There’s some common sense market wisdom that says if you like your socks on sale you should like your stocks on sale. In either case, lower prices should encourage and excite you to buy more. But while that works with socks, it rarely plays out that way in stocks.
Maybe it’s because unlike a sock, you can’t reach out and touch a stock. Of course the business behind a stock is real, but how often do you drive to your favourite factory or office building to admire the scenery? In a similar vein, value is an abstract thing that only exists in your mind, and your neighbour’s mind. In other words, I know what the colour green looks like, you know what the colour green looks like, but how do we really know we’re looking at the same colour?
There are two objective ways to determine green-ness in the stock market. Value depends on the quality of the company, and the price paid. That’s it.
Judging the quality of a company is as simple as finding it’s return on equity over long term cycles. The ROE determines durability and long term enjoyment. For the more tangibly minded, it’s like the thread count of a sock. The higher the threads, the better the quality and the longer it will last.
Judging price is far simpler. It’s no secret that buying something at a low price is better than a high price. The lower the price, the less risky a company is. Now here’s a question: do the price changes of socks at your local department store effect the riskiness of owning a sock? Of course not. Price swings are opportunities to buy socks at good prices and sell them that at high ones, but have nothing to do with their inherent riskiness. By the same token, volatility, the ups and downs of stock price, has nothing to do with how risky a company is. Getting over the volatility = risk hurdle is perhaps one of the biggest differences that separate the rational investor from the average.
Finding stocks with high quality at a low price will create a good portfolio return over time. Quality tends to drive the long term return, while the price paid tends to drive the short term return. Just like socks, sometimes good quality makes up for paying a little too much, and sometimes good price makes up for less than top quality.
And just like your sock drawer, having 40 different pairs is a bit unnecessary. Most of us can get by on about 20 pairs, or even 15.
Ok, enough sock jokes. Stocks are begging for you to treat them as real things and not just pieces of paper. They represent tangible shares of real businesses. Finding the good ones takes discipline, but is not that hard. The hard part is seeing them for what they are in the first place. Buy them cheap and good.
What I’ve been reading this week
The people who said no to a young Warren Buffett: http://www.omaha.com/money/some-said-no-to-investing-with-buffett-early-on/article_08ca205c-d2e6-5c8b-a20a-01560aea7bbc.html
You can never escape mean reversion: http://jasonzweig.com/murphy-was-an-investor/
Index investing is not a panacea: http://latticework.com/blind-capital/
Investors are holding way too much cash and it’s not smart: http://thereformedbroker.com/2016/10/25/start-now/
Canadian housing lacks good data: http://www.macleans.ca/economy/economicanalysis/when-it-comes-to-canadas-housing-market-were-in-the-dark-here/
The simple math of compounding return: http://latticework.com/the-compounding-is-just-beginning/