Ben Graham, who else?
Well, I didn’t think I would do any more “Rules” posts, but here one is:
In markets, “what is true” works in the long run. “What people are growing to believe is true” works in the short run.
This is a more general variant of Ben Graham’s dictum:
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Not that I will ever surpass the elegance of Ben Graham, but I think there are aspects of my saying that work better. Ben Graham lived in a time where capital was mostly physical, and he invested that way. He found undervalued net assets and bought them, sometimes fighting to realize value, and sometimes waiting to realize value, while all of the while enjoying the arts as a bon vivant. In one sense, Graham kept the peas and carrots of life on separate sides of the plate. There is the tangible (a cheap set of assets, easily measured), and the intangible — artistic expression, whether in painting, music, acting, etc. (where values are not only relative, but contradictory — except perhaps for Keynes’ beauty contest).
Voting and weighing are discrete actions. Neither has a lot of complexity on one level, though deciding who to vote for can have its challenges. (That said, that may be true in the US for 10% of the electorate. Most of us act like we are party hacks. 😉 )
What drives asset prices? New information? Often, but new information is only part of it. It stems from changes in expectations. Expectations change when:
- Earnings get announced (or pre-announced)
- Economic data gets released.
- Important people like the President, Cabinet members, Fed governors, etc., give speeches.
- Acts of God occur — earthquakes, hurricanes, wars, terrorist attacks, etc.
- A pundit releases a report, whether that person is a short, a long-only manager, hedge fund manager, financial journalist, sell-side analyst, etc. (I’ve even budged the market occasionally on some illiquid stocks…)
- Asset prices move and some people mimic to intensify the move because they feel they are missing out.
- Holdings reports get released.
- New scientific discoveries are announced
- Mergers or acquisitions or new issues are announced.
- The solvency of a firm is questioned, or a firm of questionable solvency has an event.
- And more… nowadays even a “tweet” can move the market
In the short run, it doesn’t matter whether the news is true. What matters is that people believe it enough to act on it. Their expectation change. Now, that may not be enough to create a permanent move in the price — kind of like people buying stocks that Cramer says he likes on TV, and the Street shorts those stocks from the inflated levels. (Street 1, Retail 0)
But if the news seems to have permanent validity, the price will adjust to a higher or lower level. It will then take new data to move the price of the asset, and the dance of information and prices goes on and on. Asset prices are always in an unstable equilibrium that takes account of the many views of what the world will be like over various time horizons. They are more volatile than most theories would predict because people are not rational in the sense that economists posit — they do not think as much as imitate and extrapolate.
Read the news, whether on paper or the web — “XXX is dead,” “YYY is the future.” Horrible overstatements most of the time — sure, certain products or industries may shrink or grow due to changes in technology or preferences, but with a few exceptions, a new temporary unstable equilibrium is reached which is larger or smaller than before. (How many times has radio died?)
“Stocks rallied because the Fed cut interest rates.”
“Stocks rallied because the Fed tightened interest rates, showing a strong economy.”
“Stocks rallied just because this market wants to go up.”
“Stocks rallied and I can’t tell you why even though you are interviewing me live.”
Okay, the last one is fake — we have to give reasons after the fact of a market move, even anthropomorphizing the market, or we would feel uncomfortable.
We like our answers big and definite. Often, those big, definite answers that seem right at 5PM will look ridiculous in hindsight — especially when considering what was said near turning points. The tremendous growth that everyone expected to last forever is a farce. The world did not end; every firm did not go bankrupt.
So, expectations matter a lot, and changes in expectations matter even more in the short-run, but who can lift up their head and look into the distance and say, “This is crazy.” Even more, who can do that precisely at the turning points?
There are few if any people who can both look at the short-term information and the long-term information and use them both well. Value investors are almost always early. If they do it neglecting the margin of safety, they may not survive to make it to the long-run, where they would have been right. Shorts predicting the end often develop a mindset that keeps them from seeing that things have stopped getting worse, and they stubbornly die in their bearishness. Vice-versa, for bullish Pollyannas.
Financially, only two things matter — cash flows, the cost of financing cash flows, and how they change with time. Amid the noise and news, we often forget that there are businesses going on, quietly meeting human needs in exchange for a profit. The businessmen are frequently more rational than the markets, and attentive to the underlying business processes producing products and services that people value.
As with most things I write about, the basic ideas are easy, but they work out in hard ways. We may not live long enough to see what was true or false in our market judgments. There comes a time for everyone to hang up their spurs if they don’t die in the saddle. Some of the most notable businessmen and market savants, who in their time were indispensable people, will eventually leave the playing field, leaving others to play the game, while they go to the grave. Keynes, the great value investor that he was, said, “In the long run we are all dead.” The truth remains — omnipresent and elusive, inscrutable and unchangeable like a giant cube of gold in a baseball infield.
As it was, Ben Graham left the game, but never left the theory of value investing. Changes in expectations drive prices, and unless you are clever enough to divine the future, perhaps the best you can do is search for places where those expectations are too low, and tuck some of those assets away for a better day. That better day may be slow in coming, but diversification and the margin of safety embedded in those assets there will help compensate for the lack of clairvoyance.
After all, in the end, the truth measures us.