One of the first thing you learn in finance is the concept of efficient markets. This implies that all quantitative data on a public company is known by all market participants, and thus the security is efficiently priced.
The General Market vs. Individual Companies
To be fair, I believe the major market indices are fairly priced most of the time. However, if you take a dart and throw it on any given stock within the index, you can bet that the 52-week high and low prices will be greatly different. This is because in auction-driven markets it’s humans making the buy and sell decisions. Even if the trading is done by supercomputers, the coding of trade decisions is made by a human.
In most cases, the quantitative data is reflected in the stock price. Superior investment returns thus do not come from superior number crunching, but rather, superior insight. Therefore, as value investors we need to be hyper-focused on situations where we have some kind of knowledge of a business or industry that gives us an edge. Another luxury we have is that we can be patient. The difficulty is not in knowing if a business is good, but to have the discipline to wait for one at the correct price.
Craziness Will Never Go Away
The true intrinsic value of a business does not change daily or monthly. The simple definition still applies: Its value is the cash it will generate during its lifespan. The market is full of intelligent participants, yet stock prices move all over the place! Like a kid on a sugar high at a theme park.
Earnings Surprises
The graph below shows something that seems to be basic market behavior:
On April 8th 2022, Sprouts Farmers Market (SFM) traded around $34,75. in just under one month on May 5th, it took a nosedive to $23,75. A 31% drop. The company had missed earnings expectations by a meaningless cent or two. Fast forward to December of the same year, we’re back to the $34 price range. Now, the cause of the jump was an earnings surprise.
In a span of 9 months, the price of the company has dropped like a rock, then climbed back by 46%. Did the intrinsic value of the busienss first decrease, and increase back hugely in mere months? The answer is of course not. This is just one example of very short time horizons. Interestingly, SFM has a market cap of around $3 billion and at least 15 analysts follow the company. This teaches us that even if there is wider coverage of a stock, it can still have a wild ride within a year.
Efficient Indeces
The shift of capital from actively managed to passive alternatives has been massive. In the US alone, there are more equity mutual funds and ETFs than there are stocks. As soon as a company hits a market cap of a few hundred million (or even less!), they tend to get analyst coverage.
Most people are not capable of valuing companies or knowing when they’re under or overpriced. This is why low-cost passive indexing is a wise choise for the majority. Dollar-cost-averaging will guarantee equal returns with the market over the longer term.
Despite the merits of passive index investing, many retail investors continue to buy individual stocks. Daniel Kahneman coined the idea of first and second level thinking. If a company is really good and has a lot going for itself, the first level thinker will buy. The second level thinker will come to the same conclusion that the company is great, but perhaps not as great as everyone says. Therefore, the price of a stock is all-important. Only then can we have a margin of safety to get us out of trouble if we’re wrong.
Most retail investors are first level thinkers.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
