I've learned a lot as an investor over the past few years. When I first started buying equity in companies, I thought of the stock market as a pretty exciting place. You've got all these whiz-bang charts that reinforce the idea that the stock market is some kind of crazy casino where stocks go up and down for seemingly no reason at all. Place your bets, gentlemen!
It's the fact that stocks do go up and down for seemingly no reason that a lot of people are scared to invest in stocks. In his seminal work, The Intelligent Investor, the great investor and teacher to Warren Buffett, Benjamin Graham, personified the stock market as "Mr. Market". He attempted to rationalize the gyrations by explaining that the stock market was like a moody, bi-polar salesman. And every day he comes to your doorstep ready to buy and sell stocks. Sometimes he's in a particularly pessimistic mood, and on days like this he is usually willing to let stocks go cheaply because he's worried about all of the problems in the world. Other days, he's feeling particularly upbeat and the stocks he's selling are priced at a premium. These prices aren't necessarily connected to the underlying performance of the businesses the stocks represent, and can quite often instead be related to psychological effects that are impossible to quantify.
But I don't submit to Mr. Market's moodiness. And you don't have to either.
When buying or selling stocks you should always separate company performance from stock performance. When you're analyzing the fundamental quantitative aspects of a company you're dealing with hard numbers. It's impossible to let psychology dictate company performance because the numbers are right there in front of you. A revenue growth rate is X. EPS has grown over the last decade by Y. You can value a company based on absolute performance quite easily in this manner.
However, problems arise for some investors when they see that Mr. Market disagrees with the valuation they slap on a company. And sometimes Mr. Market disagrees quite strongly.
This has happened to me many times. Over the last few years I've invested in companies based on strong fundamental performance, and then shortly thereafter, Mr. Market becomes particularly cynical on these companies. It's easy to ask what I may have done wrong. How can I possibly be right, and Mr. Market in all his genius be wrong?
Well, the market is compulsively consumed by emotion. Meanwhile, companies, for the most part, are not. Companies sell products and/or services. They manufacture things that people want and/or need. They produce and grow. And it's in this production that company performance can quite easily be separated from stock performance. If a company's top line and bottom line is growing at substantial rates, and investors are getting paid a larger piece of the profit pie year in and year out, yet Mr. Market doesn't like the stock, does that mean he's right?
For instance, I purchased shares in Digital Realty Trust, Inc. (NYSE:DLR) back on 6/3/13 for $59.34 per share. I analyzed the company and felt the value was there. When I analyzed the company I found that since going public in 2004, the REIT managed compound FFO growth of 18.7%, and compound dividend growth of 15.7% since 2005. Growth was slowing, but even assuming growth would be halved I still felt this was a pretty solid investment.
Well, Mr. Market didn't agree. Due to a lot of noise regarding accounting practices and potential increased competition, Mr. Market decided that shares in this REIT were worth significantly less shortly after I made my investment. Was this attitude due to actual fundamental problems with the company? No. Mr. Market was instead concerned about things that hadn't really materialized. And as such the market cap on this stock fell by ~27% by the end of the year, bottoming out at $43.04 in late December 2013. Oh, Mr. Market, you can be a moody one!
But what can I do? Mr. Market says my stock is worth less. So it must be worth less? Maybe I should just sell and move on. I obviously made a mistake, right? Wrong. I bought more.
After looking at the company again on multiple occasions and not seeing anything fundamentally problematic I decided to average down on my position and buy as Mr. Market's pessimism reached a feverish peak. I added to my position in DLR on 8/1/13 at $54.75 per share. And then I finally completed my purchasing of shares in this REIT on 10/31/13 at $46.74 per share.
But Mr. Market was pessimistic on this stock, so it must be priced even lower now? Mr. Market is never wrong, right? Well, as of today shares in DLR are priced at $53.48. And after all that noise Mr. Market was concerned about, what actually materialized over the last six months?
Digital Realty released third quarter results on 10/29/13 which showed a $1.10 in diluted FFO, a slight decline from the $1.13 they were able to generate in 3Q2012. This report also included a 4% reduction in FFO guidance, with a revised 2013 FFO per share outlook of $4.60-$4.62 vs. $4.73-$4.82 previously. So Mr. Market deemed a ~4% guidance revision worth a ~27% reduction in market cap. Emotional much?
DLR also recently increased its quarterly per share dividend by 6.4% just earlier this month. For a company that is in a lot of trouble, things seem to be humming along pretty well. Oh wait, I forgot that company performance is completely separate from stock performance.
If I would have let Mr. Market's pessimism affect my decision making process I would have sold DLR for a loss and also missed out on a 6.4% raise in my income coming from this position. I would have also let DLR shares go cheap, because when they bottomed out shares were going for about 10x FFO.
When buying or selling stocks it's imperative you don't let stock performance cloud your vision of company performance. What I might recommend you do is when you're analyzing a company, ignore the current stock price completely. I know that might be difficult to do in this age of social media and information overload. However, if you're able to think independently and value a company regardless of what Mr. Market says it's worth, you'll do well over the long haul.
I wrote an article a little while back expounding on how I analyze and value stocks. And it was only after reasonably valuing a company did I write about comparing your result to Mr. Market's. This is so that you can buy below what you deem to be fair value to increase your potential margin of safety. If you value a company at $60, and Mr. Market is selling for $50, then I'd say you're in a pretty good position assuming the qualitative aspects of the company look good.
Don't let the market's psychology overwhelm you. Insist on quality, pay close attention to the fundamentals, and stick to your guns. Use Mr. Market to your advantage; when his emotions get the best of him and he decides to offload stocks at discount prices look at that as an opportunity to buy what you were already interested in at even cheaper prices.
Stop thinking of the stock market as a casino. Instead think of it as a store selling merchandise. Because that's pretty much what it is. In this case, the merchandise is stocks. And just like any other store, some of this merchandise will be overpriced, while some of it will be priced at levels cheaper than intrinsic value. The key is to focus on the latter, while also focusing on the merchandise itself instead of the price. When Mr. Market decides to put high quality companies in the clearance section it's time to sharpen your pencil and take a fresh look at the company's prospects. If everything still looks good then you may have an opportunity before you whether Mr. Market realizes it or not.
I currently manage a portfolio with 44 different equity investments. That's 44 companies I have to keep up with. But I don't let stock prices tell me how these companies are doing. I let the companies themselves tell me how they're doing by way of monitoring annual reports, earnings reports, press releases, and other investor communications. I routinely scan for dividend increases because that tells me the company has the cash necessary to pay shareholders a rising stream of cash, and management is confident about future prospects. Relying on stock prices to make buy/sell decisions would be akin to letting the tail wag the dog.
So stay true to yourself and your analysis. Don't let Mr. Market bully you with his overwhelming emotions. Stick to quality, and focus on the quantitative fundamentals and qualitative aspects of a company. After all, a stock's fair value is based on company performance, not stock performance.
Disclosure: Long DLR