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Do You Know Mr. Market?

By Timothy M. Otte - Updated Nov 14, 2016 at 10:22PM

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Sage advice for volatile markets, from the father of value investing.

News flash! The Dow is down 7% over the past 30 days. Foreign markets appear to be crashing. Debt-market liquidity is starting to resemble a dust storm in the Sahara. Just last Friday, the Federal Reserve cut the discount rate by half a point. Central banks worldwide have been shoveling extra reserves into financial markets in an attempt to head off a meltdown. And investor confidence is getting ... well, a lot less confident.

If you read the newspapers, it would be easy to conclude that the financial markets are headed for a massive black hole. But before we all collectively decide to head for the hills, I suggest some words of wisdom from Benjamin Graham, the father of value investing.

The unstable Mr. Market
One of Graham's famous market metaphors involved an obliging but somewhat unstable fellow named Mr. Market. He imagined that you and Mr. Market were business partners, and every day Mr. Market would offer you a price to either buy out his share of the business or sell your own share. On days when Mr. Market was in a particularly good mood, he might quote you a very high price. On other days, he could be in a highly pessimistic frame of mind and offer you a ridiculously low price.

The good thing about having Mr. Market as a partner is that he doesn't mind whether you accept his offer or not ... he will inevitably be back tomorrow with a new price. Graham suggested that intelligent investors should take advantage of Mr. Market's pocketbook, but not his wisdom.

The big mistake
Regardless of what mood he shows up with tomorrow, you have the choice to ignore him or take advantage of him. Your only real mistake is to fall under his influence. "The investor who permits himself to be stampeded," Graham warned, "is perversely transforming his basic advantage into a basic disadvantage."

Another illustration of this same principle is Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) chairman Warren Buffett's insistence that he would be happy if financial markets closed down, with no price quotes available, for years. Buffett has enough confidence in the value-creation ability of the companies he owns that he knows their value will grow over time -- regardless of Mr. Market's daily whims.

A few fundamentals
Sage advice from two of the most successful investors of all time. So how do we put this advice into practical use? In times of market volatility, I like to fall back on two fundamental principles:

1. Know the companies you are investing in intimately. You may think this is carrying it too far, but I invest only in retail companies. I've worked in retail my entire career, and I am reasonably confident that I understand how these companies should be valued (although I've made some notable errors on occasion).

2. Act decisively, but don't bet the farm. Investing, after all, is a marathon, not a sprint. Making a killing by jumping with both feet into a particular stock can make for good water-cooler stories, but it can also lead to disaster. Investors should seek to generate returns over the market average for an extended period of time. Waiting to buy at the absolute bottom may sound good, but it can be pretty difficult in practice. During unstable market conditions, averaging-in to stocks you like can be an effective strategy.

Three promising retailers
By this time, I'm sure you're saying, "Put your money where your mouth is, mister smarty pants." So here goes. Here are three companies I find particularly promising.

  • Wal-Mart (NYSE:WMT) is first on my list. No doubt you think I'm crazy. Same-store sales are soft, earnings growth is slowing, and a few months ago, the company announced that it's slowing Supercenter growth because (reading between the lines here) recent investment levels are not generating returns above the cost of capital. All of this is true. But at the current price of around $43 per share, the company is trading at a price-to-earnings ratio of 14 times trailing-12-month (TTM) earnings. Millions of people shop at Wal-Mart every day, and I don't see that trend changing any time soon. Wal-Mart will be a mainstay of the U.S. (and perhaps global) economy for many years to come. I think chances are good that fickle Mr. Market will offer me an attractive price on these shares at some point in the future.
  • Starbucks (NASDAQ:SBUX) is my second choice. Again you probably think I'm off my rocker. The stock is down one-third from its high at the end of last year, and the price is still more than 30 times TTM earnings. Smart money continues to describe SBUX as a toxic high-multiple stock. But consider my reasoning: I see SBUX as one of the most carefully cultivated and powerful consumer brands in the world; operating margins are more than 11% on every dollar of sales; and despite having built a dominating competitive position, the company has the opportunity to double its volume over the next five to seven years.
  • Kohl's (NYSE:KSS) rounds out my top three. This retailer is a blend of the best qualities of Wal-Mart and Starbucks. It has a great brand, with value pricing for apparel and home furnishings that people really want to buy, and it has superior growth prospects, with improvements in technology coming on line that have the potential to add significantly to operating margins. I can't envision a scenario where Kohl's is not a successful and more powerful player on the retail scene five years from now.

Retail may not be to your taste. Certainly, Mr. Market has not been kind to retail companies this year. Nor has the economy. But my point is that Mr. Market is in a lousy mood these days, and he may not get to feeling more optimistic for a while. You can fall under his influence, or you can make a decision to take advantage of his mood swings.

But don't get carried away. Greed is good, but consistency is better.

For more words of wisdom from Benjamin Graham, check out:

Berkshire Hathaway and Wal-Mart are Motley Fool Inside Value recommendations. Berkshire Hathaway and Starbucks are Motley Fool Stock Advisor selections. Try out either service free for 30 days.

Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles and owns shares of Wal-Mart, Starbucks, and Berkshire Hathaway. The Motley Fool has a strict disclosure policy.


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Stocks Mentioned

Wal-Mart Stores, Inc. Stock Quote
Wal-Mart Stores, Inc.
$132.22 (1.85%) $2.40
Starbucks Corporation Stock Quote
Starbucks Corporation
$88.31 (1.19%) $1.04
Kohl's Corporation Stock Quote
Kohl's Corporation
$33.18 (1.72%) $0.56
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$452,697.25 (1.66%) $7,395.26
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$301.55 (1.71%) $5.08

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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