Readers of works on value investing have become acquainted with the mercurial Mr. Market. His presence everyday at the front door to offer or buy securities served as an allegory by Benjamin Graham to depict fear and greed. As Mr. Market arrives to set a daily price based on his mood, the investor decides whether to transact. Investors are taught that fundamentals should drive decision making rather than temperament. It was an important step in transitioning the practice of security analysis into data mining and out of rumor and innuendo.
One of the hallmarks of value investing is being a contrarian with a well-researched view that is different from the herd. Our friend Mr. Market is often seen as the herd as he is excitable. We believe this simplification can be the beginning of investing in value traps. Although we acknowledge the importance of the allegory, we believe it describes how the market transactsrather than how the market reasons.
When one buys an equity security the price is being set by the market as determined by the aggregate of all interested investor’s opinions. While Mr. Market may have difficulty valuing the market daily, he is more proficient at valuing an individual security. This is because the market is a sub-martingale and its expected price is higher tomorrow therefor the buyer of the market in a downturn will eventually be right and enjoy a profitable trade, the buyer of an individual security is engaged in an extremely different payoff expectation and is not guaranteed success.
We have been exposed to the reasoning of many value investors who buy a security and then utilize Mr. Market as the reasoning or even worse the investment thesis. In this case our allegorical character is not standing alone, he has an army of analysts armed with data behind him. The wisdom of crowds is a powerful concept and it is not as easy as depicting greed and fear, it is an aggregation of all market knowledge. There are rare times when this group is decidedly wrong, but it is having been described by Warren Buffett as “periodically” not consistently. Another take away from the Oracle of Omaha is that one does not have to transact at all with Mr. Market so even when a given equity has been repriced there is fundamental work to do.
One of the tenets of value investing is the concept of reversion to the mean. Investors looking to take advantage of Mr. Market are counting on either the behavior of the market or the fundamental characteristics of the company reverting to an equilibrium state. Let’s analyze these two factors:
Investors often look at the past multiples for a shorthand approach to valuation. This is common in the version of value investing known as Growth at a Reasonable Price. Price/Earnings ratios are not mean reverting although our observation of investors over 30 years leads us to pronounce that many investors believe so. Often the multiple is below the prior year’s multiple for reasons such as competition, substitute products coming to market or customer habits shifting. Cyclical companies will have a range of multiples through the cycle but will have the lowest multiple at peak earnings before the backside of the curve.
If the investment thesis is simply that the company’s multiple is below a previously observed number there is a reasonable chance that the outcome will not be one where Mr. Market is pessimistic but rather realistic.
There have been companies that have been undermanaged and have produced subpar results with languishing stock prices. Different leadership or game changing innovation can lead to a repricing of the stock (think Apple). Should we really blame our dear friend Mr. Market for being depressed? He is simply transacting today, he will be there to transact tomorrow if the facts change. It is not a depressive state that is leading him to sell at today’s price, his reasoning is clouded by today’s facts. Periodically there will be a company that will remake itself and change its profitability (Berkshire Hathaway in 1966) * but the reader should be reminded that the business that existed prior to Mr. Buffett’s arrival has been gone for quite some time.
The allegory of Mr. Market has been extremely useful in the description of stock market transactions however unless there is a name plaque with this given name on an investment committee, it is not part of an investment thesis.
*Mr. Market was not depressed upon offering Berkshire Hathaway stock for sale in the single digits, he was just lowballing the return on invested capital calculations. His analysis was that the company founded in 1839 was on its last legs because the assets were not producing sufficient return. Assets that walk on two feet are almost always measured in the rear-view mirror and come with notable risks such as buses, lucrative offers and retirement.