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This article appeared in the April 2007 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details. Do prices really matter? Following the hype over the recent global sell-off in shares, Roger Montgomery Managing Director of Clime Asset Management, questions whether analysis of price movements should be the basis of an investor’s decision when purchasing shares. Find out why he believes value investing, through investing in solid businesses is the better option. Price versus value Let’s say you have a passive part interest in an unlisted business. What happens in the stock market would have no impact on either the profitability or the value of your business. World events, economic forecasts, movements in local and international stock markets and commentary by media commentators who confuse price with value would have no impact on your business. It would continue merrily on its way, oblivious to extraneous factors, emotive influences and sentiment. You would be concerned only with its profitability and future prospects. Unless you needed to sell, or received an offer, you are unlikely to spend any time figuring what your interest in the business was worth. The fact that the price of your business is not quoted daily in the media is of no consequence. In the same way that a high price does not increase its value, a low price does not lessen it. Of course, if someone came along and made what appeared to be a generous offer, you might consider selling if it exceeded your estimate of value and your money could be more profitably employed elsewhere. Conversely, if someone made a low-ball offer, you would not automatically assume that the value of your business had declined. Price and value are two different things. Prices are only important when buying or selling. If you buy into sound businesses with superior attributes at a fair price, price aberrations, whether determined by sound judgment or by fear, greed and emotional sentiment, will neither add nor detract from your wealth. This becomes abundantly clear when you draw a straight line between a stocks price at different points of time and superimpose the squiggly lines of a price chart for the same period. While value does not progress smoothly, its determination is based on the factual business performance rather than unrelated extraneous issues that govern the actions of those who unwittingly contribute to the rich forum of opportunity we call the “stock market”. So the next time the market is flooded by uninformed comments don’t get caught up in the hype. It is always worth reflecting on time proven wisdom instead of making an emotionally driven buy or sell investment decision. Stick to finding the great businesses. If you do this and hold onto them for as long as they remain great, you will not doubt ensure that the value of your investments will rise over the years. Value investing is the solution Making knowledgeable investment decisions can have a significant impact on your life. Informed investment decisions can provide you with the financial freedom that few people ever achieve. How does no mortgage and high quality education for your children and an early retirement sound? Despite popular belief, you don’t need to be a genius to become a smart investor. You only need to make a handful of well-informed investment decisions over the course of your entire life to achieve your financial goals. The ability to confidently make your ‘handful’ of sensible decisions can be found by adopting the methodology known as value investing. As an investment philosophy, value investing is not new. It has been around since the early 1930’s when a now well-known professor of investments, Benjamin Graham, articulated the philosophy in his book ‘Security Analysis’, the bible of investment theory. If Benjamin Graham, Warren Buffet, Charlie Munger and Tweedy Browne can generate returns for shareholders in the order of 20% per annum over many decades (effectively doubling their wealth and that of their shareholders every 3.6 years), why should we try anything different? What we find amazing is that even though the valuation approach has produced superior returns for more years than any other investment strategy, the majority of people participating in the stock market choose not to practice the value investing approach. It is estimated that only 5% of all market participants choose to consistently follow Graham’s successful philosophy. Disturbingly, the other 95% of all ‘investors’, including many professional fund managers, have chosen to follow something else. Value investing is not rocket science. It does not require you to have a stratospheric IQ. What you do require, however, is the right temperament and the ability to understand and apply a few sound, time-proven investment principles. Over time, we will teach you such principles and steer you on the right path to becoming a successful value investor. The principles are not set in concrete, nor are they a set of rules that must be strictly adhered to. What they do provide is a superior investment philosophy that acts as a framework within which you can quickly identify good investments, and just as importantly, avoid low-quality businesses. Unfortunately for the value investor, there are many of the latter and not so many of the former. However, by exercising patience and waiting for the right business at the right price, you too can invest your hard earned dollars with a high degree of confidence. For many market participants, the lure of being an ‘active’ investor creates a temptation to check prices daily and trade just as frequently. Unfortunately second-guessing price direction through technical analysis often takes precedence over an assessment of intrinsic value (what the business is actually worth). Speaking with investors over the years reaffirms my belief that many market participants tend to think of shares as an ‘investment’ whose price is likely to be volatile. They forget that their part ownership, no matter how large or small, actually represents an ownership in a less volatile business that has ‘value’. Without an assessment of value, price will dictate your emotions. Emotional buying and selling decisions may or may not end up being bountiful. Consider for a moment the following question: Would you simply pay any price for the whole of a small business, a real estate investment, or maybe an interest bearing security? Of course not! You want to pay the best possible (minimal) price. However it seems that most market participants are quite happy to pay any price for a stock or share in the hope that someone will come along and simply pay more. We call this type of approach the ‘its-going-up’ strategy. I believe this is an extremely risky form of share market participation. Your first lesson: Don’t let anyone fool you into thinking that the stock market is anything but a great big auction arena where many individuals place bids and offers to buy and sell small interests in businesses. In the great auction arena, these small interests are known as stocks or shares. Your goal is to buy shares at attractive prices to build a portfolio of quality businesses, which hopefully you will be able to hold forever. Once you are a part owner, I believe the only time you should ever consider selling your partial interest is when the quality of your business is no longer perceived as being attractive. It’s that simple. If you have consistently made money in the stock market, chances are you bought interests in good businesses and at a price that represented good value, and hopefully you still hold them. On the other hand, if you have ever lost money in the stock market, chances are you bought into an inferior, risk-prone business for which you may have paid too much for the shares or you may have been simply betting on price direction using some other common but weak tool. As a partial owner of any business, commonsense would direct you to consider what likely cash flows, perhaps based on past performance, you would receive over your period of ownership. As investors, it is very important to understand that most businesses exist to generate a high positive financial return to their owners. Over time, businesses that are able to maintain or increase already high rates of profitability and reinvest retained earnings at attractive rates of return, as measured by Return on Equity (ROE), will ultimately increase in value. Over longer periods of time, this rising business value is translated into rising market prices. The bounty however, is never shared equally. So why value investing? Consider this question – can you name another investment strategy that has produced comparable returns over the past 50 years? A mountain of evidence confirms the principles of value investing have provided market-beating returns over long periods. In my eyes, value investing is the way to participate in the great auction arena where your risk is minimised by holding a portfolio of wonderful, quality businesses that you would be proud to call your own. |
