Mental Approach: Volatile Stock Prices, Stable Intrinsic Values – Part I by Steven De Klerck
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Intelligent investing is more a matter of mental approach, than it is of technique. A sound mental approach toward stock fluctuations is the touchstone of all successful investment under present-day conditions.
– Benjamin Graham, 1949
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In the sections “Valuations” and “Fundamental Risk”, I elaborated on the relationship between valuations and fundamental risk on the one hand and future stock returns on the other. The conclusion was to buy cheap, buy fundamentally safe and diversify. It is understood that the successful implementation of these conclusions preferably requires a historical sense about the notions of ‘cheap’ and ‘fundamentally safe’.
In this contribution, I describe the psychological framework in which these principles need to be applied. In absence of such a framework, equity investments way too often result in “psychological dynamite” involving disappointing returns. Here, my starting point is the way in which stocks usually are perceived.
First, investors assume that stocks are risky or highly risky. This perception stems from both the risk of facing a permanent loss of capital and the high volatility of equities. A permanent loss of capital can be avoided by applying the insights described in the previous sections “Valuations” and “Fundamental Risk”.
Secondly, investors consider stocks and equity funds as (un)attractive after periods of (weak) strong returns, in the assumption that these returns will continue to be seen in the following years. This is called (downward) upward overreaction.
In both cases, investors mistakenly focus on price fluctuations instead of on the impact of price fluctuations on valuations. In the following sections, we will see that investors preferably relegate both perceptions to the wastepaper basket.
Part 1 – Volatile Stock Prices, Stable Intrinsic Values
It is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed risky merely because of the element of price fluctuation.
– Benjamin Graham, 1949
In the chapter The Pattern of Change in Stock Earnings and Stock Prices, Benjamin Graham (1949) departs from the reasoning that the intrinsic value of a company is based on the average earnings generated by a firm over a (future) economic cycle. These average earnings logically take into account lower profits during economic recessions and higher profits in periods of economic upswing.
An example. At the depth of a recession, company A realizes earnings per share of $2. During the economic boom, the company realizes earnings per share of $5. The average earnings per share over the business cycle is $3.5 per share. When applying a conservative price-to-earnings ratio of 12, this results in an intrinsic value per share of $42 (= $3.5 x 12).
Graham however states that the behavior of the stock market substantially deviates from the notion of intrinsic value. During periods of economic recession, the stock of company A is for example $20 (a price-to-earnings ratio of 10). In periods of economic boom, the stock price goes up to $75 (a price-to-earnings ratio of 15) despite the fact that the intrinsic value of A remains relatively unchanged at $42.
Based on both the aforementioned reasoning and some anecdotal examples, Graham argues that the volatility in stock prices for the largest part is to be attributed to investors’ moody emotions rather than to changes in the intrinsic value of companies. The reasoning and the anecdotal examples from The Intelligent Investor were confirmed by Robert Shiller and some time ago they were discussed by Jeremy Grantham in “My Sister’s Pension Assets and Agency Problems“.
Long-term corporate profits are very stable and seem to offer little long-term risk.
– Jeremy Grantham, 2012
The insight “volatile stock prices, stable intrinsic values” creates various psychological advantages for investors which should not be underrated.
First, the perception will slowly grow that equities fundamentally are much less risky than usually is perceived based exclusively on the observable volatility, especially when the lessons from the sections “Valuations” and “Fundamental Risk” are strictly applied.
Secondly, the “volatile stock prices, stable intrinsic values” insight gradually affords investors to disassociate themselves from volatile price movements.
Thirdly, it will become substantially easier to rationally focus on the impact of price fluctuations on stock valuations. After a while, as an investor, you will even welcome volatile situations with valuations being a precept in order to optimally gain from the fear of other investors.
The investor must fix his eye not on what the market has been doing – or what it apparently is going to do – but only on the result of its actions as expressed in the relationship between the price level and the level of underlying or central values.
Benjamin Graham, 1949
“Communication with and support for clients in terms of valuations.
Within Pure Value Capital, we will strictly apply the aforementioned insights. The investment strategy (refer to the previous contributions) allows us to rationally communicate with investors in terms of valuations. On a periodic basis, we communicate the price-to-book ratio of the optimal value portfolio. Substantially increasing valuations in terms of the price-to-book ratio urge some caution; decreasing valuations should stir the required optimism. Otherwise said, we force both ourselves and investors to deal with stock price fluctuations in a non-emotional way. The fact that moreover we always back up clients in comprehensible business economic terms also makes it a lot easier to hold on to the strategy in the long term.