“You don’t need a lot of brains in this business. If you’ve got an IQ of 160, give away 30 points to someone else because you don’t need brilliance in investing to succeed. What you do need is emotional stability…. If you are emotional about investing, you’re not going to do well…. There is no getting around that.”
- Warren Buffett
Emotions make us human. From joy to grief and from love to rage, the range of human emotions is expansive – and feelings can run deep. It’s healthy to embrace our emotions as a natural part of human nature – but it’s also important to control our emotions so they don’t destroy us when they are intense. In the stock market, the two prevailing, opposing emotions are fear and greed. In 2018, there was a tug-of-war between the two – with fear the clear winner as the year drew to an exhausting close.
No place to hide
2018 began with the stock market marching sharply higher in January, only to decline suddenly by 10% over nine trading days in February. The first quarter roller coaster ride ended with a slight decline as measured by the S&P 500®. From there, the stock market rose consistently through the second and third quarters, posting a yearto- date gain of 10.6% as of September 30. But in the fourth quarter, the stock market at times plummeted with stomach-churning speed, with the S&P 500 declining 14% during that three-month period. In fact, Q4 2018 was the third worst Q4 since 1950.
Adding to the pain of owning US stocks in 2018 was the decline in prices of essentially all asset classes except for cash. Emerging markets, developed international markets, most commodities including oil and gold, small- and large-cap stocks, high-quality and high-yield bonds, REITs, and many other special assets all declined in value last year. There simply was no place to hide in the investment markets to avoid declining prices.
These price declines, especially in the stock market, have frightened many investors. Most all of us felt fear to some extent. This sensation becomes an actual problem if we act on our fears by selling stocks after large declines to try and ease the pain of loss. This reaction to declining prices is not a successful strategy when pursuing long-term investment success. At Hilliard Lyons Trust Company, we attempt to execute an investment strategy that avoids the mistakes that result from being an emotional investor.
Think like a business owner
Our long-term-business-owner approach to investing in stocks is meant to take the emotion out of equity investing. We begin the process knowing that one of the best ways to grow wealth is to be a long-term owner of a group of carefully selected, outstanding businesses capable of compounding their owners’ investment at attractive rates for many years.
Comparing price to value
Underlying our strategy is the truism that a share of stock represents a small percentage of ownership in a business. A stock’s price only has investment meaning when compared to the fundamentals of the underlying business the stock represents. An investor in stock should think about the same things a business owner needs to consider – sales, profit margins, competition, the balance sheet, cash flow generation, growth opportunities, potential acquisitions, human capital, and many other aspects.
Through careful study of these factors, an investor can calculate a reasonable estimate of what a business is worth, or its intrinsic value. Only then can a stock price be of any real use to an investor. By comparing the price in the stock market to the calculated intrinsic value of the business, an investor can decide whether that price is cheap, about right, or too expensive.
Speculators vs. investors
People who focus merely on the price action of a stock and not on the underlying fundamentals of the business are speculators, not investors. Investors should make investment decisions in the same way they make buy and sell decisions in other aspects of their lives – by comparing price given to value received. In the words of Mr. Buffett, “Price is what you pay, value is what you get.” In making significant purchase decisions, we want to get at least as much value as the price that we pay. On the sell side, we try to sell at a price that is equal to or greater than the value we are parting with. Whether we are in the market for a house, a car, or a washing machine, these are the principles we put into practice, consciously or not. In the stock market, the same should hold true. By sticking with this discipline, we should buy stocks at prices equal to or less than our calculation of intrinsic value and sell stocks at prices greater than that value.
Mechanized, short-term transactions
The stock market is not priced rationally all of the time. The owners of stocks must expect and accept the fact that stock price changes are sometimes irrational. The structure of the stock market today contributes mightily to the occasional disconnect between price and value. Estimates are that anywhere from 50% to 90% of daily trading volume is very short-term in nature and run by computers. High-frequency trading, algorithmic trading, hedge fund trading, and ETF trading all take place with no thought given to the difference between individual intrinsic values of businesses and their stock prices. Massive amounts of money move around quickly with no concern for individual companies’ long-term fundamentals.
Much of this activity resembles the trading that takes place in commodities like wheat, soybeans, or metals, which have no intrinsic value. Given the prevalence of this short-term trading, it is no surprise that stock prices and business realities can sometimes lose their connection. Even though Wall Street has created this mess of hyperactive trading, over the long-term it is still growth in underlying business value that drives returns for the patient and intelligent investor.
A sober, long-term view
As we apply our investment disciplines in today’s market, it is important to remember that the intrinsic values of the companies we own in your portfolios are more stable than the stock prices that represent them. By our calculation, those intrinsic values actually were stable or rising throughout the year even while stock prices declined in the first quarter, rose in quarters two and three, and then declined dramatically in the fourth quarter. The market was clearly reacting to influences outside of business performance
Noise hiding the signal
The factors that pundits cite as driving stock prices lower in recent weeks include fears of the Federal Reserve making mistakes in its execution of monetary policy, the potential for a lasting trade war with China, political uncertainties, and slowing global economic growth. While there are also a number of positive business and economic factors today, the markets don’t seem to be focused on them right now. Because nobody has a crystal ball, we don’t know exactly how the items worrying the markets today will be resolved. We do know that this decline has left stock prices of businesses we own trading at discounts to their intrinsic values. For instance, we calculate that our Large Cap Equity portfolio is trading at a discount of nearly 20% to what we believe it is worth. Clearly, in this environment, we think it is the buyer of stocks who is getting a good deal, not the seller. Remaining rational At times like these, emotional stability is crucial in trying to achieve long-term investment success.
Buying stocks today, or at least not selling the ones you already own, is the rational thing to do – yet that runs counter to the feelings of fear that a rapidly declining stock market produces. When Mr. Buffett said long ago that we should “be greedy when others are fearful, and fearful when others are greedy,” he was talking about times like these. Successful long-term investing requires us to be rational at all times and never emotional in our decision-making. It is hard to do, and it requires tremendous self-discipline, with a singular focus on the long term. But there are great rewards for those who can consistently put these investment tenets into practice.
What lies ahead
While we make no predictions on what may happen in the short-run, we are unwavering in our belief that a portfolio of excellent companies whose intrinsic values increase over the years will produce attractive returns in the stock market over full market cycles. Whether the market is giving investors a painful decline or a euphoric rise, it is growth in intrinsic business value that will generate lasting investment returns over the years. So we will continue our search for excellent companies that can grow their underlying business values for inclusion in your portfolios.
As we begin a new year, we are grateful and humbled that you continue to entrust the care of your important financial assets to Hilliard Lyons Trust Company. As we have for the past several decades, we pledge to you our best efforts in helping you achieve your investment objectives and goals.
Past performance is not a predictor of future success. All investing involves the risk of loss.