Former Columbia professor Benjamin Graham once said, “Price is what you pay; value is what you get.” Many investors agree with this statement – though only outside the investment arena. Few of us would refuse to buy an item in a department store just because it is on sale, yet many do just that when it comes to the stock market. The fear associated with buying a depressed stock, obviously, is that the price decline signifies a fundamental problem. Yet even if the decline has been caused by a decline in intrinsic value, the question is whether the price has declined more than the value erosion warrants. Disciplined investors try to estimate the intrinsic value of companies within their circle of competence and buy them when the price drops far below estimated value.
The Parable of Mr. Market
Graham’s 1949 classic The Intelligent Investor describes something akin to a free option contract available to every investor: At any time, you can choose to buy or sell a share of a business in the market at the prevailing bid price. If you believe the price is sufficiently below or above intrinsic value, you may exercise your option to buy or sell (short) the stock. Writes Graham,
“Imagine that you own a small share of a private company that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”
If you are a prudent investor or a sensible businessman, you may be happy to sell out to Mr. Market when he quotes you a high price for your $1,000 interest in the business, and equally happy to buy from him when his price is low. But the rest of the time it may be wiser to form your own ideas of the value of your holdings, based on independent research and analysis.
Contrary to what is taught in most finance curricula, “Mr. Market,” at least in the short term, is not an infallible appraiser of businesses (a “weighing machine”) but rather the sum product of the opinions of a herd-like group of investors susceptible to subjective influences and cognitive biases (a “voting machine”).
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