Crucial to successful investing is recognising the difference between price and value. In the 2008 Berkshire Hathaway letter to shareholders, legendary investor Warren Buffett wrote, “Long ago, Ben Graham taught me that price is what you pay; value is what you get.” This is an easy to understand idiom that people would be used to in everyday life, but often have difficulty applying in their investing life.
In the stock market, there is a wide range of factors that impact prices in the short term. Many are “human” influences–emotions such as fear and greed, reactions to economic and political news, under- and over-reactions to short term events. A stock’s value on the other hand is a less volatile and more objective number, one that can be determined by methods such as assessing cash flows (fundamental value) or comparing to other similar assets (relative valuation).
The difference between price and value can be small at times and magnified during market bubbles and crashes. When the market is rallying, investors have the tendency to rush in and buy a stock because of a “fear of missing out”. The future is bright, money abounds, and there’s no price too high. On the other hand, when the market is falling, investors become nervous. Their time horizons shrink, their wallets get tight, and prices fall. As Michael Santoli from Bespoke Investment Group once said, “appetites and crowd psychology drive markets in the shorter-term, not math.”
It’s important to recognise how wildly share prices can fluctuate. As shown below, the S&P 500 has declined by more than 20% 12 times since World War II (and it fell just short in 2022). Smaller fluctuations happen even more frequently, with a greater than 10% decline happening on average every 2 years. Remember that this is for the overall index, which contains 500 large and profitable companies. Individual stocks can move to much greater extremes, particularly those that are smaller, less diversified, and more sensitive to the economy. Even Berkshire Hathaway, known as one of the highest quality and most successful companies in the world has experienced a share price decline of more than 50% three times in its history.
However, rarely do these rise and falls in the share prices reflect how much the value of the underlying company has changed. As previously mentioned, the short term moves in shares are an emotional response, as investors react to the news of the day. The good news for investors is that a stock’s price usually returns to its fundamental value eventually. As the father of value investing Benjamin Graham said, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” Recognising and taking advantage of this dislocation is exactly why Warren Buffett and many other value investors have been so successful.
Microsoft’s (NASDAQ: MSFT) share price hit an all time high in 1999, after more than doubling from $25 to $58 in the previous 2 years. Investors who sold out the previous year were initially left wondering what could have been. But at a staggering 74 times annual earnings, Microsoft was priced to perfection. The company delivered a very healthy earnings growth of 10% per year between 2000 and 2009, and yet its share price remained basically unchanged (it had also declined back to $25 in 2000). Even though it grew at a very healthy rate, the severe overvaluation back in 2000 meant that Microsoft shareholders received very little return for their efforts. In fact, investors who parked $100,000 in a 10-year treasury bond (which was yielding 4.66% at the time) would have almost doubled the return generated from investing the same amount in Microsoft, with far less risk.
Following the initial covid crash in March 2020, the stock market rebounded hard and fast in 2021 driven by rock bottom interest rates, mammoth government spending, and a boom in retail trading. The big tech stocks (Microsoft, Apple, Facebook, Amazon and Google) soared at an average of 40 times annual earnings, and Tesla rocketed to a staggering 234 times earnings (with a market capitalisation higher than all of the other car manufacturers combined). The record highs of the NASDAQ had people asking if this was indeed a “new normal” or dotcom 2.0? For one, Berkshire Hathaway vice-chairman Charlie Munger called the sharemarket “crazier than the dotcom boom.”
Since then, the market has taken a dramatic hit, with Facebook (NASDAQ: META), Tesla (NASDAQ: TSLA), and Amazon (NASDAQ: AMZN) each declining more than 50%. The story was even more fatal for heavily-promoted smaller tech stocks. Cathie Wood’s high profile Ark Innovation (NASDAQ: ARKK) fund fell 80% from its peak, and companies such as Snapchat, Paypal (NASDAQ: PYPL), Robinhood (NASDAQ: HOOD), Zoom (NASDAQ: ZM) and Nikola (NASDAQ: NKLA) all declined more than 70% from their respective peaks. Yet even after such dramatic declines, many of these stocks remain expensive relative to their underlying value. Aside from a few exceptions such as Zoom and PayPal, most never made an annual profit and it’s uncertain whether they will in the future.
An investor can, on the other hand, benefit substantially by identifying a company trading below its intrinsic value. One such master of this was the first generation of “The Davis Dynasty”, Shelby Davis, who generated phenomenal returns of more than 20% per year for decades. Mr Davis was most well-known for the “Davis Double Play,” where an investor benefits from both the growth in earnings at the company and an increase in the valuation multiple applied to the shares.
Let’s look at one such example that needs no introduction: MasterCard (NYSE: MA). An outstanding company that well-respected investor Chuck Akre called “one investment every investor should own some of.” In the 5 years between 2016 and 2021, MasterCard’s earnings per share (EPS) increased a very attractive 276% from $3.70 to $10.20. Even better for investors though, the Price to Earnings (P/E) of MA shares increased from 27.5x to 40.5x, adding another 47% to investors’ returns!
One of the keys to successful investing is understanding the difference between the price and value of a company’s shares. Share prices can fluctuate dramatically, and they often don’t accurately reflect the value of an individual company–particularly during market booms and busts when human psychology takes over.
As we saw with Microsoft and MasterCard, identifying a company’s strengths and future prospects is only one part of the equation. There’s no doubt that these are both high-quality companies that delivered strong earnings growth and dividends for shareholders. But the return that investors received was highly dependent on the price they paid. Assessing the true underlying or intrinsic value of a company is the mainstay of successful investors such as Warren Buffett, Chuck Akre and Shelby Davis, and it can be well worth the effort.
