“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham
There’s always something to worry about in the stock market – interest rates, tax policy, the ups and downs of the business cycle, regulatory changes, wars and civil unrest, natural catastrophes and a host of other things.
The beginning of 2016 has seen a sharp decline in global stock markets. Most headlines point to economic weakness in China and a plunge in oil prices to explain the fall. Experts sound pessimistic. Investors are concerned. Should they be invested in stocks? Should they hold more cash?
Let’s look at how we make buy and sell decisions as markets fluctuate.
The Principles We Use
1. Market price and business value are not the same thing.
Business value is based on a cool-headed appraisal of the cash flow we expect a business to produce over time. Market price may begin with an appraisal like this, but it’s then often colored by emotional influences, especially greed or fear.
In a bull market, optimism reigns. Investors tend to assume that recent strong results will last far into the future. Market prices may rise above business value. In a bear market, the opposite happens. Investors tend to assume that recent poor earnings growth will last a long time. Market prices may fall below business value.
Recent concerns about China and oil prices are based partly on reason and partly on emotion. The slowdown in China does have an impact on businesses around the world, whether they do business directly with the country or work with others who do. Some adjustment to estimates of future profits seems in order.
Weakness in China, though, has some compensating benefits that aren’t to be seen in recent headlines. A decline in the exchange value of the yuan makes imports cheaper to buyers in the US and elsewhere. Slower growth has led to decreased demand and lower prices for many commodities, including oil. This hurts commodity producers, but it is a big benefit to most everyone else.
2. Market prices are simply offers. You choose whether to take advantage of them.
If someone quotes me a price on life insurance or I receive an offer for my used car, I understand that I don’t have to agree to either one. We view stock quotes the same way. If market prices are above business value, we will sell. If prices are below business value, we are willing to buy.
Noted investor Benjamin Graham famously used the example of Mr. Market to illustrate this point. Imagine, he said, that you own a business with a very emotional fellow named Mr. Market. He frequently offers to buy your part of the business, sometimes at a high price and sometimes at a low one. You are not obligated to accept a low offer, so it only makes sense to sell when the price is fair.
3. Do not place yourself in a position where you are forced to sell.
Those who borrow heavily to fund a stock position may be forced to sell if the stock price falls. Those who focus on the day-to-day or minute-by-minute trading in the stock market may lose perspective during a downturn. They can become demoralized and reach an “I can’t take this anymore” moment that leads them to sell at a bad time.
4. Own companies that will benefit from volatility.
The global economy is a complex system. It’s made up of a vast network of ever-changing, ever-adjusting connections and relationships, few of which can even be observed. Physicist Per Bak likened such a system to a sandpile. A layer of sand is simple and stable. As grains of sand are added, complex structures form, topple and re-form in often unpredictable ways.
Great companies take advantage of volatility, even when their own share prices are down. Businesses that have free cash flow, low debt and savvy management can take advantage of uncertainty and low prices. They can invest in new projects, acquire other companies or even buy back their own stock.
Take Advantage of Downturns
We love to own businesses with these characteristics. A downturn in the market gives us the opportunity to add new companies to client portfolios or buy more of what we already have at good prices.
Barry Dunaway, CFA®
Executive Vice President & Director of Research
America First Investment Advisors, LLC
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.