Stock Market Lies

Stock Market Lies
By Richard Gibbons May 2, 2005

Value investors are independent thinkers. They don't need the crowd to validate their ideas, nor do they act contrarian simply for the sake of being different. While Sun Microsystems (Nasdaq: SUNW) and JDS Uniphase (Nasdaq: JDSU) were zooming up at the height of the tech bubble in the late 1990s, Warren Buffett was criticized as being out of touch with the realities of the new economy. Now that the bubble has popped, Buffett's company, Berkshire Hathaway, is close to all-time highs, while Sun and JDS Uniphase investors have been slaughtered.

Buffett wasn't avoiding technology just to be a contrarian. Berkshire's portfolio has piles of great businesses bought at reasonable prices, not just cheap businesses bought when nobody else wanted them. Companies like American Express (NYSE: AXP) and Moody's (NYSE: MCO) can hardly be considered cigar butts, but they've made Buffett wealthy nevertheless. Buffett's success can be attributed to well-reasoned purchases made within an investing framework based on value principles.

This approach sharply contrasts with most of the financial industry, which is why it is an interesting exercise to examine, from a value perspective, the disinformation that the financial industry pitches at investors every day.

"If you were out of the market for the best 30 days in the past decade, you would have lost money."
Mutual fund advisors often use this statistic to urge investors to stick with them for the long term, despite the fact that advisors themselves tend to be traders -- the typical managed mutual fund has an average turnover rate of 85%. But while being shocked and appalled at such hypocrisy is an entertaining hobby, it's also worthwhile to analyze the reasoning behind the claim.

The statistic is accurate: $10,000 invested in the S&P 500 a decade ago grew to almost $25,000 today (excluding dividends), while without the best 30 days, it would be worth only $7,700. But before making conclusions about market timing, consider the opposite statistic: If you were out of the market for the worst 30 days, you would have made $76,000. If the first statistic is saying that you should remain invested at all times, this statistic seems to be saying that trading to avoid bad days is critical. What gives?

Neither case is accurate. Rather, the statistic is used as propaganda to help fund companies pitch their funds and discourage investors from selling. There are many good reasons to be a long-term investor, including tax-free compounding, reduced expenses, and reduced risk. But this statistic is not a good reason.

What do these statistics mean to the individual investor? It's not clear, except that if you're a trader, some bad or good luck on a few select days could have very dramatic effects on your portfolio. But as a value investor, I think of some potential benefits of a margin of safety. By buying a stock at a discount to its intrinsic value, I'm likely to avoid the worst of the fallout on those worst 30 days, and my long-term performance should be superior.

"The trend is your friend."
This catchy one-liner reflects the momentum that stocks gather: Stocks going up tend to keep ascending, while stocks going down tend to keep falling. The logic driving the claim is a combination of psychology and faith. The psychology is that investors would prefer to buy a stock that's going up and therefore keep pushing it up. The faith is the belief that if something's going up, there must be some reason for it, so it will probably continue to do so.

This reasoning might work for day traders, but it is quite bizarre from a value perspective. First, if a stock is going up, then, all else being equal, it becomes less attractive to value investors because it is approaching -- or exceeding -- its intrinsic value. The upside is less and the downside is greater. Conversely, a stock going down becomes more attractive because both the margin of safety and potential return increase. Value investors love to buy goods when they're on sale. So the trend isn't a value investor's friend, but actually an enemy, like an evil maharaja, Jar Jar Binks, or a berserk koala.

The value investor's true friends are competitive advantages and a margin of safety. Competitive advantages ensure that the company will outperform others for a long time, while a margin of safety dramatically reduces the chance that the value investor will suffer significant losses.

"Run your profits, cut your losses."
This expression is the bedfellow of the "friendly trend" from above -- and with such a nickname, it has many bedfellows, including "buy high, sell higher" and "don't catch a falling knife." It means that if you're making money on an investment, don't sell quickly, but if you're losing money, then run for the hills. Frequently, it's implemented with some sort of stop-loss rule, such as "sell any stock that falls by 10%." The idea holds some appeal, since if you have the same number of winners and losers, but make more on the winners, then you will come out ahead.

However, this reasoning trips over the same stumbling block as momentum investing: It ignores valuation. If a stock has fallen 10% below your purchase price, that does not imply anything about the intrinsic value of the company. If the stock is down on negative news that decreases your estimate of intrinsic value, such as Merck (NYSE: MRK) after its Vioxx withdrawal, or Doral (NYSE: DRL) taking a hit to its balance sheet and changing its business model because of troubles with interest-only strips, then it makes sense to reevaluate the position.

But if the stock falls with no fundamental change, or falls further than is justified by the change in the intrinsic value, then a value investor would be more inclined to increase the position than decrease it. After all, the upside has become bigger and the downside smaller. The intrinsic value of Martha Stewart Living Omnimedia (NYSE: MSO) fell when Martha Stewart went to court, but the share price declined far more than the intrinsic value. Now that the homemaker's troubles seem to be behind her, shareholders who bought during the trial have tripled their investment.

"The market is always right."
Traders say this when the market is not doing what they expect it to do. It generally means that the trader believes his or her reasoning to be incorrect, since the market isn't acting as planned. Consequently, the traders should cut their losses. I love this expression because it's so pessimistic. It reminds me of Eeyore, blue-grey donkey and portfolio manager: "I was just kind of guessing where the stock was going anyway, and I was wrong. Oh, well."

Value investors think this expression is quaint. The market is right occasionally, but overall it tends to be pretty bipolar, with individual stocks priced both above and below intrinsic value. Really, if a stock is priced at less than the discounted value of its expected future returns, then the market is wrong. In such cases, value investors are able to make extraordinary profits both from long-term growth in the business and from the stock returning to intrinsic value. In fact, identifying such stocks is Motley Fool Inside Value's primary goal.

In conclusion
Many common investing expressions don't hold up when examined from a value perspective. However, this can be a great thing, as those who do believe in such maxims may push stocks away from intrinsic values, providing an opportunity for value investors to profit.