We are often told that the financial markets are the closest possible thing to the perfectly functioning market. All new information is almost instantly acquired by all players in the market so nobody ever has an advantage through more knowledge of events than anyone else. Information is disseminated so efficiently that it is impossible for anyone to gain additional knowledge except for those making gains by illicit means such as insider trading. The belief in the total efficiency of financial markets has led some traders to dispense with the notion of keeping themselves informed about the fundamentals of the companies they invest in.
This belief in the total efficiency of markets means that the share price must always be an exact reflection of the sum total of knowledge in the market about that particular stock. The share price is assumed to be showing the price arrived at by rational investors behaving in a logical manner and weighing up all the available information. The share price as arrived at by the actions of players on the market is thought to be the only rational price at which that share could be sold, taking into account all that is known at that moment.
The only problem with this idea of the financial markets is that it does not stand up very well when it is confronted with reality. On one day the rational investors decide that a certain share is valued at a particular price. The following day it may be three percent lower. Not much has changed in respect of news about that company or its ordinary shares, but the rational investors keep coming to different conclusions about the value of the same share based on the same information.
The value investor can use the irrational fluctuations of the market for his own benefit. The value investor forms an idea of the intrinsic value of the shares based on his calculation of the future performance of the enterprise. The fluctuations of the market price mean that there are more likely to be times when the share is significantly undervalued in comparison to its intrinsic value. The value investor can profit from the irrational behavior of Mr. Market.
The idea of Mr. Market was apparently first put forward by Benjamin Graham and has often been commented on by Warren Buffett. According to this idea Mr. Market is your partner in a private business. Every day he comes to you and gives you a price at which you can acquire his share of the business or at which he will acquire yours. Although the business in which you and Mr. Market are engaged is a stable one, the quotes given to you by Mr. Market can fluctuate wildly every day. Sometimes he is over-optimistic about the business and will only let you buy his share of it at a very high price. At other times he is depressed about the prospects for the business and is prepared to let you buy his share at a much lower price, worrying that if he does not quote a low price you will want to sell your share of the business to him and leave him to handle the problems on his own.
Even if you don’t take up Mr. Market on his offer one day, he is always there again on the next working day to make another. All the value investor needs to do is to compute the intrinsic value of the business, compare it to the offer made by Mr. Market and acquire the share of the business when it is significantly lower than the intrinsic value and there is a good margin of safety between the two values. The main trap that the investor can fall into is to imagine that there is some wisdom behind the offers made by Mr. Market and that they are based on logic rather than emotion. The investor should not try to predict the offers that will be made by Mr. Market, or to try to perceive any trends in his random thoughts.
When the price quoted by Mr. Market today is lower than the price quoted yesterday, the value investor should not think that this by itself means that the share is undervalued. The value of the share can only be estimated rationally by looking at the intrinsic value of the business. The main lesson to be drawn is that the value investor must understand the enterprises and their intrinsic value before buying stock. The investor should never rely on the market’s view. Any investor whose knowledge is less than that of Mr. Market should perhaps not be trying to invest in stocks at all.