Capital Beliefs

"In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

 

In other words, over the long-term, returns are driven almost exclusively by fundamentals (Graham’s “weighing machine”), but in the short-term, market fluctuations are the result of the changing opinions (“voting machine”) within the market.  Those short-term votes are cast by both investors and speculators. If investing is primarily a long-term project – and this author believes it is – then, as we will see, this distinction is vital.

 

To explore the distinction, let’s look at the perspectives of five legendary investors. The Fantastic Five include: famed British economist John Maynard Keynes (who spent his early years as a speculator, then moved toward the mindset of an investor); Benjamin Graham, the founder of modern security analysis; Warren Buffett, Coca-Cola’s best customer; Seth Klarman, the guru to market gurus; and John Bogle, advocate of the little guy and founder of Vanguard.

 

Mr. Market

 

Graham believed investors should think about their ongoing dealings with the “short-term voting machine” as a business partner named “Mr. Market.”

 

Graham:

 

“One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”

 

Klarman on Mr. Market:

 

“An ever helpful fellow, Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets. He provides this valuable service free of charge. Sometimes Mr. Market sets prices at levels where you would neither want to buy nor sell. Frequently, however, he becomes irrational. Sometimes he is optimistic and will pay far more than securities are worth. Other times he is pessimistic, offering to sell securities for considerably less than underlying value"…

 

"Some investors—really speculators—mistakenly look to Mr. Market for investment guidance. They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they. The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.”

 

 The Distinction

 

Graham on the difference:

 

“The most realistic distinction between the investor and speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices.”

 

Klarman on why the difference is rarely obvious:

 

“Market participants do not wear badges that identify them as investors or speculators. It is sometimes difficult to tell the two apart without studying their behavior at length. Examining what they own is not a giveaway, for any security can be owned by investors, speculators, or both."

 

 

Details on the difference, again from Klarman: 

 

"Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price; or by a narrowing of the gap between share price and underlying business value.

 

Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based not on fundamentals, but on a prediction of the behavior of others.”

 

 

A Speculator in Investor’s Clothing

 

John Bogle (with the help of Keynes) explains how Mr. Market pushes most people’s attitude toward one of speculation.

 

Bogle writes:      

 

 “Keynes saw this relationship (tendency to speculate) clearly, noting that ‘the organization of the capital markets required for the holders of quoted equities requires much more nerve, patience, and fortitude than for the holders of wealth in other forms …. some (investors) will buy without a tremor unmarketable investments which, if they had (continuous) quotations available, would turn their hair gray.’ Translation: It’s easier on the psyche to own investments that don’t often trade.”

 

 

In other words, publicly traded markets require more nerve because most people try to make sense of anything their eyes can see.  Graham provides insight into the types of trends that move people toward excessive speculation.  

 

Graham:

 

“The wider the fluctuations of the market, and the longer they persist in one direction, the more difficult it is to preserve the investment viewpoint in dealing with common stocks. The attention is bound to be diverted from the investment question, which is price is attractive or unattractive in relation to value, to the speculative question, whether the market is near its low or its high point.”

 

Becuase, markets perpetually go through such periods Graham concluded:

 

“We doubt, however, whether many individuals are qualified by nature to follow consistently such an investment policy without deviating into the primrose path of market speculation. The chief reason for this hazard is that the distinctions between common-stock investment and common-stock speculation are too intangible to hold human nature in check... But when the investor employs the same medium as the speculator, the line of demarcation between one approach and the other is one of mental attitude only, and hence is relatively insecure.”

 

History has proved Graham was right to have his doubts.

 

Temporary Attitudes  

(Two examples) 

 

1972

 

After the great bull market of the 1950s and 60s, Graham describes why he believed the collective wisdom of the market at the moment was likely temporary: 

 

 “In the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin. Compare this with the attitude of the public toward common stocks in 1948, when over 90% of those queried expressed themselves as opposed to the purchase of common stocks.  About half gave as their reason “not safe, a gamble,” and about half, the reason “not familiar with.” It is indeed ironical (though not surprising) that common-stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history; conversely the very fact they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into “investments,” and the entire stock-buying public into “investors.”

 

A horrible bear market ensued not long after Graham’s warning. Many “investors” left the market and would not return for decades. By 1979, Business Week ran a story announcing The Death of Equities."

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Excerpt from the 1979 Death of Equities article:

 

"Whatever caused it, the institutionalization of inflation--along with     structural changes in the communications and psychology--have killed     the U.S. equity market for millions of investors.  "We are all thinking shorter term than our fathers and grandfathers did," says Manuel Alvarez de Toledo of Shearson Loeb Rhoades Inc.'s Hong Kong office.    

 

Today, the old attitude of buying solid stocks as a cornerstone for one's life savings and retirement has simply disappeared.  Says a young U.S. executive: "Have you been to an American stockholders' meeting lately?  They're all old fogies.  The stock market is just not where the action's at." 

 

Contrary to the collective wisdom of 1979, that year was one of the greatest moments in history to commit capital to the stock market. A long bull market was about to take off just as most people had moved back to the attitude that the stock market was a speculative gamble.  

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2000

 

Buffett provides insight into a period many readers are familiar with; a time when many temporary-investors would later realize they were speculating. 

 

He wrote:

 

"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."

 

Keynes sum's up the mistake of these temporary-investors: 

 

“It is dangerous to apply to the future inductive arguments based on past experience unless one can distinguish the broad reasons for what it was.”

 

No Speed Limit

 

Those who develop the attitudes of the true-investor have the indirect benefit of identifying periods when the temporary-investors (speculators) can have outsized impacts on the market. Bogle explains how that's important: 

 

“Years ago, Keynes worried about the implications for our society when “the conventional valuation of stocks is established [by] the mass psychology of a large number of ignorant individuals.” The result, he suggested, would lead to violent changes in prices, a trend intensified as even expert professionals, who, one might have supposed, would correct these vagaries, follow the mass psychology, and try to foresee changes in the public valuation. As a result, he described the stock market as “a battle of wits to anticipate the basis of conventional values a few months hence rather than the prospective yield of an investment over a long term of years.”

 

Those who stay mindful of this recurring-risk are better prepared to keep the attitudes of a true investor and operate from a position of strength when strength is most needed. 

 

Or as Graham said: 

 

“The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on…..Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.”

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Rob Dainard