What do we do When Mr. Market Offers Cheap Prices?
I just wanted to send along a note to give you some insight into how we’re thinking about markets these days here at Tumwater. The short version is that we believe today’s markets are giving us a very good buying opportunity which is why we’ve been doing some rebalancing for private client accounts to take advantage of it.
To dig into the markets a bit I want to bring back an old market analogy made famous by Warren Buffett’s mentor, Benjamin Graham. Ben Graham imagined the stock market as a person he called Mr. Market. And Mr. Market is manic depressive, swinging wildly from giddy, irrational exuberance to all-is-lost, the end is coming, depression and everything in between.
Mr. Market comes to us each day and quotes us a price for our stocks at which he will buy everything we have or at which he will sell us more of those businesses. On days when he’s in a manic mood he’ll offer us super high prices – often higher than the businesses we own are actually worth. And when he’s depressed, he’ll offer super low prices – lower than they’re actually worth.
And that’s one of the most important realizations an investor can come to – the fact that the price Mr. Market happens to be offering us at any given point is, or at least can be, very different from the true value of the businesses we own.
But each day we’re faced with a choice.
At the price Mr. Market offers that day, do we want to sell what we have, buy more, or ignore him and just keep what we have? How do we make that decision in a rational way? We do it by going back to the essence of exactly what it is we’re doing and why, when we buy stocks in the first place.
When we buy stocks, we’re just buying shares of real businesses – usually some of the largest, best managed, and best financed businesses in the world. And the only rational reason for us to want to own businesses is for the profits they generate – both today and in the future. So we want to compare the price Mr. Market is offering us to the profits we’re getting and expect to get from the businesses we own.
That relationship is known as the price to earnings ratio or PE ratio. It’s the price we pay today for each dollar of profits, or earnings, that the businesses we’re buying generate each year.
Over the last 25 years that Price-To-Earnings ratio has averaged $16.32. In other words, we’ve had to pay $16.32, on average, for each dollar of annual profits we’d get from that point forward.
The lowest we’ve paid was at the low point of the Great Recession in March 2009 when we only had to pay $10.30 for each dollar of profits. The highest point in the last 25 years was at the end of the dot.com bubble in March 2000 when we had to pay $27.20 for each dollar of profits. So that was the range; $10.30 was a screaming deal and $27.20 was wildly overpriced with $16.32 as the average.
Today, Mr. Market is clearly in one of his depressed moods.
He’s offering us a price that is 30% lower than he was offering us less than one month ago. It’s a price that amounts to a PE Ratio of about $14.00 for each dollar of profits. Not quite the screaming deal we got in the Great Recession but still meaningfully lower than the average price we’ve had to pay for each dollar of profits over the last 25 years by about 14%.
Now obviously, Mr. Market could come to us tomorrow, or next week, or next month, or next year and offer an even lower price. In other words, the stock market could certainly go down from here but the old formula for investment success is buy low, sell high. And today it’s hard for me to see how today’s price could be considered high. So, to follow the formula we need to be buyers today, not sellers.