The Aleph Blog » Blog Archive » The Rules, Part XXXV

The Rules, Part XXXV

Stability only comes to markets in a self-reinforcing mode, from buy and hold (and sell and sit on cash) investors who act at the turning points.

Beyond the vicissitudes of the markets, there are businessmen.  They have a sense of what their capital costs.  They reason regarding acquisitions and selling off their own holdings/subsidiaries.  They ask themselves how permanent current financing conditions are likely to be.

They don’t play momentum; they just look for when buying or selling businesses makes sense.  The market, on the other hand, has many that only want to buy what is rising, and sell what is falling, to a first approximation.

The market is about business, not stock trading.  Businesses are primal, trading markets are secondary. When businessmen find a publicly-traded business trading at an attractive value, they buy it, particularly if there are synergies between the businesses.  Thus during the bust phase of equity and credit markets, M&A often consists of cash-rich firms buying out firms that are in distress.

The same is true in boom times.  Companies sell themselves, or subsidiaries to leveraged players who think the game will go on much longer than reality will bear.  The sellers sit on the cash; the buyers enjoy the losses when the bust comes.

Volatile markets favor those with strong balance sheets — those that can wait for a better day, or, those that can wait for better opportunities. In either case, they can wait; they do not have to buy or sell now.  They are experiencing no cash flows forcing them to action.

Those with strong balance sheets focus on return on book capital, and avoid leverage.  They look to grow the book value (“net worth”) of their company, and ignore secondary goals.  They are shareholder-oriented.  They take advantage of both sides of the boom-bust cycle — selling near peaks when return on capital is lousy, and buying near troughs when return on unlevered capital is fat.

This is simple stuff, but hard to execute, because the fear/greed cycle interferes with rational calculation.  Regardless, absolute valuation investors put in the tops and bottoms of markets by their selling and buying.  To the degree that technical analysis works, it is because they trace the bread crumbs of large valuation oriented investors.

That’s all for now.  Thoughts?  Give it to me in the comments.


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7 Responses to The Rules, Part XXXV

  1. [...] David Merkel, “To the degree that technical analysis works, it is because they trace the bread crumbs of large valuation oriented investors.”  (Aleph Blog) [...]

  2. ivanhoff says:

    What is your definition of a value investor?

    There are many sizable buyers that accumulate because of the growth prospects or at least use a mixed approach of value and growth. They leave pretty big traces in the market too.

    Your theory about the important role of replacing cost in investment decision is plausible, but market have have never been rational and they will never become such. Sentiment plays huge role, especially when other people’s money are involved. Most money managers don’t manage just money, but their investors’ sentiment. Very few managers have earned the patience of their clients – most have just 1-2 years to be right and as we both know, some rational investment ideas take much longer to come to fruition.

    • My version of value investing is polyglot. I try to buy assets cheaply. I try to educate clients that it takes a while for value to be realized, so try to give me a full market cycle.

      A number of value investors like Michael Price, Mario Gabelli, Warren Buffett, etc., watch where transactions in various industries occur in the private markets, and that aids their investing. Thus they tend to buy when the assets slip beneath their long term private market value. Some, like Leucadia or Loews will also sell or spin off fully-priced subsidiaries.

      Businessmen drive the market at turning points, as I tried to say in my piece. They don’t drive it so much in-between; that’s where momentum comes in.

      Thanks for writing.

  3. ivanhoff says:

    This is one way to look at things, but there is much more behind turning points.

    There are technical traders that also look for reversion to the mean and step up when price extends too much from its LT average. Plus, we all know that many value investors are very early in their purchases (bottom picking) – they need the liquidity that fear and forced liquidation usually brings, in order to establish positions big enough to make a difference in their portfolio.

  4. [...] The Rules: The Market is About Business, Not Stock Trading – The Aleph Blog [...]

  5. [...] Valuation investing drives the market long-term – Aleph blog [...]


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