Graham, a finance professor at Columbia University, asks you to imagine you are partners in a private business with a man named Mr. Market.
Each day, he comes to the office and offers to buy your interest in the company or, if you prefer, sell you his stake. The important thing to remember is that Mr. Market is very emotionally volatile.
Sometimes he feels very optimistic and thinks the future is endlessly bright. On those days he makes a very generous offer for your half of the business, sometimes considerably more than it is worth. On other days he is depressed or fearful and thinks the future is gloomy.
On those days, he is prepared to sell you his stake in the business at well below what it is worth.
Now imagine that Mr Market is not an individual but every other investor in the share market and that your stake is not in a private company but in a portfolio of public companies.
The price that shares trade for on the Stock Exchange reflects a balance between buyers (who have an optimistic view about the underlying company’s growth potential) and sellers (who have a pessimistic view).
When pessimists outnumber the optimists, the price goes down and vice versa.
The change in a share price has as much to do with people’s attitudes than the underlying value or earnings potential of the company it represents.
Many people believe in an efficient market where a share price reflects all there is to know about a company and therefore is always correctly priced.
I’m not so sure.
Let’s look at how Mr Market has been behaving in recent days. On the back of steep declines in the US market, the price of most shares on the New Zealand market have fallen lately. A little over two weeks ago, the market’s largest company, Telecom Corporation, was selling for $5.23 a share. By Wednesday this week, it was $4.72.
That’s a decline of nearly 10%. Yet Telecom is no different now than 17 days ago. It still has the same number of switchboards, customers and services.
Chances are it is still going to make the same profit in the current financial year as it was when investors were chasing its shares. Rather than there being a dramatic change in Telecom’s fortunes, it is more likely that Mr Market is in one of his depressions and was prepared to sell his stake at a comparatively low price.
This sort of behaviour goes on day after day and investors need to become immune from the swings between over optimism and deep pessimism that afflict so many people.
One way to do that is focus on a company, not its shares. If it is a financially strong company with good management and growth potential, then it is worth buying. The trick is in not paying too much for it. The best time to buy a good company is when Mr Market is having a bad day.
