Frank Martin, CFA September 2014 Martin Capital Management, LLC
Q4 2019 hedge fund letters, conferences and more
“Price is what you pay, value is what you get.”
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
One of Warren Buffett’s favorite old admonitions reveals that price and value are not always the same. While the intrinsic value of a business is admittedly a somewhat imprecise estimate that depends on assumptions, it nevertheless stays within a much narrower range than the common stock price investors are asked to pay on any given day. As we’ve all seen, price can vary wildly depending on the emotions of the crowd.
Historically reliable measures reveal that prices today have become widely disconnected on the high side from underlying values. And as Frank explains in his latest commentary, that means there may be danger for investors who extrapolate present market conditions into the future. In truth, the future may look much more like the past… than the present.
Warren Buffett: “Price Is What You Pay, Value Is What You Get”
Most investors have likely heard the old adage invoked as the title of this commentary. It’s a safe bet, however, that far fewer have thought through its deeper implications. “Price is what you pay, value is what you get,” implies that price and value are not always one and the same. To be sure, its inherent wisdom is not universally embraced. The ubiquitous practitioners of Modern Portfolio Theory and its efficient market hypothesis bristle whenever they hear such utterances from those of us throwbacks who hold the contrary point of view.
“What you get,” intrinsic value, is in simplest form the discounted present value of future cash flows. The words in italics are variables about which opinions may differ as they involve forward-looking assumptions about discount rates and cash flows. Those assumptions and opinions mean there will always be a degree of imprecision in estimating intrinsic value (“what you get”), but the variability is far less erratic than “what you pay” for securities. The disparate amalgamation of investors and speculators making buy or sell decisions both influence and are influenced by markets. This contagious and sometimes emotionally charged combination can excite the manic-depressive tendency of markets, causing extreme and fundamentally unjustified oscillations in market prices, often when least wanted or expected.
Let’s assume, for example, the approximated intrinsic worth of a security is $10. Its price might theoretically fluctuate over a market cycle between, say, $5 and $20 (falling 50% below intrinsic worth in percentage terms and rising 100% above), while intrinsic value remains comparatively constant.
But that’s only half the story. Just as surely as prices can and do temporarily defy the gravitational tug of value, in the end the hard laws of physics trump the soft science of crowd psychology. The farther prices rise above or fall below their fundamental value, the greater the store of potential energy to be released in the resulting disequilibrium. Once the reversal process begins, momentum develops and markets generally overreact. Does (can?) a swinging pendulum stop on a dime, at its position of balance between the two extremes?
The signature advantage of active capital markets for long-term investors is the forum it provides to inexpensively and conveniently purchase or sell securities for 6 ½ hours every business day of the week. Ameritrade and E*TRADE, which cater to a rather frenetic coterie, would not be in business were it otherwise. By accepting or rejecting the “market’s” price at any given moment, an investor is effectively determining the only variable within his control. Investors can’t set prices, but rejecting a bid or offer makes a bold assertion: The amorphous market is occasionally way off the mark in pricing value.
Accepting or rejecting is not so much a discrete decision as it is a process requiring the discipline and skill to screen out the onslaught of the market’s endless noise in search of an occasional meaningful signal. The intrusion extends to smart phones, insidious devices that we empower so that the markets can tempt and taunt us anytime and anywhere.