What do you do when price goes down?

[+]

When you buy a new car and drive it off the lot, the price others would pay for it goes down that instant. In fact, on average, the market price of a new car declines 20% in the first year. How do you react to that?

Did you make a mistake in buying? Did you think about that price drop ahead of time? Would you feel better or worse if you had daily, monthly, quarterly or annual price quotes on  your purchase?

These questions are not idle chatter, because any investment you make will decline in market price at some point in time. If you respond rationally to that decline, you’ll get very satisfactory results over time. If you don’t, you’ll be your own worst enemy.

Every investment rises and falls in price over time. Go ahead and accept that right now. Cash fluctuates with inflation and deflation; bonds fluctuate with interest rates; commodities fluctuate with supply and demand; stocks fluctuate with all the above and more. It’s a fact of life.

If you expect fluctuations to occur, you can react prudently to market price–benefiting from volatility. If you hope your investments will only go up in price, you’ll panic and sell at the wrong time. That will lead to lousy results.

Acknowledge it right now: whatever you buy will fall in price at some point in time. You should be prepared, specifically, to see any stock you buy both drop by half and double over time. How can you possibly sleep at night or react prudently to such an acknowledgement? By clearly understanding the difference between market price and underlying value.

As Warren Buffett put it, price is what you pay and value is what you get. Let me modify that statement a little: market price is the amount you’d pay or receive if you had to buy or sell RIGHT NOW! If you don’t have to buy or sell right now, market price should not be your main focus.

Market price is the intersection of the price a seller is willing to sell and the price a buyer is willing to buy. If the seller is panicking, they are likely to take a lower price. If the seller is euphoric, they’re likely to want a higher price. When sellers and buyers agree to make a transaction, that’s market price.

But, what if particular buyers and sellers aren’t knowledgeable or rational. What if they are panicking like they did in early 2009, or overly euphoric about technology stocks like they were in early 2000? In those cases, market price may not be a very good indication of underlying value.

Market price tends to depend on who is doing the selling and buying at any point in time. If the people you are selling to or buying from are sober-minded, intelligent, knowledgeable, then market price and value are likely very similar. If not, then not.

Underlying value is the value to someone sober-minded, intelligent, knowledgeable. Think about someone who has been in an industry for 30 years, who knows and understands suppliers and buyers, who grasps the full context of where the industry has been and is going, who knows growth rates, input prices, distributors, shipping costs, financing rates, the competition, etc.

When that expert looks at a business, they don’t think about market price, they think about dividends, returns on investment, cash needs, industry dynamics, and they think about it over the long term. When an expert comes up with what a business is worth, that assessment is based all the relevant information available at the time, and will much more accurately reflect the long range value of the business. Unlike Wall Street analysts and most investors, an expert isn’t thinking about market price in 6 months or 6 seconds, they are thinking about customers, buildings, factories, raw materials, long term contracts.

To successfully invest, you need to focus on underlying value instead of market price. Market price then becomes your servant instead of your master. If buyers and sellers are scared, you may want to buy from them. If they are euphoric, you may want to sell to them. At all other times, you look at their price quotes like a disinterested shopper. You aren’t forced to buy or sell and aren’t swayed by the crowd’s frequent price quotes and dramatically shifting opinions.

This is the key to successful investing. If you need to buy and sell right away, market price is your guide, and you’re likely get a poor deal. If you don’t need to buy and sell, then you should feel free to focus on underlying value first and market price second.

In this way, you benefit from swings in the market. If you focus on what the expert does: long term cash flows, industry dynamics, underlying asset values, etc., you can easily take or leave market prices. Then you can buy assets cheap and sell them expensive, and you’ll get very nice returns.

But, if you focus primarily on market prices, you’ll panic when price drops and sell at the bottom, or become euphoric as prices climb and buy at the top. That’s what most people do in the stock market, and that’s why they get lousy results.

Next time the price of something you own drops, ask yourself if you are focused on market price or underlying value. If the truth is that you don’t know anything about the underlying value of what you own, you shouldn’t be investing your own money. If you are focused on underlying value, ask yourself if you would be panicking if you owned the whole business. It is, after all, a portion of the business that you own. 

Yes, the future may not look as good as the past. Yes, competitors or the economic cycle may be making things difficult, but did the value of your buildings, factories, inventory, cash and future cash flows really drop by 30% just because reported earnings missed Wall Street’s forecast by 5%? 

If no, then it’s probably time to buy more of the business. If yes, then take a week or month to think about and review all the relevant data, and wait until your emotions have simmered down. In the cold light of full analysis, you may decide the business isn’t as bad off as others think. Or, you may decide it really is doomed and you should sell. Wait until you’re sober-minded to do so.

Make market price your servant, not your master. Focus on underlying value. Your net worth will reflect this choice over time.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What do you do when price goes down?

It’s normal to worry, but this is not the time to panic

Below is a slightly altered version of an email I recently sent to clients:

Dear Clients,

As you’ll see next week, my client letter was written at quarter end and doesn’t address recent market volatility. With that in mind and considering the recent market drop, I decided to throw together a quick email to all clients giving my opinion of what is happening and what my response is.

I’ve summarized my thinking in quick bullet points for those short on time or not as interested. Then below, I go into more detail on each point for those who want more info. Finally, my intent is to try to answer your questions as well as I can and to get a dialogue going if you are concerned. Please feel free to contact me at any time if you want to talk to me about what is going on. I will be available or quickly return your calls. This is a stressful time, and I’m here to answer your questions.

1. It’s natural to be worried, but panic selling now will lead to regret in the long run.
2. Historically, this decline is not out of the ordinary.
3. I believe recent government action will work, although it will take some time and it will lead to higher inflation in the long run.
4. It’s not possible to time the market, so trying to sell now and buy at the “bottom” almost always leads to worse results than holding on.
5. The market is throwing the baby out with the bathwater.
6. Our underlying businesses are strong even though their prices are going down.
7. This is a historic time to invest!
8. One of the reasons you hired me is to let me worry about the market for you. That’s what I’m trying to do for you now.

Now, the details.

1. It’s natural to be worried, but panic selling now will lead to regret in the long run.

Being worried is normal–I’m having no fun watching your and my portfolios decline. It’s easy to anchor on recent market tops and expect the highs to continue–there was a lot of media coverage about the Dow hitting 14,000 this time last year. People are panicking because they are scared, but reacting by selling is the worst investment plan and will lead to tremendous regret when the market does rebound. Temporary highs and lows can make you feel better and worse than you want to. The market swings up and down dramatically, so it’s best to focus on longer term averages. A wise person once said that courage is not the lack of fear, it’s the ability to act in the face of fear. Right now, not selling is taking a lot of courage.

2. Historically, this decline is not out of the ordinary.

The stock market tends to decline an average of 40% when recessions hit, which is about every 5-10 years. We’re down around 40%, so this decline is in line with history. As Mark Twain said, history doesn’t repeat, but it sure does rhyme. Sometimes the market goes down by 20%, sometimes it goes down by more. No one knows where this one will bottom, and trying to pick the bottom is a fool’s errand. Our economy and financial sector are facing the worst period since the Great Depression, but that doesn’t mean it will look just like the Great Depression. Comparisons to history are useful, but expecting the same outcomes in the same way is a mistake.

3. I believe recent government action will work, although it will take some time and it will lead to higher inflation in the long run.

Current government plans have flaws, but I believe they will get credit markets and the economy going, eventually. The cost will be higher long term inflation and more regulation, but I do think it will work. The market tends to bottom 6-9 months before the economy does. Economic data comes out months and years after the economic bottom is clearly reached. Waiting for the economy to improve will lead you to miss the huge stock market rebound that will occur. It’s hard to see past our current turmoil, but a long term focus helps.

4. It’s not possible to time the market, so trying to sell now and buy at the “bottom” almost always leads to worse results than holding on.

Like the search for the Holy Grail and a perpetual motion machine, people are always trying to time the market by buying at the bottom and selling at the top. Unfortunately, this isn’t possible, and every attempt to do so ends in tears. I remember buying a company called JLG in 2000 at $8.88 per share, watching it decline to $3.95, and then selling it when it climbed above $17. I had doubled my money when the market was doing terribly, so I felt good about myself. But then JLG climbed to $60. It’s easy, in hindsight, to think I should have known that JLG was worth a lot more than $3.95 at the bottom and buy more. It’s easy to think I should have waited for $60 to sell at the top. Having been through that ride, though, I know very well that it’s not possible to pick the tops and bottoms. Instead, I focus on the underlying value of the business and buy when it goes down and sell when it goes up. I never pick the exact bottom or top, but over the long run, I’ve had very good results.

5. The market is throwing the baby out with the bathwater.

When the market panics, everyone feels so much pain they sell no matter what price they get. This leads people to throw the baby out with the bathwater, and that is what I’ve been seeing since Oct 1st. People are selling good companies and bad ones, small and big, everything. When that happens, it’s very unprofitable to join the crowd and sell, too. This is a sign of how much pain people are in, not the underlying value of businesses. In the long run, the market will recognize underlying business value, even if it takes a while and some pain to get there.

6. Our underlying businesses are strong even though their prices are going down.

When I look at our underlying businesses, I feel very confident. Software companies will continue to sell software and make money, even in a down market. People will still subscribe to cable, even if they don’t pay for HBO anymore. Smart insurance companies will continue to write insurance. Discount retailers are doing better than ever as people look for bargains. Europe’s lowest cost airline is still lowest cost and, and with little debt, can continue doing business and make more money than competitors, smart holding companies have investment money on the sidelines and the inside scoop on the best deals in the market when everyone else has no cash to invest, well capitalized insurers are writing more insurance now that AIG and other insurance companies are in severe trouble, big pharmaceutical companies will continue to sell drugs to people who need the medicine to live longer, happier lives, great banks are expanding by buying competitors at a fire-sale price because most other banks are on the ropes, auto insurers will continue selling car insurance because people have to buy it to drive, smart chemical companies will continue to make vital chemicals and pay lower prices for gas and oil inputs, large integrated oil companies will continue producing and refining fuel for people who will continue to heat their homes and drive their cars, large international banks will continue to grow their international banking franchises and will be able to buy up competitors because they are more conservatively financed than competitors. Many companies are strong and exploiting the downturn–but their prices are going down! Why? Because people are panicking, not because the businesses are going bankrupt.

7. This is a historic time to invest!

If you look back at market history and see 2002, 1998, 1991, 1987, 1982, 1974, 1962, 1953, 1942, 1938, 1932, etc., you will see market bottoms where things were awful. 2002 was the bottom of the tech blowout. 1998 was the bottom of the Asian Contagion. 1991 was the Saving and Loan bailout and recession. In 1987, the market dropped over 20% in one day! 1982 was a sharp recession and the Time magazine article of the “End of Equities.” 1974 was a terrible recession, extremely high inflation, the pullout of Vietnam, etc. And so on and so forth. They were each excellent times to invest and extremely tough moments to do so. What made them great times to invest? Because some people panicked and others didn’t. The people who didn’t panic made out like bandits. If you have extra cash to invest, put it to work now. If you don’t, hold on for now. The roller coaster is on the way down, our stomach is in our throat, we know it will go back up again but can’t think about that because we feel awful. But, holding on is the most profitable route.

8. One of the reasons you hired me is to let me worry about the market for
you. That’s what I’m trying to do for you now.

An important part of my job, in addition to researching and picking investments, is to take the pain for you of watching the market go down. If you can, turn off the TV, get off the Internet, put down the business section of the newspaper. Go out and do something fun. Spend time with loved ones. I remember watching TV for 48 hours after 9/11 and after Hurricane Katrina, and I managed to convince myself that more doom was right around the corner. It wasn’t, and it probably isn’t now. Let me focus on this stuff for you, let me take the pain for you. That’s what you pay me for.

I don’t want to short change current events. These are tough times.

I don’t want to undercut how miserable it is to watch our portfolios decline in value–I’m agonizing because I feel responsible for your money.

If you still have concerns, please call or write me. I’m standing by and waiting to talk to anyone who calls.

Take care and have a great weekend,
Mike

Michael Rivers, CFA
Athena Capital Management Corp.
719-761-3148
www.athenacapital.biz

Visit my blog: www.mikerivers.blogspot.com.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.