If we're able to do this we make money. Its a simple formula that hinges on four things and four things only. Or as a sceptic would put it ...
How do you know that the company is great?
How do you know what the right price is?
Why would sellers sell their stock at the right price?
Why would a stocks ever converge to their proper value?
Volumes have been written on the first two questions. We ourselves write about these in our investor letters fairly regularly. So in this post lets focus on the last two. Besides, these are much easier to answer anyway. The answer to questions three and four simply is "We do not know but they do". To both the questions. Since we don't know the answer let's check what Ben Graham, the father of value investing, had to say about it.
Here's an excerpt from a Senate committee hearing on Factors affecting the buying and selling of equity securities. Specifically, this is the statement and the Q&A section for Graham. Towards the end of a rather candid and insightful interview the following exchange takes place ...
THE CHAIRMAN: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of people decide it is worth 30, how is that process brought about-by advertising, or what happens?
Mr GRAHAM: This is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.
Even Graham didn't know!
We can perhaps speculate why someone would be in a hurry to sell something at a ridiculous price. It could be any of the following ...
- A fund manager faces redemptions and sells whatever he can. This was a common occurrence during the '08-09 crisis. It usually results in a sell-off in the most liquid securities. You sell what you can.
- A fund manager puts up gates in his fund so an LP sells another, possibly well performing, fund to raise money. Again very common during the recent crisis.
- An investor needs cash for whatever reason so he raises it by selling securities. This is a super-set of the first two.
- A business that has been performing really well is now widely owned. So widely owned that its trading at ridiculous valuations. Say this business makes cars that fly. One day one of these cars collides with a drone being used to ship diapers from an online retailer. TV coverage gets filled with a flying car and diapers on fire. Investors start questioning whether a flying car is that good an idea in the first place so they dump the stock. At least the ones who bought without valuing the stock in first place will certainly dump it.
- A security no longer fits the mandate so its sold. A fund that does not invest in junk bonds will not invest in a credit that's on its way to downgrades. Index funds have to sell securities that get kicked out of the indices.
- Recent declines in price often perpetuate sell-offs. It could be year end window dressing by a fund or an automated momentum strategy or an investor who simply panics. The result in all these cases is the same.
- A certain large country decides one day that it owns way too much debt of certain other larger country and decides to diversify aggressively. OK, this one is scary but its not far fetched.
The point is that it's often impossible to put one's finger at THE reason. From the sellers perspective the reason could in fact be quite rational. The result is always the same; more volatility. And this volatility is EXACTLY what creates opportunities.
Strangely though most of the finance community does not agree with us. Volatility is a dirty word especially the academic part of the finance circles. Volatility to them is risk. To us the possibility of capital loss is risk. Risk a mistake made valuing a company or a drill rig that catches fire or an owner who decides to plunder the company. Volatility, to us, is what makes the investment world go round.
To be fair we can think of at least two ways that volatility can harm an investor. First has to do with a human being's emotional make up. Without volatility there will be no trading. After all, if the slot machine always comes up with 2 bananas and an apple then what's the point in playing? So more volatility (to an extent) equals more trading, which means more commissions out of an investors pocket. Ergo, lower returns.
Moreover, if greed and fear belong to the same zip code in your brain as investment analysis then volatility must be avoided at all costs. It will simply force you to buy euphoria and sell misery.
The second reason is leverage. A levered position does very poorly in the face of volatility. When a margin call comes you have to liquidate regardless of the long term prospects of your position.
However, the volatility-risk mix up in finance literature has nothing to do this these two reasons. Volatility in finance is simply a construct best avoided. Why? We have our suspicions but let's explore those in our future posts.
For a value investor of our ilk volatility is a blessing. Volatility happens. People sell things for personal, financial and sometimes totally dumb reasons. Sometimes at the right price (from our perspective).
Similarly, once we buy the stock at the right price should we pray for the stock to just sit there? The right price is one that's far below the intrinsic value of the business. In other words we just created a heads-we-win-tails-we-lose-little situation for ourselves. So what's the point of NOT flipping the coin?
So in summary while its impossible to know exactly why a stock diverges from and converges to its intrinsic value, it does. And praise the lord that it does. For without this random movement there would be no value investing.