More than 50 years ago, Benjamin Graham, the ‘Father of Value Investing’, observed “In the short run the market is a voting machine, but in the long run, it is a weighing machine”. That one quote contains as much wisdom today as it did then and it’s implications have been long recognised by those we consider Investment Masters.
Klarman 2017 letter on
- Bitcoin
- the danger of Chinese leverage
- Discipline while value investing in bubby times
- Value investing is not dead
- Radicalization of politics
- Dangerous FAANG valuations
Q1 hedge fund letters, conference, scoops etc
What Graham was referring to were the two forces acting on securities, namely human psychology and business fundamentals. In the short run, human psychology can overwhelm fundamentals. However, over the long term it's a securities earnings that determines returns.
Stocks are more than just pieces of paper. When you invest in stocks you are investing in the underlying businesses; management prowess, business culture, competitive advantages, re-investment opportunities and the like. The ultimate determinant of the price of the stock will be the underlying business' performance. Buffett once again reiterated this in his 2017 annual letter..
"Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well."
The key to long term market beating results then is to identify quality businesses whose earnings will grow, buy them at a reasonable price and stick with them. It is the sticking with them where most investors come undone. Adopting the mindset of a business owner as opposed to a stock trader can help.
“Our business owner mentality.. allows us to virtually ignore the constant babble of short term macro noise." Allan Mecham
"People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business.. You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn't pay a totally silly price. That is what it is all about." Warren Buffett
There are some good reasons a focus on earnings works. Firstly, share prices are volatile, and far more so than corporate profits. Share prices are influenced by the emotions of the crowd. And even more relevant today, they can be driven by the flows of indexing, ETF's and momentum strategies.
"Securities prices rise and fall much more than profit ... Why is that so? Primarily, I think, because of the dramatic ups and downs in investor psychology” Howard Marks
“When an S&P 500 ETF is purchased, its underlying securities are not bought for their individual value, earnings potential, financial health, or any other metric. Those securities are purchased simply because they are on the ETF’s shopping list. This process is without regard to the price/value relationship. As a result, serious distortions in price have accumulated.” Frank Martin
Consequently, short term share prices can do almost anything. The record amount of money in passive funds today, means you can and should, expect irrational prices. There is no price too high for an index fund to BUY and there is no price too low for an index fund to SELL. Prices get set by flow not fundamentals.
Secondly, a business' value is a function of its future earnings, often estimated using a multiple of earnings approach.
“Business value is rooted in long-term earnings.” Allan Mecham
"Investors own a claim to the current and future profits of a company" Christopher Bloomstran
“Past profits only rewards past investors not today’s buyers. And it is future earnings that make up intrinsic value.” Francois Rochon
If you buy a business whose earnings are higher in the future, it's likely the share price will be as well. Consider a simple example. You buy a $100 stock earning $10, ie an undemanding P/E of 10X. If its earnings grow at 12%pa, in ten years it will be earning almost $28. Providing the P/E's unchanged, it will be trading at $280. If it is still trading at $100, the P/E would be just 3.6X, an unlikely scenario.
“There are only two things that matter in investing. What are they going to earn, and what multiple are people going to put on that. Let’s not make our business any more complicated than this” Larry Robbins
The good news for investors with a long term investment horizon is that in the long run, earnings and shares prices do converge.
“If the business does well, the stock eventually follows” Warren Buffett
“Ultimately the market does reflect value, even if it may seem to lose its marbles for unbearably long periods” Leon Levy
“Stock prices often move in opposite directions from fundamentals but long term, the direction and sustainability of profits will prevail” Peter Lynch
"Over time, earnings determine a stock's value" Joel Tillinghast
“We believe that the market performance of a share of common stock, over an extended period of time, is likely to follow the business performance of the underlying company” Lou Simpson
"Market performance and corporate performance are rarely synchronized over the course of a calendar year. But as more time passes, the synchronization between the two inevitably begins to reveal itself. Francois Rochon
“We recognize that over long periods of time, the share prices of our holdings should grow at a pace driven by the economics of the underlying businesses.” Chuck Akre
“Over the intermediate to long-term in the stock market, business performance has been inexorably reflected in share price performance.” Bill Ackman
"On any given day, market prices are driven almost 100% by sentiment. As one's investment horizon lengthens, however sentiment matters less and returns are more dominated by cash flows" Andy Redleaf
“Long-term gains in the intrinsic value of a company are more important than short-term gains in stock prices. The market has a way of fairly pricing stocks over long periods. Provided a company performs well, its stock price will invariably reflect the performance” Christopher Bloomstran
Maintaining your focus on a company's earnings rather than the share price can give you the fortitude to hold-on when share prices maybe telling you to sell.
"Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it... The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate." Warren Buffett
“Note that I have no interest in the development of share prices. This is why I don’t waste your time with a discussion of the fund’s or individual company’s price development. If a company regularly increases its earnings power, the share price will track this over time. A robust investment process correctly identifies companies which increase their earnings power. A rising share price is the outcome. My sights are firmly trained on process.” Robert Vinall
“We do not evaluate the quality of an investment by the short-term fluctuations in its stock price. Our wiring is such that we consider ourselves owners of the companies in which we invest. Consequently, we study the growth in earnings of our companies and their long-term outlook.” Francois Rochon
And by thinking about future earnings you're also less likely to overpay for a stock or get caught in a value trap.
“Bear in mind--this is a critical fact often ignored--that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.” Warren Buffett
“Occasionally, people lose track of the fact that in the long run, shares can’t do much better than the companies that issue them” Howard Marks
“The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.” Warren Buffett
“Wild swings in market prices far above and below business value, do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains” Warren Buffett
It's time to look for businesses which offer the potential for sustainable earnings growth. Buy them at reasonable share prices and the returns will follow!
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now ... . Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. “ Warren Buffett
Article by Investment Masters Class
