Wednesday, April 8, 2015

Business Success is not the same as Investor Success

My recent post about stock-picking drew a thoughtful anonymous comment explaining the reader’s trouble with indexing. Here is the (lightly edited) comment:
“Indexing is counter-intuitive. Doesn't it seem reasonable that if you bought the companies in the S&P 500, then sold off high flying market darlings and poorly-managed businesses, and used the proceeds to double up on the best run companies that you would beat the market? The evidence is no; professional managers who spend 40+ hours a week doing just this cannot consistently beat the index. What gives?”
Let’s start with the high-flying stocks. Nothing is flying as high as Apple right now. I have no idea if Apple is currently a good buy, but no doubt some people think it’s destined to drop. Let’s go back to 2000 when Apple was also on good run. Anyone who excluded Apple from their portfolio then would have missed out on a 25 times increase in its stock price. The truth is we can’t be sure if a high flyer will fly higher or crash.

As for the businesses that aren’t doing well, their stock prices are usually low as a result. Even a terrible business may be a good investment if the market is too pessimistic about the stock. In fact, value investors seek out stocks where other investors have driven its price too low.

Stock-pickers need to consider more than a company’s business prospects. They need to consider the current price. A business’s success or failure does not necessarily reflect how investors will fare. What matters are the business’s prospects compared to its current price. It is this type of analysis that is very difficult to do better than investment professionals.

It’s always possible to look into the past and see which stocks you wish you hadn’t owned. But when we look at today’s stocks without the benefit of hindsight, it’s far from obvious which stocks will be the stinkers.

10 comments:

  1. So you are saying that a company that never had a profit (NT) over a 6 year stock price run up (NT) didn't deserve to have it's stock price (NT) go up that high? Stock price isn't based on business success (NT) ? Hmm.... I'll have to think about that.

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    1. @Alan: We can see things like this in hindsight, but not in advance.

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  2. The fundamental issue, and what the poster is really indirectly asking about, is the efficient market hypothesis. In theory, since all information about a public company is known, its price SHOULD be exactly what it is worth (since the market is efficient, and all known information is considered in the price). The reality is that this fundamentally does not even come close to working. Even if market participants receive the same info, they may judge its impact on price differently for many reasons. Therefore, as you are saying, the price of a stock does NOT reflect the business fundamentals, but rather how a preponderance of people JUDGE the business. Which can be wrong for more reasons than I could count.

    Think of a piece of historic art, or a classic car. What is it worth? There is no right answer. It's worth what people are willing to pay for it based on its attributes. Preference for those attributes can change over time. A stock, sadly, is no different.

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    1. @Anonymous: Yes. I can guarantee that some stock prices are very wrong. But I don't know which ones. Even if I study some businesses very carefully, my guesses about which ones are over-valued and which are under-valued are very likely to be wrong. So, I own the index and spend my time on more interesting pursuits.

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    2. Agree. Moreover, I would even argue that the concept of stock price being "wrong" is impractical, because it assumes that there is "right" price. "Right" relative to what? I would argue that after hundreds of years, there is no consensus on how things ought to be valued. Is it P/E? P/S? P/B? Something based on yield? Beats me.

      Again, think of the art or classic car. What is the "right" price for a classic Mustang? There isn't one, because everyone's definition is different. There may at best be a "range". Likewise, it's impossible for there to be a "right" stock price.

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  3. Wondering if anyone owns shares of Berkshire, or more precisely, why would anyone own any stock but Berkshire? Their business is investing, and there's been no more successful investor than Buffett. Sure there's hindsight, but maybe after 20 or 30 years of BRK trouncing the indexes, a retail investor might take notice of that success.

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    1. @SST: Buffett says himself that his days of trouncing the index are over because Berkshire is too big. If I could go back in time and invest in Berkshire, I'd do it.

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  4. Munger says the same regarding declining advantage. In their first 25 years, BRK returned 20% per year more than the S&P; that's down to 4.5% for the last 25 year period. There are lots of reasons for the spread but even forward looking, if Berkshire managed to beat the market by only 2%/yr for the next 25 years...well, we know from mutual fund fees how big a difference those little amounts add up to.

    I would consider BRK more of an index unto itself (and pseudo hedge fund) rather than a vanilla public stock. Who knows if Buffett's successor can carry the torch, but I'm willing to bet the Buffett investment and business values are deeply entrenched within the Berkshire company, enough to ensure future success on both fronts.

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  5. Actually, over the last 10 years BRK has only marginally outperformed the S&P and underperformed over the last 5 years. One could argue that BRK is really a large value fund, and BRK has underperformed a large value index fund over the last 15 years

    http://seekingalpha.com/article/1945621-why-bother-diversifying-just-buy-berkshire-hathaway

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    1. @Grant: That's interesting. I've decided to sell off my Berkshire. My wife still has a small amount that we're holding because of a large unrealized capital gain.

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