Long-term investment in equities is the best way to create long term wealth for most people.
You can invest in bonds or cash if you need income or want to preserve the value of capital in the short run but for long term wealth creation, for most people investing in equities is the best option.
The question then is what is the best strategy for investing in equities?
There are many ways of investing in equities ranging from short-term, chart-driven technical trading to long-term fundamental investing and many different strategies in between.
These different strategies have different risk-reward profiles and different probabilities of success.
Our biased view is that the strategies that have the best probability of success are those which have longterm perspective and are deeply based in fundamental analysis. We briefly share the rationale for our view here.
The first important point to make is that a share is not and cannot be reduced to a gambling chip, a ticker or a chart. When you purchase a share, you are buying an ownership participation in a company and behind each company is a unique market position, a particular management and team and a particular strategy. All of these have to be understood.
Benjamin Graham who founded the modern discipline of Security Analysis and taught the course in the same subject to Warren Buffet and many other great investors once famously described the market as follows:
In the short run, stock prices can go in any direction. If stock markets, sectors and particular stocks are popular and are being bought (people are voting for them with their money) will go up. On the other hand the markets, sectors or stocks which are unpopular, (and people are voting against them by not buying them or selling them or even shorting them) will go down.
These short-term price trends will happen all the time and may persist in the same direction for a long time leading to situations where relative valuations will be very greatly distorted. However, true long-term investors should not pay too much attention to these moves as they may not be of long-term economic significance and could be just random. They matter a lot to the short-term speculator but should not matter at all to the long-term investor.
However, in the long-term stock prices are not random at all. The movement in prices will completely reflect the long-term profits and free cash flow that a company generates. The prices of companies which generate cash will rise proportionately with that cash generation. On the other hand, companies which show losses and bleed cash will see their share prices fall directly and proportionately with these losses. In the long run, the market is indeed a weighing machine and as anybody who has tried to lose weight knows, weighing scales tell the ultimate truth – no amount of talk and spin and stories can change it. It is what it is.
Benjamin Graham has described the correct approach towards market fluctuations in a famous parable about Mr. Market. He asks you to imagine that you are a 50% shareholder in a private company. The balance 50% is owned by your business partner called Mr. Market.
Every year you work hard in your business and thanks to your efforts it makes steady progress. You and your partner have a very detailed idea about the business and the market it operates in and the trends in sales, cash flows, margins and so on.
The problem is that your business partner, Mr. Market, is not a calm, steady, patient kind of fellow. In fact he is impulsive, hyperactive and given to volatile mood swings. Every working day without fail he comes to you and tries to get your attention to focus on two bits of information. First, he will quote a price at which he will buy your 50% share in the business. Second, he will also quote a higher price at which Mr. Market will sell you his 50% share in the business.
You notice that Mr. Market has very remarkable mood swings. Sometimes he is very optimistic and his prices reflect this and are very high. At other times he is very pessimistic and he quotes very low prices.
You know intimately the trend of sales, profits and cash flows in your company and have a very good idea of the prospects for the business. Therefore have a good idea of what the business is reasonably worth. This value is a “best guess” and consists of range of values rather than a single value.
After a while you notice that the daily prices quoted by Mr. Market are often roughly in line with “true” value range of the business. However, sometimes, he is way off. When he is of pessimistic frame of mind, he is willing to sell you at an absurdly low price. At other times, he is very optimistic and is showing prices which are much higher than your carefully estimated value range.
You are too busy running your business and consider the daily babble of Mr. Market to be a useless distraction and most of the time you completely ignore him. However, Mr. Market has one endearing quality as he does not take your rejection personally. You ignore his plaintive pleas for days in a row, he still turns up on the fifth day and quotes his prices.
So what are the lessons of this story.
- The market’s valuation of companies will be much more volatile than the “true” valuation.
- You are free to ignore Mr. Market most of the time but you should be happy to take advantage of him when he is making a big mistake.
- You must not fall under the influence of Mr. Market. You should not rely on Mr. Market to tell you what the value of your company – you must have your own independent estimate of the company’s value.
Graham’s story is a parable and has an important lesson for how investors should approach the market.
Successful investors need a long-term view, ignore short term market fluctuations. They have some logical, detailed framework for analysing businesses and calculating the valuation of companies. This means they need to understand economics, business strategy, accounting and valuation.
The good news is, doing this does not require any great intelligence. The bad news is, it needs a lot of hard work and practice and the results take time, perhaps a long time to achieve results. This is bad news since this goes against human nature – most of us want to get rich quickly and without effort.
We will discuss many aspects of all these elements in great detail in a series of future essays.