Voting Machine vs. Weighing Machine
“In the short-run the market is a voting machine, but in the long-run the market is a weighing machine.” — Warren Buffett
Housekeeping Note
A huge thank you for the mention from Liberty in his Substack post on Monday. After publishing one update a week for the past few months, I’m amazed that he is not only able to publish three updates a week, but that the quality of each one is off the charts. If you’ve come here from his mention, thank you. I hope you find my thoughts worth your time and you stay awhile. I started this mainly to keep the cobwebs from clogging my brain in retirement and to see how it goes — and I’ve been having fun doing it. If you are reading this and haven’t signed up to have each week’s update delivered to your email, please take a second and subscribe…it’s free, so the cost is your time and attention. These are two commodities we often take for granted but are really FAR more precious than we realize. Whether you’ve been around since the start or are new, I appreciate you being here…THANKS!
TL;DR Summary
Stock prices are set in the markets and fluctuate quite a bit…this created the allegorical character of Mr. Market who makes an offer to buy/sell shares.
While Mr. Market is designed to create an image of market prices occasionally being too high or too low, the alternative concept is the efficient market hypothesis which states that the market price is the best estimate of the stock’s true value.
Human nature makes investors want the best of both alternatives. Buying stocks from Mr. Market at artificially low prices, followed almost immediately by the efficient market hypothesis recognizing the low price and correcting it (or Mr. Market moving to an artificially high price).
In reality, it is more likely to take awhile (possibly multiple years) for our insights (assuming they are correct) to get recognized and reflected in market prices.
While we wait, we have the advantage of more time to establish a position and for the firm’s capital allocation decisions to work in our favor.
However, while we wait, things change. We must exhibit the patience and conviction to wait for our story to be recognized, while also maintaining a questioning vigilance to verify that our story is still there.
Introducing Mr. Market
The origin of Mr. Market seems to go back to the 1949 book “The Intelligent Investor”1
Imagine that in some private business you own a small share which cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.
Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman will you let Mr. Market's daily communication determine your view as the value of your $1,000 interest in the enterprise?
You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your owing ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
In other words, Mr. Market is always out there offering you shares of stock or offering to buy shares of stock for a given price. While that price may very well change by a couple of cents per share between the time you decide to buy/sell and you execute your trade, for the most part you know what you will pay to buy the stock or receive if you sell the stock. Now you need to figure out what YOU feel the value is and, if there is enough of a difference between what Mr. Market says it is worth and what you feel it is worth, you can have a transaction.
Efficient Market Hypothesis
In an efficient market, the best estimate of the value of a security is the current market price. Note that this does not mean that the current market price IS the correct value or that tomorrow’s price will not be much higher/lower than the current price. Instead, it means that the current market price does not present an opportunity for you to earn a return that is higher (or lower) than the fair risk-adjusted rate of return. If markets are efficient, we can only earn higher (or lower) returns by
taking on more (or less) risk or
being lucky (or unlucky)
Let’s look at each of these quickly, starting with risk. One of the key tenets of finance is that investors are risk averse.2 This doesn’t mean that investors want to avoid risk. Instead, it means that they are only willing to take risk when they receive adequate compensation for that risk. Therefore, riskier investments should, on average over time, earn higher returns than investments with less risk. If you earn higher returns as compensation for taking on higher risk, this is still consistent with market efficiency.
The second factor is that there is nothing preventing investors from being lucky or unlucky. When someone won the nearly $700 million Powerball jackpot in early October of 2021, we didn’t decide that they were really gifted at picking numbers. Instead, we recognize that the fortune of luck was on their side. How about the investors that purchased shares of GameStop for under $20 per share to start the 2021 year and saw their stock soar to over $300 within a couple weeks? Was this a case of investors recognizing that Mr. Market was selling them shares WAY too cheaply one day and offering to pay them WAY too much a couple weeks later? Or merely a case of good fortune? We know that luck plays a part in virtually every avenue of life, so it should be no surprise that it happens in investment decisions as well. Therefore, if I earn a higher than risk-adjusted return, there is good reason to believe that I may have been lucky rather than good.
Mr. Market Revisited
At this point, we’ve introduced the concept of Mr. Market (well, actually re-introduced it, Benjamin Graham beat us to it by a little over 70 years) and the Efficient Market Hypothesis. Note that these two ideas do not align. If you believe markets are efficient, then you probably should just own a well-diversified portfolio that matches the risk level you are comfortable with and avoid analyzing individual stocks.3 If you ARE buying individual stocks, you are making a bet that you have a better understanding of the true underlying value of the individual stocks than our friend Mr. Market does. There is nothing wrong with either approach. I personally believe that markets are reasonably efficient, but sometimes individual situations like GameStop, AMC, and others make that a hard argument to buy into fully. Plus, and this is one of my personal foibles, I like trying to out think the consensus opinion. Therefore, I have a mix of diversified portfolio and actively managed portfolio. This keeps me engaged in the markets and should end up either providing some opportunity or not costing me returns.4 Assuming markets are efficient, then managing leaks from overtrading, market timing, tax decisions, etc. should all be more important than stock selection. On the other hand, if markets are not 100% efficient, then I will either be rewarded, on average, for better decisions or penalized, on average, for worse decisions.
This is where we get to the area where investors display an irrational mindset. We want markets to be inefficient when we buy a security as this is necessary to create opportunity. Then, as soon as we buy the security, we want markets to become efficient and recognize that we were right. In other words, we want BOTH outcomes. Mr. Market around to offer us irrational discounts followed almost immediately by “rational” pricing that allows us to profit off of our wise insights. Now granted, we are often willing to wait a few days or maybe even a couple weeks before we get proven correct, but once we start counting in months our blood pressure starts to rise.
However, if you think of a stock as representing a piece of an actual business instead of as a trading instrument, it becomes less important that the price rises significantly. As a matter of fact, there are two scenarios where it can actually be better for us if Mr. Market continues to err on the side of pessimism for a long time. First, this gives us more time to establish a position. Often, in finance, we assume that a position should only be a set percent of one’s portfolio. However, this ignores the reality of how most of us build wealth over time. Over the first 10-20 years of wealth accumulation, most of our portfolio growth comes not from returns, but from saving. Consider a young couple that just graduated from college to start their careers and makes a combined income of $100,000. Assume that they save 10% of their pretax income (weekly) and earn a 9% rate of return while their income grows at 5% per year. After 10 years, they will have $196,523, but over $125,000 of that came from their savings. If they see an opportunity to invest 5% of their portfolio, that is less than $10,000. However, 5 years later, they will have $420,648 and 5% of their portfolio will over $21,000. Therefore, they can increase their investment significantly over time as their wealth accumulates.5 If Mr. Market had come to his senses quicker, then our hypothetical couple wouldn’t have been able to accumulate as large of a position. Attractive opportunities that stay underpriced for longer time frames allow investors to accumulate larger positions.
The second factor is through capital allocation. Consider a business that is popular and everyone wants to jump on board this opportunity. That tends to attract lots of capital. While opportunities are dynamic instead of static, it is rare to find instances where the potential dollar value of the opportunities continues to increase faster than the amount of capital that can flow into it. For example, one of the areas that is popular at the moment is electric vehicles. The total addressable market is expanding, but so to is the capital flowing into the field. Capitalism tends to overreact which means more capital flows in than opportunity is created. This will push down the return on invested capital (ROIC) going forward. This is why we see business cycles over time.
On the other hand, if an opportunity is overlooked for any specific reason (for example, tobacco may be out of favor due to ESG concerns or regulations on marketing), this restricts new capital flow and allows firms to maintain a higher ROIC for a longer time frame. In addition, if the firm is returning capital to investors through stock buybacks, the cheaper valuation makes the buyback a better deal for shareholders who hang onto their shares (as was covered in one of my earlier issues). A third factor that may occur if you are trading outside of a tax-sheltered account is that if you recognize a capital gain in under a year, you need to record that as a short-term capital gain for tax purposes. This will result in the IRS taking a bigger cut of your profits and lowering your rate of return.
Our natural desire is for markets to be inefficient in our favor when we buy the stock to create an opportunity, followed quickly by recognizing the error of their ways (or better yet, overreact to the upside) so we can quickly recognize a profit. However, there may be some benefits to our old friend Mr. Market being slow to recognize the error of his ways and taking a few years to correct it.
The above graph shows Microsoft stock from 1999 through 2013. Not exactly a chart to inspire the envy of other investors as it was essentially dead money for 14 years. However, from the start of 2014 through the end of the September 2021 (7.75 years), Microsoft compounded at over 32% per year. By having the time to accumulate a position and taking advantage of Microsoft’s capital allocation decisions during the “dead money” time period, the reward over the last nearly 8 years was immense.
Cautionary Note
One mistake is to think every stock works out like Microsoft. Obviously it doesn’t. What this means is that you need to do the work while you hold on to your companies (and remember, a share of stock is ownership in the company — so think of it as holding onto a piece of the company rather than merely a trading instrument). There is no way to KNOW what the future holds. Just ask John Bogle of Vanguard fame.
If “Nobody Knows Nothing”, how do we evaluate whether or not to stay invested? There is no single answer (did you not just listen to the video of Mr. Bogle telling you that?). However, there are some things you can do. These include
Stay up to date on the company, industry and their competitors. Yes, this is a lot of work as it means you need to read 10Qs, 10Ks, conference calls, etc. However, you can’t evaluate a company’s capital allocation decisions and management’s focus on investors without understanding the firm and it’s competitive environment.
Keep a journal. Why did you buy the stock? What were you expecting to happen and why? Is that happening or why is it not happening? One problem is that our minds often play tricks on us and we forget why we owned the company and what our expectation was. Note that if the thing you expected to happen did happen, it doesn’t mean you have to sell. That may have opened up a new opportunity. Apple reinvented itself with the iPod, then with the iPhone, then on the computer front. However, we can’t evaluate our decisions if we don’t remember what they were.
Does the valuation make sense? This is somewhat of a controversial one (I would argue that it shouldn’t be, but it is). The reason is because valuation is hard and it is fuzzy. However, there are things that just don’t make sense. If you think a stock should be trading for between $100 - $180 per share and it is trading for $400 per share, it is fine to sell. It doesn’t mean you are right and Mr. Market is wrong, just that you are unable to make a compelling argument that there is an opportunity for you.
Do you understand why you own the stock? I owned (for a brief time period) shares of Intel because the valuation appeared to be too cheap. However, I quickly realized that I don’t know enough about the semiconductor space and what creates competitive advantages/disadvantages to be able to make a compelling argument. I couldn’t meet the first criteria on this list, therefore I shouldn’t own the stock. So, I sold it. Mistakes are going to be made. Just correct them, rather than compound them.
If we want to take advantage of the market distinction between being a voting machine in the short-run vs. a weighing machine in the long-run, we need to exhibit patience, conviction, and vigilance. If we are not willing to wait for the long-run to arrive or lose our conviction by the short-run fluctuations, we will not be able to hold our position for the long-run benefits to kick in. However, we also must be vigilant and ensure that the reasons we established the positions are still valid. Companies are not unchanging monoliths, but instead are constantly evolving — for better and for worse. The reasons we liked the company two years ago may no longer be valid today.
This is where your author must admit that he has never fully read “The Intelligent Investor”, nor does he intend to.
This is somewhat debatable as there is some evidence that investors may fit a more loss averse framework where they are not trying to manage risk, but instead avoid losses. However, for practical purposes, risk aversion is the primary focus.
Note that a well-diversified portfolio does not just own stocks, but would own a mix of asset classes (stocks, bonds, precious metals, real estate, etc.). The weights of these asset classes will vary depending on your preferred risk level.
I say not costing me returns because if markets are efficient, then I shouldn’t be able to identify in advance stocks that are going to outperform OR underperform. If all securities are fairly valued, then I should neither be able to gain an edge by picking a mix of securities that I find attractive or do worse by picking a mix of securities that I find attractive.
Obviously the real numbers will vary as returns, raises, and savings rates are almost never constant. Think of this as just a hypothetical example.