Stability only comes to markets in a self-reinforcing mode, from buy and hold (and sell and sit on cash) investors who act at the turning points.
Beyond the vicissitudes of the markets, there are businessmen. They have a sense of what their capital costs. They reason regarding acquisitions and selling off their own holdings/subsidiaries. They ask themselves how permanent current financing conditions are likely to be.
They don’t play momentum; they just look for when buying or selling businesses makes sense. The market, on the other hand, has many that only want to buy what is rising, and sell what is falling, to a first approximation.
The market is about business, not stock trading. Businesses are primary, trading markets are secondary. When businessmen find a publicly-traded business trading at an attractive value, they buy it, particularly if there are synergies between the businesses. Thus during the bust phase of equity and credit markets, M&A often consists of cash-rich firms buying out firms that are in distress.
The same is true in boom times. Companies sell themselves, or subsidiaries to leveraged players who think the game will go on much longer than reality will bear. The sellers sit on the cash; the buyers enjoy the losses when the bust comes.
Volatile markets favor those with strong balance sheets — those that can wait for a better day, or, those that can wait for better opportunities. In either case, they can wait; they do not have to buy or sell now. They are experiencing no cash flows forcing them to action.
Those with strong balance sheets focus on return on book capital, and avoid leverage. They look to grow the book value (“net worth”) of their company, and ignore secondary goals. They are shareholder-oriented. They take advantage of both sides of the boom-bust cycle — selling near peaks when return on capital is lousy, and buying near troughs when return on unlevered capital is fat.
This is simple stuff, but hard to execute, because the fear/greed cycle interferes with rational calculation. Regardless, absolute valuation investors put in the tops and bottoms of markets by their selling and buying. To the degree that technical analysis works, it is because they trace the bread crumbs of large valuation oriented investors.
That’s all for now. Thoughts? Give it to me in the comments.
By David Merkel, CFA of alephblog
