Why do we buy what we buy? Buy low and sell high, right, sounds simple by not always easy to do. Two terms that you will hear on the evening business shows are “momentum investing" and "value investing”. Momentum strategies are nothing more than buying into a hot stock when everyone else is. Momentum stocks can go up fast, but as you may recall in early 2000, they can tank just as quickly.
Value investing, however, is a little more involved. Did you ever wonder how a company like GE or Citigroup’s stock could fluctuate in price from $15- $25$ per share over a 1-2- year period? If these companies have, say, a billion shares outstanding, it would mean that on one day you could have bought GE for $20 billion and another day $35 billion. How can that be? Is the company selling twice as many X-ray machines or jet engines one year versus another Possible, but not very likely. It is extremely unlikely. It is extremely unlikely that the long term “fair” market value of a company fluctuates as much as its stock price. What fluctuates sharply over short time periods is the motion of the investor.
Periodically, the market gets it right, i.e. stocks trade at or near their long term value. So why do share price move around so much ever year, when it seems clear that the values of the underlying businesses do not. Well, as Joel Greenblatt, the author of The Little Book That Beats the Market says “who knows and who cares? Maybe people go nuts a lot. Maybe it’s hard to predict future earnings. Maybe people get a little depressed and don’t want to pay a lot for stuff. Maybe people get excited sometimes and are willing to pay a lot”.
It’s not really important to know why, only that it happens. There are many factors involved determining “fair” market value. Suppose you determine a business is worth between $10--$12 per share, and at various times during the year, its shares could be purchased for between $6—$11. If you were confident about your estimate of what the business was worth, it might be a difficult decision to buy the stock when it was trading near $11. But when shares in that same company during that same year were available at close to $6, your decision becomes much easier. At $6 per share, if your estimate of value is close to correct, you would be buying shares in this company for only 50 or 60 cents on the dollar.
Think of the process in graphical terms, where the estimated fair market value of the stock is a horizontal line on a graph. Over time, when the actual stock price fluctuates over or under the line, that fluctuation signals a buy or sell.
The wide short term variations between a stock fair market value and it current price is the primary reason we focus on valuation. One of the greatest stock market theoreticians, Benjamin Graham, put it this way: “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. The decision is always yours. You can sell your shares to him, buy his or do nothing. Sometimes Mr. Market is in such a good mood that he names a price that is much higher that the true worth of the business. On those days it would probably make sense for you to sell. On other days he is in a bad mood and names a very low price. On those days you might want to take advantage of Mr. Markets’ crazy offer to sell shares at such a low price.”
The key is an understanding of long term fair market value, so you can be buying below the line and selling above the line.