Value investing works if stock prices fluctuate around business value. Only then can stocks be bought at discounts to business value (or sold at premiums to business value).
Value investors believe that markets price stocks in ways that produce such gaps.
Graham’s metaphor described this behaviour as Mr. Market, viewing market action as the collective psychological behaviour of human beings prone to periods of excessive optimism and pessimism. The conception yields several insights for what value investing is.
FACTORS INFLUENCING MARKET PRICES
Numerous complex factors influence stock market prices. Graham identified two categories of factors:
- speculative and
- investment.
Speculative factors are the jungle of the marketplace and include
- technical aspects of market trading as well as
- manipulative and psychological ones.
Investment factors relate to valuation, principally assessments of financial data, including
- earnings and
- assets.
Factors sharing traits of both the marketplace and valuations, which Graham called future value factors, include
- managerial qualities,
- competitive circumstances, and
- a company’s outlook for sales and profits.
All of these factors are filtered through the lens of the investing public’s attitude, which produces trading decisions and bids and offers in the market. The output is market price.
The idea that anyone can predict the outcome of this process, or that it works in a way that yields prices just equal to value, is far-fetched. Value investing considers trying to measure market sentiment a waste of time. Value investing focuses primarily on business value, not market price.
Emphasizing businesses over prices enables value investor to know that owning stock means owning an interest in a going concern. That mental quality promotes the discipline necessary:
- to define a circle of competence,
- do financial analysis, and
- assess value-price relationships.
Pervasive market price data makes it harder for equity investors to appreciate that they are part owners of a business, making disciplined analysis elusive.
The only reason to consider market sentiment is because in times of general economic despair and market malaise, the odds of successful stock picking rise. Three factors contribute:
(1) There are more companies likely to be price below value,
(2) There are fewer investment competitors likely to wade into the thicket, and
(3) The media and regulatory pressure tend to promote quality management and conservative accounting.
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