If you consider yourself an investor then no doubt you’ve heard the story of ‘Mr Market’ – the emotionally unstable, totally illogical neighbour that comes to your house and offers to buy your shares or sell you new ones at a different price every day. Some days, he offers a high price and other days he offers a low one. You never really know what he’s going to offer or why; the only thing you do know is that he’ll be back tomorrow.
If you take a share or security as a little piece of a company, then its true value is directly correlated to the amount of cash that company can return to its shareholders, either through dividends or through capital appreciation. Without new information about the companies behind the securities or the markets they’re trading in, there is no rational reason why Mr Market should offer a different price one day to the next – nor any reason why you should feel compelled to accept it.
Those fluctuating prices are known as ‘market volatility’. The more the prices fluctuate, the more ‘volatile’ the market is. And you know what? That volatility is actually your friend. Let’s say that you value a share of a company at £5 per share, taking into account its profitability, turnover and strong balance sheet. One day, Mr Market knocks on your door and offers you shares at just £2.50 each. Everything about the company is exactly the same, but now you get to buy it at a 50% discount!
That discount to fair value is what pretty much guarantees you making a future profit. You don’t know what tomorrow brings; the economy might enter a depression, the company might be guilty of accounting fraud, or a major competitor might release some amazing new product that steals half your customers.
BUT if nothing about that company has changed, then right now, that company is trading at an enormous discount to fair value, and eventually the market is going to realise that and you’ll be sitting on a healthy profit when Mr Market returns and offers you £5 or more for each of your shares.
Common sense tells us that a company that has invested prudently in good staff, developed a strong competitive advantage, sells compelling products and which manages its balance sheet effectively will likely continue to do so in the long-run. This is unlikely to be the case for ever (just take a look at General Electric to see that), but it is likely to be the case for the immediate future.
If we take this to be true, then an enormous part of successful investing simply comes down to carrying out our analysis, determining a fair value for a company, and then waiting for Mr Market to come and make us a crazily depressed offer to buy shares in that company. We then wait, and wait, and wait some more, collecting our dividends and waiting until Mr Market returns in a fit of joyous optimism to buy back our shares at fair value (or even an exaggerated valuation that overvalues that company).