As a market participant, at some point you will have come across the term “market cycles”. Everything moves in cycles. Seasons change from cold to warm. The political atmosphere shifts from right to left, and back. The more you understand history and human nature, you begin to see cyclicality in everything. Businesses are no exception.
Counting Beyond Three
In business, you won’t know how long market cycles lasts. Don’t waste your time trying to figure out a cycle’s length. By definition the future is unknowable. It is more important to know where in the cycle you are. Good times usually don’t last forever, but neither do bad. Intuitively we understand this, but when emotions are involved, our sense of reality gets blurry.
Ben Graham is quoted to have said: “In markets, human beings cannot count beyond three”. What he meant by this is that if a company has say, three consecutive rising quarterly earnings, the market cannot help but be excited about a stock. This of course applies in the opposite case as well. Sometimes these are merited, other times not as much.
As an intelligent investor, you understand that Mr. Market has a short attention span. He’s constantly looking for the next hot thing. The intelligent investor also understands that we are investing in real businesses. Not charts or fluctuating price quotations. We have an owner mindset, and understand that business takes time. And rarely does underlying business value change in mere months.
Valleys and Mountaintops
Business cycles move from mountaintops to valleys, then back to mountaintops. Inevitably, almost all companies will at some point in their lifespan find themselves in a valley. During these times, Mr. Market is extremely pessimistic. Usually he believes the firm has lost all its climbing gear, and the valley will be flooded any day.
Your job as an intelligent investor is to understand the valley. How did the firm end up here? How steep is the climb up? Does the firm have the required gear to climb? Is the valley populated by other unfortunate climbers, and what are their chances? Is the valley real or imagined? Figuratively speaking, piles of debt combined with diminishing cash flow can be considered the valley being flooded. But there are times when the valley is just an illusion.
Just as with valleys, the mountaintop needs to be gauged as well. Unfortunately for the climber this is much, much harder. For those who buy businesses for less than they are worth, buying is always easier than selling. The problem is that intrinsic value is usually a range of values, not a specific number. The hard part is knowing if you are climbing a mountain with rising peak, or have you already enjoyed the view and it’s time to exit by helicopter into the next new valley.
Evacuating the Peak
If you’ve had ascents in markets, its guaranteed you have found yourself prematurely excited, and sold. Likewise, there are plenty of times you have avoided a valley, but it never flooded and the climbers made it out spectacularly. Consider this the price you pay for participating in markets.
it doesn’t matter which valleys or peaks you miss. The only ones that matter are the ones you participate in. In an investing lifetime, you don’t need countless correctly analyzed valleys and mountaintops to do well. You only need a handful. In general, the valleys you gauge correctly and climb for extended periods will wipe out the inevitable mistakes. The key is in deliberately seeking out the valleys, not the mountaintops. For most people, this is psychologically too difficult. The mountaintop and its magnificent (real or perceived) views are too alluring compared to the valleys.
Conclusion
So when do you call the helicopter to pick you off the mountain? Like most things, it depends.
If you buy a stock based on a discount to its assets (with no telling if these assets will expand), it’s safe to say that the helicopter should be called once the value of existing assets is reflected in the stock price. If you bought a company with steady, predictable cash flows, the price will reflect these cash flows at some point. You may want to sell once the price reflects intrinsic value in terms of cash flows, but this is not always ideal.
Personally, I’ve started to warm up to Mohnish Pabrai’s advice on when to sell if you’re holding on to a good company: Don’t sell when it’s fairly priced, don’t sell when it’s slightly overpriced. Sell when its greatly or ridiculously overpriced.
-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
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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