stock price movements come before single point data releases such as earnings or industry data like same store sales. If the subsequent data is a “surprise” in the direction of the early stock price move, investors use this as “proof” that “They” knew it ahead of time and perhaps the data could have been discovered had they looked hard enough or set up their news feed better. These investors forget the times when the opposite occurs because it doesn’t confirm their belief. Investors also tend to ignore the fact that for every “They” that is buying/selling there is a “They” that is selling/buying. Perhaps the “new information” is relevant to your thesis, but that should be analyzed in a context that is devoid of the price reaction to it.
“Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer. This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit.
This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.
Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.”
Margin of Safety, Seth Klarman
Sometimes buying early on the way down looks like being wrong, but it isn’t.”
— Seth Klarman
People who rely heavily on forecasts seem to think there’s only one possibility, meaning risk can be eliminated if they just figure out which one it is. The rest of us know many possibilities exist today, and it’s not knowable which of them will occur.” Howard Marks
We read lots of mutual fund and hedge fund letters written to their shareholders by professional investors. We are always looking for new ideas and are always interested in seeing the analysis of other investors that we respect. We are not too old or set in our ways to not learn new things. One theme that is consistent in the ideas that these investors present in their letters is that they are buying a stock after a significant decline in the share price (or selling after a significant gain). These successful investors are taking the same information that others found so disconcerting/euphoric and acting with a conviction that goes opposite of the current direction of the stock price would seem to indicate is prudent. They act this way because they have a strong view about the long-term intrinsic value of the company and rely on their fundamental research to draw that conclusion, not the current direction of the stock price. The information these investors derive from the stock price is the input to determine current valuation, nothing more.
Frequently, investors look at changes in stock prices over a day or even weeks when there is no “new news” and attempt do divine what “They” know that he or she doesn’t. The investor begins to ask questions like, “What do the “channel checkers” know that I don’t?” What “new” piece of information is out there somewhere that I am unaware of that I need to find? This is the most dangerous type of thinking for a long term investor.
In 1981, Nobel Prize winner, Robert Shiller published an article in the American Economic Review that tried to answer the question, Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” His conclusion was:
“We have seen that measures of stock price volatility over the past century appear to be far too high- five to thirteen times too high to be attributed to new information about future real dividends if uncertainty about the future dividends is measure by the sample standard deviations of real dividends around their long-run exponential growth path.”
In other words, his conclusion was that stock prices fluctuate much more than a rational change in the underlying fundamentals would justify. Therefore, attempting to assign a meaningful change to the long term fundamental intrinsic value of a company based on the movement in a stock’s price to either no news or a specific news event is very unproductive. This is not the same as saying that all stock price movements do not accurately reflect a change in the intrinsic value of a company, just most.
In Jeremy Grantham’s Q2 2012 letter, he points out that, “stock prices are 19 times more volatile than the underlying fundamentals would warrant most of the time”. He believes this volatility is driven by career risk (i.e “the market can stay irrational longer that the client can stay patient”), which “creates herding or momentum which drives prices far above or far below fair price.” He goes on to point out that his co-woker Ben Inker wrote in an April, 2009 white paper that, “two-thirds of all corporate value lies out beyond 20 years. Yet the market often trades as if all the value lies within the next five years, and sometimes five months.” The point here is that by looking at stock prices on a regular basis, the investor/analyst is subjecting himself to needless stress about the potential change in the long-term intrinsic value of a company being discounted in the current change in the stock price. In fact, in Grantham’s calculation is correct the odds are 19-1 against the chance the stock price movement reflects a real change in intrinsic value.
While researching for this article, I came across an excellent post of the blog, Base Hit Investing entitled, “Circle of Competence, Fat Pitches, and How To Become the Best Plumber in Bemidji.” In the blog post, John Huber pointed out that average high price of a stock for 10 randomly selected stocks in the S&P 500 (SPY) was 135% of the average low. He states, “It’s remarkable to me that a sample list of stocks with an average market cap of $50 billion can have market valuations that fluctuate by as much as 35% on average—or to put it in dollar terms, around a $17 billion yearly fluctuation. And this is in a year where the volatility has been well below normal (the VIX is currently at 12). These 12 month ranges would be much wider in a year like 2011.” He also randomly looked at ten stocks in the Russell 2000 and found a 58% gap between the 52 week high and low. His conclusion was, “Obviously this list tells us nothing about the intrinsic value of these stocks—only that the prices fluctuate widely. But it should be fairly obvious that prices are fluctuating much more than intrinsic values—which provides us with opportunity.”
“Sometimes buying early on the way down looks like being wrong, but it isn’t.”
— Seth Klarman
Some investors seem to think if they monitor stock prices frequently, they will be able to act more quickly and reduce the potential loss. However, it is not always clear that a sudden decline in a stock price represents a permanent impairment of the investment. While the phrase “let your winners run and cut your losses quickly will improve your investment results” seems self-evident (especially for momentum strategies), distinguishing the fact that any particular mark to market loss will automatically become a permanent loss on an ex ante basis, is not that easy to do. As Howard Marks stated in his latest memo:, “In the short run, it can be very hard to differentiate between a downward fluctuation and a permanent loss. Often it can really only be done in retrospect.” He goes on to state that, “we can ride out volatility but we never get a chance to undo a permanent loss.”
According two Marks, a permanent loss can occur for either of two reasons:
- A. Other-wise temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timefame; financial exigency; or emotional pressures.
- B. Investment itself is unable to recover from fundamental reasons.
Some investors will choose to shoot first and ask questions later in every case, which means that the reactions of others in the short run is weighing heavily on their investment process that is supposedly focused on the long run. This could negate the “time arbitrage” advantage that focusing your analysis on the long term fundamental drivers of a business can provide. Of course you will frequently be wrong on your assessment of the long-term fundamentals of a business and selling first was the correct action to take. But we believe that focusing on building an investment process that emphasizes valuation and the investment decision making process, you will have spent your time more productively than watching stock prices waiting for situations where you need to act immediately.
“It seems most people in the prediction business think the future is knowable, and all they have to do is be among the ones who know it. I’m solidly convinced the future is unknowable.”
“If you define risk as anything other than volatility, it can’t be measured even after the fact.” Howard Marks
Behavioral Finance Factors
Another potential problem with frequently viewing stock prices is that it may subject the investor to a plethora of behavioral finance factors that can negatively impact results (such as anchoring, overconfidence, extrapolation, too much weight to new information). There are numerous papers and books that highlight investor overreaction/under reaction to “new news” that can manifest itself into a short term phenomenon like Post Earnings Announcement Drift or PEAD. For more discussion on the various factors that impact investment decision making we suggest readers start with the paper entitled, “Efficient Markets Hypothesis” by Andrew Lo. The bibliography contains most of the important papers on the subject since Paul Samuelson’s paper entitled, “Proof That Properly Anticipated Prices Fluctuate Randomly” was published in 1965. Richard Roll published a study in the Journal of Finance in July, 1988 that began with the statement, “Even with hindsight, the ability to explain stock price changes is modest.” He went on to state that “Most scholars and practitioners have resigned themselves to poor ex ante forecasting power for stock price changes.” James Montier and Michael Mauboussin have written several books on how investor’s behavior impacts valuation. A discussion of these papers and books is beyond the scope of this article. Of course, Warren Buffett has weighed in on some of this theory…
“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”
Over our investment careers, Gregg and I have encountered numerous analysts, investors and portfolio managers who feel it is important to their investment success to have access to stock prices on a frequent (insert your definition here) basis in order to keep up with what “They” are doing to the price at that moment. Somehow, this ritual has become an accepted part of the investment process and these individuals have come to believe that there is a significant amount of company specific, fundamental information contained in these mostly random price movements. Shiller, Marks, Buffett, Munger, Grantham and others have pointed out that stock prices move significantly more (five to nineteen times more) than the change in the underlying intrinsic value would justify. Expending a significant amount of mental energy attempting to distinguish between which price movements are noise and which price movements are foretelling a fundamental change in the long-term intrinsic value of a company is unproductive.
If you are still not convinced, think about this. If you look at almost any well-known (or even unknown for that matter) academic paper that creates portfolios to simulate the returns of any investment strategy, regardless if it is a “value” strategy or a “growth” strategy or a “momentum” strategy, the portfolios are usually rebalanced monthly or even less frequently depending on the amount of data that is available to create a meaningful sample size. In other words, these are the only times the price of the stock matters. Even in Joel Greenblatt’s very popular book The Little Book That Beats The Market, his model portfolios held roughly 30 stocks for one year and rebalanced at the end of the year. So if an investor was following this strategy, he would only need to look at a stock price twice a year, the first and last trading day of the year. Yet I have no doubt that there were numerous occasions throughout the year where stocks in the portfolios had large moves in either direction and someone dutifully noted the proximate cause of the move and made a prediction about the future prospects of the company based on that proximate cause and the magnitude of the move. Again, this is not to say that there are not times when this information can be useful to the investment process. But Gregg and I have found that focusing on the process of understanding business models and how to value companies and being sensitive to the initial valuation of that company when you make an investment is magnitudes more important to investment success than spending time trying to assignment meaning to any particular stock price movement.
One of the difficulties in buying a portfolio of companies at low valuations that are not performing well in terms of their business fundamentals and their stock prices reflect this, is that, in aggregate, the strategy has historically outperformed the market over longer periods of time. However, when you look at the companies in the portfolio on an individual basis, there are times when none of them seem to have any possibility of success based on price movements and “news flow”. Investors tend to constantly check stock prices to see if “today is the today” the turnaround in the stock price has begun or that my thesis has been invalidated. To quote Ben Graham, “That man would be better off if his stocks had no market quotation at all for he would then be spared the mental anguish caused him by other person’s mistakes of judgement.”
Other Ben Graham Quotes:
“The investor should always remember that market quotations are there for his convenience either to be taken advantage of or to be ignored.”
“The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful.”