Here's How to Think About the Stock Market Right Now

Imagine that flat-screen TVs go on sale for 50% off on Black Friday. But instead of causing people to stampede over each other to claim one for themselves, they panic and run in the opposite direction.

"Buying a flat screen TV for such a big discount terrifies me," says a 27-year-old man while jogging anxiously toward his leased BMW 3 series.

"I'll buy one next year once they're back to full price," say a mother and father as they load their children into their heavily financed 2016 Honda Odyssey, Touring Elite edition.

But as the parking lot empties, a handful of folks start showing up. They arrive in fully owned, but not fully loaded, Honda Civics and Toyota Camrys -- boring cars that last a long time and are cheap to maintain. They saunter into the store and buy TVs for half of what they would otherwise have to pay.

"Those people have no taste in cars," thinks the guy in his leased BMW 3 series. "They clearly have no idea when to buy TVs," say the parents as they pull Coca-Colas out of their refrigerated console.

Fortunately, the madness ends the following year. Flat-screen TV prices haven't only recovered; they're higher than they were the year before. The guy driving the BMW buys one, as do the parents in their Honda Odyssey.

It strikes them when they get home that purchasing a TV the previous year for 50% off may not have been a bad idea. But, then again, the holiday season is no time for buyer's remorse.

This seems absurd, but it's exactly what happens when the stock market drops, as it has since the end of last year. When stock prices were high, people bought them without abandon. But now that many stocks are patently cheap, your average investor won't touch them with a 10-foot pole.

Shares of incredible companies are trading for very attractive valuations right now. Coca-Cola (KO 1.50%) is yielding above 3%. Shares of Wells Fargo (WFC -0.56%) have dropped by a fifth since the middle of last year. And IBM (IBM 1.05%) is yielding more than 4%.

And you don't have to take my word for it that stocks like these are not only cheap but also prudent investments. All three of them are among the biggest positions at Berkshire Hathaway (BRK.A -0.28%) (BRK.B -0.68%), the Warren Buffett-led conglomerate that's returned a total of 1.8 million percent as of its 2014 annual report.

Source: CNBC's Berkshire Hathaway Portfolio Tracker.

In IBM's case, in particular, shareholders can buy shares today for meaningfully less than Berkshire Hathaway did five years ago. When Buffett started buying shares of IBM in the second quarter of 2011, they traded at an average price of $167. Today, they're down to $125.

But just like the big-screen-TV example, Buffett doesn't view this as a negative. Here's how he explained it in his 2011 letter to shareholders of Berkshire Hathaway:

[W]hat happens to [IBM's] earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years.

Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

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The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

This logic has been borne out time and again over the past 50 years. It's the central theme of William Thorndike's invaluable book The Outsiders, which traces the strategies of the best-performing CEOs since World War II. "What separates these CEOs from the rest is that they're iconoclasts; they don't follow the conventional path," Thorndike told me last month.

All but one of the CEOs Thorndike studied used stock buybacks aggressively, to supercharge their returns. Henry Singleton, the "Babe Ruth of buybacks," repurchased 90% of his company Teledyne's shares at an average price-to earnings multiple of 8. The net result: $1 invested in Teledyne's stock when Singleton founded it in 1963 was worth $181 by the time he stepped down as chairman 27 years later.

This same logic holds true today for companies like Coca-Cola and Wells Fargo. Through the first nine months of last year, Coca-Cola had repurchased just under $2 billion worth of its outstanding common stock. Wells Fargo, meanwhile, bought back $8.5 billion worth of its shares last year. For long-term investors in any of these companies, in turn, lower stock prices in the short-term are almost invariably good.