Long-Term Investors: Pretend The Stock Market Shut Down For Five Years

Includes: BRK.B, CL, CVX, IBM, JNJ, KO, PG, XOM
by: Tim McAleenan Jr.

One of my favorite Warren Buffett quotes comes from an early 2000s letter to the shareholders when said that, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” While that’s not a quote most people would take literally, I do think Buffett captures a mentality that is far too often lacking in most investors today.

Forty to fifty years ago, the only way most people got stock quotes was when they checked the morning paper. I remember hearing a family story about how my great aunt would only look at her quarterly statement, check that everything seemed to be "all right," and then went about her life’s business while the money compounded. The environment that exists around us largely makes that an impossibility on today’s culture — if you go to the Wall Street Journal website, any business channel on television, or the website for any brokerage, you got bombarded with up-to-the-minute quotes that can tell you information you’re supposed to act upon — Oh no, Johnson & Johnson (NYSE:JNJ) is down 2%, or Coca-Cola (NYSE:KO) is up 3% pre-market trading, Berkshire Hathaway (NYSE:BRK.B) bought part of IBM (NYSE:IBM) — buy, buy, buy! You get the idea.

If the purpose of long-term investing boils down to identifying great companies with strong competitive advantages that churn out ever-growing amounts of profits that are trading at reasonable prices, then the day-to-day background clutter can easily distract us from that reality.

Let’s say you bought a $150,000 house in cash in a local neighborhood that you managed to rent out to a tenant. You charge $1,000 per month for rent. You receive $12,000 annually to deploy as you wish — you can fund further investments, use the money to meet income expenses, have some fun in Las Vegas, whatever. If you knew that $1,000 was coming in every month, what would you do if someone said that house is only worth $75,000 and that’s all he’d pay you for it? You’d probably laugh, mention that you have no interest in selling at that price, and go back to counting that monthly income.

But a lot of times, that mentality doesn’t extend to the stocks we have, which much like the rental home, represent a claim on ownership. Who cares if the price falls — if the company is growing profits and dividends, why should you let the irrationality of others panic you into taking a loss?

I’m not trying to say that we should completely ignore stock price fluctuations. If you own shares of Proctor & Gamble (NYSE:PG) and the per share price rises to $150 tomorrow due to the irrational exuberance of the market, by all means, you should take advantage of that share price overshoot and take in a hefty profit. But like Benjamin Graham said, “The market is there to serve you, not instruct you.” Let’s say that you own 1,000 shares of Colgate-Palmolive, which gives you over $2,000 in annual dividends from the company. If the price of the stock falls to $40, why should you care at all as long as you knew the business was safe — people were still brushing their teeth with Colgate toothpaste and washing their dishes with Palmolive dish soap — and the dividends were still coming in like clockwork? If anything, you should use the stock market decline to load up on more shares of Colgate, since each share you buy would entitle you to double the profits before the price fell.

The point of the Buffett quote about closing the stock market for five years is this — we should research and put forward the same amount of due diligence when researching a stock that we would do if we were buying a local rental property, storage unit, pizza den, or car wash. If you buy shares of Exxon-Mobil at $75 because you’re convinced they’re undervalued, then what Mr. Market does from there (in the way of stock price declines) shouldn’t spook you in the slightest unless there is an actual impairment to the earnings power of the company. Some of the numbers out there on average investor returns are scary — from 1982 to 2000, the stock market on average posted returns well into the double digits annually, yet the average investor pocketed returns between 3-4% due to poor trading decisions — that’s nuts! If you mentally told yourself, “Chevron at $85 per share is a good price. Once I buy 250 shares, which represents a proportional claim on all future earnings of the company, I will hold this stock for at least five years unless the stock price far exceeds my estimate of intrinsic value or some new development comes along that makes me question the long-term earnings power or dividend growth I originally projected”, then you will become a much better investor that is isolated from the fear of the market. One of the greatest enemies that the investor must constantly guard against is himself, and it would be wise to put into place mental rules and safeguards that would deter making snappy judgments that could cripple long-term returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.