I was reading Joel Greenblatt’s The Little book that still beats the Market and it had a very important insight which is highly relevant in today’s times. With trading apps and financial influencers everywhere, it is easy to let stock prices guide our decisions. But price and value are two very different things and can have very poor correlation at times. As investors, our job is to find good opportunities that give us the most value. Figuring out a company’s true value is not simple. We guess, estimate, and sometimes get it wrong. But what if we could figure it out? What would we do with that knowledge?
Take the example of Zomato. In the last year, its stock price ranged from ₹127 to ₹305. Was it cheap at ₹127? Was it expensive at ₹305? Could it have been cheap at both prices, or expensive at both? This wide price range happened in just one year. If we looked at its price over a few years, the range would likely be even wider. This leads us to ask:
- How is this possible?
- Does something change every year to justify these big differences?
- Does this make sense?
That’s a very wide range of movement in such a short period (the recent bull market has made it very common, but actually it is not). Looking at the price over a two to three-year period would give an even wider range. So these are the questions everyone has to ask:
How can this be?
Does something happen each and every year to account
for this change in value?
Does this make sense?
Most of the time, these wild price swings don’t make sense. They happen all the time, but the value of a business doesn’t change that quickly. Why do stock prices move so much? Because people are not rational. They keep changing their guesses about the future earnings and value of businesses. And these guesses often change with market conditions. The most important point is that we don’t need to understand every reason for these changes. Instead, the focus should be on finding the underlying value of a business.
The following explanation of Benjamin Graham is one of the simplest yet most important of all time. Imagine that you are partners in the ownership of a business with a
crazy guy named Mr. Market. Mr. Market is subject to wild mood swings. Each day he offers to buy your share of the business or sell you his share of the business at a particular price. Mr. Market always leaves the decision completely to you, and every day you have three choices.
You can sell your shares to Mr. Market at his stated price, you can buy Mr. Market’s shares at that same price, or you can do nothing.
Sometimes Mr. Market is in such a good mood that he names a price that is much higher than the true worth of the business. On those days, it would probably make sense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that he names a very low price for the business. On those days, you might want to take advantage of Mr. Market’s crazy offer to sell you shares at such a low price and to buy Mr. Market’s share of the business. If the price named by Mr. Market is neither very high nor extraordinarily low relative to the value of the business, you might very logically choose to do nothing. In the world of the stock market, that’s exactly how it works. In short, you are never required to act. You alone can choose to act only when the price offered by Mr. Market appears very low or extremely high. Graham referred to this practice of buying shares of a company only when they trade at a large discount to true value as investing with a margin of safety. The difference between your estimated value per share and the purchase price of your shares represent a margin of safety for your investment. If the original calculations of the value of shares turns out to be wrong due to bad market conditions, some regulatory change, new competitors or a failure in the business model, the margin of safety in the original purchase price could still protect us from losing money. In fact, these two concepts—requiring a margin of safety for your investment purchases and viewing the stock market as if it were a partner like Mr. Market— have been used with much success by some of the greatest investors of all time.
The summary is that stock prices have wild movements all the time and that does not necessarily denote a change in the underlying value. One of the best stockpicking skills is to find the intrinsic value of a company and picking good bargain buys. But with too much information floating around these days and media’s easy reach, everyone is influenced by the overflow of information and we have the urge to constantly buy and sell everytime. Though understanding the true value of a company and buying it at the right levels is difficult, what is even more difficult is to act only when the time is right. The markets are crazy most of the time but only YOU have to decide when you have to act. Patience is a virtue which is highly rewarded in the market.
Equitygram 