The Little-Known Secret of the Stock Market

Earlier this week I watched Jon Stewart interview CNN's Ali Velshi on The Daily Show and was a little surprised at something Velshi said. When explaining why the market was behaving like some out-of-control Six Flags roller coaster, Velshi said that "the stock market has become a barometer of how investors around the world feel." Stewart responded by suggesting that it's like an investor mood ring, and everyone had a good chuckle.

Velshi is a sharp guy and is CNN's chief business correspondent. And of course he's absolutely right about the stock market being a barometer for how investors feel. But I'm going to quibble with one small part of what he said, and that's that it "has become a barometer."

In fact, this is nothing new at all. In his classic Security Analysis -- which was first published in 1934 -- Ben Graham wrote:

The prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers.

Or we can look to Warren Buffett, who, in a 1987 letter to Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) shareholders, quoted a similar Graham view:

As Ben said: "In the short run, the market is a voting machine but in the long run it is a weighing machine."

It's easy to lament the turbulent times that we live in and assume that things were different in "the good old days," but in this case, as in so many others, the simple ways of those times passed never really existed. Mr. Market has always been pretty nutty and investors have always allowed themselves to be pushed around by a wide array of cognitive biases.

Investors beware
Going back to Velshi, he nailed it when he told Stewart that "the stock market is a collection of the value of the underlying companies, and that's what the judgment should be." He added that the value of those underlying companies didn't change nearly as much as the stock market was suggesting last week. The latter point is something it doesn’t take a Ph.D. in finance to figure out, and yet it's something that seems so painfully overlooked sometimes.

Check out a few of the big movers last week.

Company

Price Change Aug. 5 to Aug. 8

Price Change Aug. 8 to Aug. 9

Price Change Aug. 9 to Aug.10

Price Change Aug. 10 to Aug. 11

Berkshire Hathaway (BRK-A) (5.9%) 8.0% (6.1%) 4.5%
Schlumberger (NYSE: SLB  ) (8.9%) 5.4% (4.9%) 5.0%
Citigroup (NYSE: C  ) (16.4%) 13.8% (10.5%) 6.3%

Source: Capital IQ, a Standard & Poor's company.

These aren't little dinghies that can be pushed around by a light wind -- these are massive companies. For a nearly $180 billion company like Berkshire Hathaway, the 8% change that it saw last Tuesday means a difference of $14.2 billion. Sure, you could argue that Berkshire owns a hefty stock portfolio that was probably getting pushed around, but we'd then want to take that a step further and ask how much the underlying value of major holdings like Coca-Cola, American Express, and Procter & Gamble (NYSE: PG  ) were really changing in the course of one day.

Similarly, Schlumberger and Citi had some economic sands shifting under their feet, but the size and the whipsawing of those stock movements makes no sense when you start thinking in terms of the true, underlying value of the company -- not just the trading price of the paper stock.

The real smartest guys in the room
In the fall 1984 edition of the Columbia Business School magazine Hermes, Warren Buffett wrote a piece called "The Superinvestors of Graham-and-Doddsville." In it, he presented a list of long-term investment records that included his own investment partnership, Bill Ruane's Sequoia Fund, Walter Schloss' investment partnership, and Tweedy, Browne. These investors all topped the results of the broader market and did it by focusing on the underlying value of the businesses they were investing in and only buying when the wild swings of the market offered up a price that was a discount to that underlying value.

Here's a simple illustration of what we're talking about here.

The above is an actual stock chart with a trend line added. The idea is that, over time, this company has built its business and grown, and the underlying value of the business has increased. All the while, the stock market has been doing its own thing -- at times accurately recognizing what the business is worth, but often getting overly pessimistic or wildly excited and pricing the stock too high or too low.

In practice, it's not quite as easy as that, because the underlying value of a company rarely moves in a perfectly straight line. But the idea is the same -- that there is a true value for the company that usually changes slowly over time and is not necessarily reflected by the stock price.

Though the market's volatility has settled down since last week's craziness, that doesn't mean that investors are suddenly focusing on underlying value or that stocks are now priced properly. Investor pessimism and a current distaste for large-cap companies means that there are more quality companies trading at single-digit price-to-earnings multiples than we've seen in a long time. Microsoft (Nasdaq: MSFT  ) and its forward P/E of 8.6 is one of my current favorites, but there are plenty of others that jump out as potential price-is-less-than-value opportunities, including Travelers Companies (NYSE: TRV  ) and Kohl's, with respective P/E's of 8.3 and 9.5.

Want even more ideas? My fellow Foolish analysts have compiled a free report -- "13 High-Yielding Stocks to Buy Today" -- which details some of their favorite dividend-paying stocks.

The Motley Fool owns shares of Coca-Cola, Microsoft, Berkshire Hathaway, Citigroup, and Schlumberger. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Microsoft, Berkshire Hathaway, and Procter & Gamble. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Microsoft and Berkshire Hathaway, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool’s disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (12) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 19, 2011, at 5:56 PM, doctorfool1 wrote:

    Excellent article. This is something i have recognized for about a decade now thanks to my own experience with the stock markets. Investor sentiment is what matters to traders, company fundamentals are what matter to investors. The latter group can take advantage of sentiment and advisors' recommendations from time to time, but to truly achieve stable growth the fundamentals are key. The stock market is not risky for investors. It's risky for those who try to be traders. Thanks to the advice of TMF and Warren Buffett small time investors like myself can make sense out of the nonsense that sometimes prevails. Invest in good companies- that should be a no brainer. Money will be made. The discipline to not give in to wild fluctuations is the hard part. Thanks Matt. Fool on!!

  • Report this Comment On August 19, 2011, at 11:18 PM, kitcotalltom wrote:

    Yeah...I read the article. Sounds interesting. But there is something that this author did not address...Doesn't that Stock Chart appear as a classic Double Top? My bet is that the chart IS the DJIA. Time to short it?

  • Report this Comment On August 20, 2011, at 1:12 AM, TMFKopp wrote:

    @kitcotalltom

    That's really what you came away from this article with?

    And it's not the DJIA.

    Matt

  • Report this Comment On August 20, 2011, at 12:40 PM, ET69 wrote:

    Its true, I have had to learn how to buy on dips and sell offs. Its patience and discipline. Sort of like the old kenny Rogers song - you gotta know when to hold'em and know when to fold'em.

  • Report this Comment On August 20, 2011, at 1:17 PM, DavesHere wrote:

    A lot of the volatility in the markets would be muted if investors understood one very simple principle which I have never seen or heard a great investor express, but which is implicit in all their writings and conduct. All accept, as a starting point, the assumption that the markets will be here long after we are not, possibly in some form which we would not recognize, since change is to be expected, but that there will be markets. If there is a line that separates the amateur investor from the professional, this is it.

    To operate as though the markets might be destroyed wholesale and take all capital with them, the fear underlying the most extreme dips, is nonsense. Not that it could not happen, but the logical end of such an event would be that the money we rescue on the way out will have no value because, in order for the markets to go to zero, the entire economic system will have first to collapse.

    To put it in a familiar, biblical context, six thousand years ago, if you had lived half way up Mr. Ararat, you would have been a fool (small "f") to reduce your capital by the cost of flood insurance because the only event that could have allowed you to collect would have prevented your insurer from paying off.

    So it is with the markets. Professional investors address risks they can meet with some effect, including supply disruptions, demand disruptions, irrational swings in sentiment, etc. and ignore the one risk against which their best efforts would be fruitless. Removing this major distraction makes it far easier to navigate all other risks.

  • Report this Comment On August 20, 2011, at 1:24 PM, akaluna wrote:

    Graet article! Good work.

  • Report this Comment On August 20, 2011, at 2:04 PM, jokesonu wrote:

    Great article. Control your emotions, do your home work and cooler heads will prevail.

  • Report this Comment On August 21, 2011, at 10:10 AM, dctodd27 wrote:

    Isn't it funny that the author talks about the Graham-and-Dodd approach to investing, and then justifies his stock picks with "forward" p-e ratios...Ben Graham proposed using 7-10 years of average historical earnings in common stock analysis to take into account a company's profitability over the entire business cycle. Anytime I hear somebody justify their analytical conclusions with forward p-e ratios, I know for sure they don't know what they are talking about.

  • Report this Comment On August 22, 2011, at 3:51 AM, isacsimon wrote:

    Great article! Very informative. Thanks Matt!

    -Isac

  • Report this Comment On August 22, 2011, at 12:02 PM, TMFKopp wrote:

    @dctodd27

    Thanks for the thoughtful comment. All three companies mentioned have 10-year P/Es below the broad market's average.

    Forward P/Es may not be perfect, but when used as a quick measuring stick against that company's past valuations or the entire market's valuation, it can often point to value.

    Matt

  • Report this Comment On August 22, 2011, at 1:21 PM, dctodd27 wrote:

    @TMFKopp

    Wasn't expecting a response - thanks for taking the time.

    A forward PE might be a quick calculation but if used in the wrong way it can be dangerous. Forgetting for a moment the fact that analysts' estimates of future earnings are notoriously bad, comparing current *forward* PEs to past *trailing* PEs is comparing apples to oranges. A more useful analysis would be to see what the historical forward PE numbers of MSFT, TRV and KSS look like relative to where we are right now.

    Taking into account a full market cycle's worth of actual results seems to make more sense. Like Buffett said, "Wait for the fat pitch." When average historical PEs are low relative to their own historical ranges (rather than when they are simply below that of the broad market), those are the times to find names that are truly undervalued and to load up on.

    Just my two cents.

  • Report this Comment On August 22, 2011, at 1:51 PM, StartEarly wrote:

    Great article.

    I'm surprised there's no mention of the Buffett-ism of being greedy when others are fearful.

    If the stock mark is really a poll on investor outlook, and if (big if) you assume that that outlook oscillates around a mean which approximates true value, then simple logic dictates that the more negative the community is feeling, the better the value you are getting by purchasing.

    The "big if" can be supported by the statistics of group polling. This demonstrates that, although individuals may have very poor accuracy in assessing a value (for example, the number of golf balls that can fill a car), if you poll enough people the average is usually significantly more accurate [I would need to search for a reference here].

    The same can be applied to the markets: nobody really knows true value, but poll enough people over enough time (to cancel out the short-term mood swings) and the average is probably pretty close.

    Ergo, the more pessimistic the market is in the short term, the more discounted the price is from true value, and the better deal you get by purchasing. Vice versa, the more optimistic the market is in the short term, the more inflated the price is and the worse the deal you get by buying.

    Be greedy when others are fearful, and fearful when others are greedy.

    **disclaimer: Of course, this all assumes you are a true Buffett buy-and-hold investor. Otherwise you're timing the market, and you get hosed (on average). I'll reference "Random Walk Down Wall Street" for that one!

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