Back To Basics

posted on November 7th, 2012 by Bellmont Research Team

The share market can at times be a bewildering place, yet in many ways we tend to make it much more complicated than it need be.  Unfortunately some very self-evident underlying truths tend to get overlooked in preference for complex and often tenuous relationships, and this can cause us to make some very foolish investment decisions.  Below are some of the more important facts to remember when investing in the share market: ignore them at your peril…

A means of exchange

The share market, as with any market, is there to provide buyers and sellers with a mechanism for exchange.  It has no intent, no sentience and reflects only the cumulative sentiments of its many participants.  Should the value of a share fall on a particular day, it is solely because those that participated in trade with one another agreed on a price that was lower than those investors that traded the day before.

Certainly, they may have had good reason to view the value of the shares differently, but they can never be said to have been right or wrong at that point in time; the trade was entered into voluntarily, at a price that was agreeable to both buyer and seller.  Of course, excluding the potential for different circumstances and priorities, they necessarily must have a different view of the future: the buyer must have considered the shares to have more value than their cash, and vice versa for the seller.

The future will surely validate the sentiments of one and, peculiar though it may seem, both may in fact be proved correct if their time frames are different.  But the point is that on any given day, the market price for a particular share is nothing but a reflection of the combined sentiments of many individual agents.

Don’t ever convince yourself that the quoted share price on any particular day is the outcome of an objective, considered and rational analysis of the underlying business and its investment return potential.

Short term movements are irrelevant

Whether your shares rise or fall on any given day should hold very little relevance to true investors.  There is even less relevance in the daily movement of the market indices (such as the ASX200), which may in fact bear little similarity to the structure of your portfolio.

The market price for a share matters only when you are considering buying or selling.  At all times in between, though it be infinitely easier to observe than to experience, the daily movement in price should be of little concern.  At least it should be if your reasons for buying the shares in the first place was to benefit from the commercial performance of the underlying business.

If however you have purchased the shares because you were of the view that other market participants will soon be prepared to offer you a higher price than what you yourself paid, then you are not investing.  You are speculating; which is merely a more sophisticated way of saying gambling.  When speculating, your strategy is based on what is called the ‘greater fool theory’; and history shows this to be an extremely unreliable strategy.

Nevertheless, if this be the case, kindly ignore all that has been said above.  The immediate trajectory of the market is everything, and may lady luck treat you with kindness.  Just be wary of any conviction that you can accurately and consistently anticipate the broader sentiment of millions of irrational and emotional people, operating in a chaotic and unpredictable world.  Confusing coincidence for prescience is easy to do in the market, but it is a dangerous trap well worth avoiding.

When price matters

Price of course matters very much for investors too, but mercifully only at those times when you are buying or selling.  For those that only commit funds that are not needed in the short term, this provides a great deal of comfort, and indeed a great advantage.

The decision to act on any given day is anything but mandatory, and it is because of this that patience is among an investor’s most important allies.  You may well desire to own a part of a successful business with sound prospects, but if the market is currently undergoing a bout of unbridled optimism, then its best to stay your hand and await a better opportunity.  There is a subtle but extremely important difference between a good businesses and a good investment.

Contrary to what many will tell you, a rising price is not in the interest of those that desire ownership.  If the underlying asset is sound, it is in your interest to see its value plummet, and the further the better!  Assuming, that is, that the fall in price is unrelated to any material change in the ongoing fortunes of the underlying business.

As an investor, it is only in your interest to see higher prices when you are looking to sell.  Yet despite this very obvious fact, many investors are encouraged to buy only after a period of strong price appreciation.  Similarly, many will be convinced to sell when prices fall for fear of experiencing further losses.  The net effect of such an approach is to buy when prices are high and to sell when prices are low.  This is not a sensible approach.

You cannot time the market

If share prices are determined through an auctioning process between a large group of irrational, emotional individuals, all acting in regard to their own unique circumstances, then to predict market prices requires a God like understanding of all the multitude of variables and connections that are at play.  Not only that, you must also have a level of prescience that allows you to know of future events/news before anyone else.

In short, consistently and accurately predicting share price movements is impossible.  (Anyone who suggests otherwise is either a fool or a fraud. After all, such prescience would be evidenced by substantial wealth; a feature noticeably absent for those that tend to make these claims.)

Yet accurately timing the market is of little importance for successful long term investors.  All that matters is that the business that underpins your shares continues to perform well and grow its earnings over time.  So long as you acquire the shares at a reasonable price, you will always do well in this situation, regardless of whether or not you picked the absolute bottom.

Consider buying Monodelphous (MND) shares 3 years ago at $10.  You would have missed the low of that year by a substantial margin, with the price at one point touching $5.25.  As disappointing as the short term ‘paper’ loss may have been, few people would regret the investment today: their shares would have more than doubled in value, and they would have received a 37% return in the form of dividends.  Not a bad return considering the poor timing of the purchase.

Summary

Being a successful investor is about acquiring ownership in quality businesses at sensible prices.  Success is driven by the performance of the underlying entity and has virtually nothing to do with correctly anticipating short term fluctuations in price.

To quote the great investor Warren Buffett: “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value. Though it’s seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders.”

 

Andrew Page – Team Invest



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