Understanding Price Declines

By: Dan Erdle

Overview

The purpose of this post is to remind ourselves how we should think about price declines, discuss common misconceptions around falling prices, and touch on specific actions we might take when met with declines. Above else, the key to understanding price declines, as well as taking the correct action in response to them, is understanding the difference between Price and Value.  In dealing with this topic it is fundamental that we differentiate the two. We are concerned with Value. The rest of the world is obsessed with Price.

Pullbacks Teach Us

I think it is useful to discuss three lessons that corrections teach us that are relevant on the level of the personal investor. They have to do with managing the practical aspects of investing. Price declines teach us:

• The need to always remain humble. In a rising market the world is full of bull market geniuses. Don’t fall into the trap of thinking that investing is easy or that you have it all figured out. There is no such thing as a free lunch.

• Don’t invest money that you can’t reasonably set aside for 3-5 years. If you are investing money that you will need in a short time you are setting yourself up for failure.

• Pullbacks teach us that while stocks tend to be easily converted to cash, we can never be sure at what price. We should plan to invest only the amount we can reasonably say we won’t require in the near future.

 

Price vs. Value

Appreciating the distinction between Price and Value will solve a lot of heartache. Let’s briefly review these concepts and hopefully we will see how understanding these two ideas can help in dealing with falling prices. Discovering the price of a stock is easy. Punch in the ticker and up will pop the price. Price on a given day is merely the result of supply and demand for the shares. If there are more buyers than sellers the price will rise; if the opposite is true, they will fall. Given that price is dictated for a desire for shares in the marketplace, price is influenced by a variety of factors beyond the fundamentals. It is influenced by emotion, market sentiment, predictions, rumors, and popular opinion.

While discovering the price is easy, determining a stock’s value is more challenging. What do we mean when we speak of the underlying value of a stock? First, let’s remind ourselves that when we are speaking about value we are discussing the underlying business represented by the stock. As value investors we are always buying a business, never little pieces of paper that are constantly changing hands. So when we are discussing value we are always talking about the ability for the underlying business to produce cash on behalf of its owners.

I think the easiest way to conceptualize the idea of value is to ask yourself a series of questions: If I were able to buy the entire business, thereby assuming its liabilities and current cash, and have access to all of the profits it will make until the end of time, how much would I pay? Another way to think about it is: what would a rationally informed buyer and seller exchange the business for in a private transaction? Given this review there are several things we should remember:

• When speaking of price declines, we are almost always talking about supply and demand for shares in the market, not any change in the underlying business’s ability to produce cash.
• Prices move much more than Value because prices are driven by numerous factors besides fundamentals.  Human excesses will drive short term prices in unpredictable ways.
•  Because short term price swings are separate from Value and beyond our control, we should not allow ourselves to become overly fixated or emotionally drained worrying about price swings.
• Because of the transitory nature of prices—they are literally here today gone tomorrow—long term success can only come from focusing on value. If we focus on price, we have nothing to ground our decisions in because they are constantly changing. Value is much more stable.
• Value is determined by the underlying business’s ability to produce cash on behalf of its owners. Value investors look to the business for returns not changes in the market price.

Conventional Thinking

Conventional thinking around stock prices tends to assume that when prices go up, it’s a good thing and when prices go down, it’s a bad thing. We cheer when we see our portfolio values increase and we get depressed when we see it has gone down. People tend to want to own a stock after it has gone up in price, thinking it is a good stock because it has done so well. Inversely, people tend to want to stay away from stocks that have fallen in price because they see them as damaged goods that no one wants.

By and large what has just been described is an error in thinking. Most of these misconceptions are a result of our inherent, subconscious psychological and social biases. The fact of the matter is that for opportunistic value investors such as ourselves we should cheer when prices decline and become more apathetic the further they rise. This is another instance where the courage to go against the crowd reaps tremendous benefits.

Gone Shopping

In most aspects of life, people have a solid understanding of prices. Most people in their day to day dealings prefer that they pay less for something than more. Let’s say we were out shopping one day and we saw a pair of pants we really liked. They are of high quality, they fit us well, and we like the way they look. If we got to the counter and the cashier asked us if we would rather pay $100 or $50 for the pair of pants, all of us would jump at the opportunity to pay the lower price. In fact in the normal course of our lives we feel good about paying low prices; we all like to feel we are getting something on sale.

Now imagine the same store but under different circumstances. Imagine thinking about buying that same pair of pants but just then a sales person comes over to tell you that the pair of pants you are looking at just underwent a price increase. Just a moment ago they were $100, but they are now $150. Most of us would take this information as clearly a negative in buying the pants. None of us wants to feel like we are not getting our money’s worth. The fact that the pants are now more expensive would give us pause before buying and may even lead us to shop elsewhere.

For whatever reason, all of this level-headed thinking goes out the window the moment we mention the word “stocks.” In the world of stocks, people tend to be drawn to stocks that are high in price, and may even point to the fact that a stock has gone up in price as a reason for buying it. If you compare investing to the purchase of the pants, in investing people irrationally feel better paying $100 rather than $50, and the information that they now cost $150 makes many investors even more enthusiastic about buying. People would do better if they bought their stocks like they bought their pants.

What should we take away from the shopping story? It’s fairly straightforward: As purchasers of an item—whether it be pants or shares of stock—we should want to pay a lower price not a higher price. Just like when buying pairs of pants, we should feel good about having the opportunity to buy stocks at lower prices.

Some Simple Math

Numbers are few people’s strength so I will keep everything simple. Imagine a situation in which you loan your friend $50 and he told you that he would give you $1 of interest. In finance, the $1 would be what we refer to as a cash flow. Given this situation, what is your rate of return? All we have to do is divide 1/50 to get a return of 2%.

Now imagine another one of your friends offers to give you that same $1 of interest, but only wants a loan of $20. What is our rate of return now? 1/20 is….. 5%. Now another friend will give you $1 of interest, but only wants to borrow $10; your rate of return in this situation is 10%.

Stop and look what is occurring in the above scenarios. As you have to give up less and less for the same level of cash flow, your rate of return increases. In other words as your price or cost decreases, your forward rate of return increases. There is an inverse relationship between price and rate of return. This point is so mundane that it is brushed over by many investors. Repeat it again: As price decreases in regard to a cash flow, forward rates of return increase.

When we think about falling stock prices we should never forget the above mantra. Remember in our discussions of Value that as investors in stocks should think in terms of the cash flow producing abilities of the underlying businesses. Well, when thinking about the cash flow from a business we should treat it no different than if buying pants or making a loan to your friends. The same rule applies: For a given level of business cash flow, we should want to pay less not more. As our price for a given level of cash flow decreases, our forward rate of return increases.

Dealing With Declines in a Pre-Existing Portfolio

As buyers of stocks we should not feel bad about market declines but should actually welcome them. For all of us not currently in retirement, we will be net buyers of stock in the coming decades. Therefore one of the best things we can have happen to us is be given the opportunity to find high quality businesses that produce cash flow and purchase them at lower and lower prices.

You may be saying this may be well and good but that still leaves us with the problem that price declines likely effect stocks already in our portfolio just as much as those we are looking to buy. For some reason, even though we all understand the benefit of falling prices, none of us like to see them in our portfolio. There are a number of points I can offer to help put the losses in your portfolio in context:

• Any loss in your portfolio is only temporary until….you sell. You must remain disciplined and stick to the core Value principles discussed in this newsletter and elsewhere. Never panic and always seek calm rationality.
•  As discussed in the Price vs. Value section, price swings are transitory in nature and likely to be effected by things beyond your control. Don’t take them too seriously.
• When met with price declines, redouble your focus on Value. As we have discussed, price and value are two very different things. Focus on looking for returns from the cash producing abilities of the businesses you own, not from price fluctuations in the market.
• You have to have a long term investment horizon. If you have a long term horizon, the temporary losses in your portfolio can be viewed as just noise. While price declines may be painful in the here and now, are you really likely to remember this moment 5 or 10years from now?
• Use cash in the portfolio or money earned from outside sources to purchase your high quality businesses in the portfolio at even better prices. Seek opportunity in price declines, not negativity.
• Falling prices are the friend to the Value investor. Like in the story for shopping for pants, you are being handed the opportunity to buy the same item—except this time at a better price.
• Understand that even when you buy things at low prices, it does not mean that it is going to go up tomorrow. It is almost impossible to time the market so you must become comfortable with not catching the absolute bottom. Things can always still go down in price; it is the price we pay for not being able to predict the future.
• I cannot emphasize it enough: market declines affect the price of your investments not the value.  Continue to force yourself to internalize the difference. It is the key for getting through momentary rough patches that are bound to occur because of price fluctuations.