Newsletter August 22, 2008

InvestorsFriend Inc. Newsletter August 22, 2008

Have You Become Mr. Market?

The late great Benjamin Graham, a legendary investor and financial teacher and the main early mentor to Warren Buffett invented a concept called Mr. Market. Graham and Buffett suggest that we think of the stock market as being like a somewhat insane business partner, subject to extremely violent mood swings. On certain days Mr. Market is irrationally exuberant and offers to buy certain shares you hold at insanely high prices (remember Nortel at $120?). On other days Mr. Market is severely depressed and despondent. On these days Mr. Market offers to sell to you shares in great businesses at very low prices. (In the early 80’s the market was selling at a average P/E multiple of about 8 and many profitable blue-chip companies could be purchased for less than book value).

Graham and Buffett advise you to use Mr. Market’s mood swings to your advantage, buy when stocks are cheap and sell when the irrational exuberance of Mr. Market pushes stock prices well beyond their intrinsic value. As Buffett has often said, be brave when others are fearful and be fearful when others are brave.

The concept of Mr. Market suggests that we buy low, and sell high.

Most investors would agree that it is wise to take advantage of Mr. Market’s strange mood swings and buy the bargains when “he” offers them and sell when “he” offers to buy at inflated prices.

But what do most investors actually do? If a stock that you own is up 100% in a year, is your first thought to sell? Or is your first thought to hang on for more gains? Do you spend time thinking about whether the stock is now significantly over-priced? Or do you think only about how much farther it might rise. When you think about this stock that has made you money do you get a “warm feeling” that tends to make you want to continue to hold it rather than selling even a portion?

If a stock that you own quickly drops 25% on no news, is your first thought to buy at this lower price? Or, is your first thought more along the lines of “dang, I should have sold that stock, now I feel like a chump, maybe I better sell before it falls further”? Most investors naturally find it hard to get excited about putting¬† more money into a stock that has just handed them a 25% loss.

Most investors naturally feel better after the market has risen for a period of time. For most people it is easier to buy stocks when they have risen rather than to buy when stock prices are down. A part of our brains automatically assumes that a rising trend will continue as will a falling trend. We know that logically we should buy low and sell high. But emotionally it is easier to buy high and sell low. (Hoping to sell even higher or to avoid selling even lower).

Collectively, Mr. Market is the total consensus of all investors. Therefore it is clear that most investors are to a large degree the irrational Mr. Market. Rather than take advantage of Mr. Market, most investors are in fact Mr. Market.

Each of us should ask ourselves to what degree we have been playing the part of the irrational Mr. Market. If you realize that you have become Mr. Market then you can take steps to stop it.

Personally, I almost always look at the fundamental value ratios of any stock before I buy or sell. Often a stock that I am emotionally attracted to because it has a strong business and its price is rising, turns out to be over-priced when I crunch through the valuation ratios. In this way I can often use logic and math to prevent myself from acting on an emotional feeling that a certain stock is a buy. Similarly I use fundamental analysis to identify when stocks seem to be over-priced.

Individual Stock Trading Versus Portfolio Management.

Many investors become too focused on individual stock trading and spend little or no time on portfolio management.

I must admit, I have been guilty of this.

Just because you expect a particular stock to rise is actually not sufficient reason to buy that stock. (I sometimes forget this fact.). With an excessive focus on individual stocks you end up buying a stock simply because you are afraid that if you don’t you will “miss out” on its rise in price. However from a portfolio management point of view it may make sense to ignore a stock that you think will rise in favor of another stock that has even better potential. Or maybe you should ignore a promising stock because you already have sufficient or too much exposure to that stock or that sector. Or perhaps you should forego investing in a particular stock because you want to keep your cash allocation at a particular level.

The right question to ask is not “should I invest in XYX”, but rather, “what is the best investment, if any,¬†for me right now”.

Before selecting individual stocks we should set at least some basic portfolio goals such as a certain allocation to cash bonds and equities. For the equity component we should set some rules regarding sector allocations. for example we could set a rule of not having any more than 20% of our portfolio in any given sector. We may also wish to set target exposures for Canada, the U.S. and international.

An essential step in Portfolio Management is to be aware of your percentage allocations to equities, bonds and cash. In most cases your broker statements will not break out this information. Therefore investors who wish to take this should calculate the break outs manually periodically, at least once per year and much more often for active traders.

The above is conventional wisdom. Note that in contrast, Warren Buffett teaches that it is okay to ignore conventional portfolio diversification wisdom and concentrate your investments heavily in a few companies which you are confident are great businesses with competitive advantages, and which are simple businesses that you understand, ran by trustworthy intelligent management and for which the share price is reasonable. The reality is that most of us will not be able to claim that all of our investments meet Buffett’s criteria. (Although we should work toward that goal). In the absence of fully meeting his criteria, a certain amount of portfolio diversification is a good idea.

Market Direction – Should You Care?

Almost all investors worry too much that the market has declined or will decline.

If we owned and ran a great small business that was producing an excellent and growing income, we would likely not worry much about fluctuations in the value for which we could sell the business. Most owners of successful small businesses are not thinking about selling. They worry about growing their revenues and keeping their costs under control.

When we own shares of a successful business it makes good sense to think like a business owner and worry about the profits of the business. However as share owners we only see the profits reported four times per year. But the stock market tells us every day or every minute what we could sell our shares for. Most investors end up focusing too much on the market value of our shares and do not spend enough time thinking about the actual value of the future profits. If you buy shares at a reasonable price and the earnings per share rise each year, then the share price will rise over a period of years. The trend may be very erratic and the shares will drop in price at times. But if the earnings keep rising and the stock was purchased at a reasonable multiple of earnings, then it will be a god investment. In the long-term the performance of the business is what matters and not the opinion of the market on any given day.

New investors with many years of investing ahead of them should cheer stock market declines. For new investors, the chance to buy additional shares at lower prices is a benefit that should far out-weight any loss suffered on past investments.

Similarly, any investor with many of years of investing ahead of them is likely to benefit from a market decline. Sure, the loss in market value on an existing portfolio hurts a lot. But the chance to buy shares at lower prices in the future over a period of years is a large benefit. Over a long period of the time the P/E ratio on the market is likely to revert to some long-term average number. Temporary spikes that bring the market P/E above 20 may feel very good but gains caused by this are likely to be temporary. Similarly if the market P/E dips much below 12 to 14, this is likely to be a temporary loss that will be regained. It may be impossible to predict when market multiples will revert to long-term averages but they are reasonably certain to do so over time.

Investors who are no longer investing new money and are beginning to live on their invested assets do need to worry about market direction. Ideally, this worry was considered at the time that the allocation was made between riskier investments and safer investments. Even for these investors much of “noise” of market fluctuations is likely to be averaged out over the years, and therefore may be of little long-term consequence.

Some analysts believe that recent declines in the general market are only the first stages of a major decline. Some of these pessimistic analysts believe that the North American economy will suffer a major collapse. If the economy did collapse then stocks would do likewise. But most analysts believe that the North American economy will continue to grow over the years and in the long term stocks will increase in value along with the economy.

END

Shawn Allen, President
InvestorsFriend Inc.

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