Who is Mr Market?

To help explain large swings in market prices to his students at Columbia University in New York, the father of value investing, Benjamin Graham, devised a parable based around a hypothetical businessman he named Mr Market. Mr Market was a tragic figure who, unfortunately for him, was prone to severe mood swings: euphoric one minute and depressed the next. Mr Market was not a random person, as luck would have it he was also your business partner! Although difficult to handle most of the time, you found you could utilise his mood swings to your advantage. He was a very fickle fellow and on the days he was in a deep low, he would offer to sell you his portion of the business at very depressed prices, and on the days he was euphoric, he would offer to buy you out at stratospheric prices. Although he had more dollars than sense, he was a very accommodating chap, and every day he came into work and quote you a price at which he would buy and sell, but he would leave it up to you to decide whether to take him up on his offer.

The moral of the story is that, like Mr Market, share markets around the world are susceptible to mood swings and irrationality. The market quote is there for you to take advantage of or to ignore each day; it will be back tomorrow without fail. Never let other people's moods dictate your own, think for yourself, and back your own ideas and judgement.

 The power of compounding

Assume you are 30 years old, have saved $100,000, and that you're in the market for a savings account. You look around for the best rate available and find a bank offering 25 per cent per annum (yes, the bank is very generous). Assume further you invest your savings in this bank account for the following 50 years, without adding to it or remove from it, and that, for simplicity, transaction costs, taxes, and inflation are ignored. He then posed the question: how much would be in your bank account after the 50 years; i.e. when you turned 80 years old?

Without fail, the students would come back with answers not exceeding a few million dollars; $5 million at the most. In fact, after investing $100,000 for 50 years at 25 per cent per annum you would have in excess of $7,000 million, or $7 billion! But 25 per cent, 'that's crazy!' you say. In fact a duo of managers, Warren Buffett and Charlie Munger, have been able to achieve a similar compounded rate over an extended period of time utilising an approach not dissimilar to that of James Alexander & Co.; i.e. a focused investment approach based on fundamental analysis and the margin of safety principle.

This basic illustration of compounding shows the power of the more general natural phenomenon known as exponential growth. If you are able to achieve the returns illustrated above, each $4 coffee you buy at the age of 30 will cost you, or your children, over $280,000 by the age of 80. Taking into account this opportunity cost, you may want to reconsider the purchase of that $50,000 (I mean $3.5 billion) car.

Be wise: begin saving early and make the power of compounding work for you.

Value versus price

In modern portfolio theory, value and price are assumed synonymous and, in a perfectly efficient market, equal. This makes sense in theory: why would someone sell an asset for less than its value, and equally, why would someone pay more for an asset than its value? Doing so would be irrational and reduce the person’s net worth. Unfortunately, the downfall with this approach in practice is that both the buyer and seller have to arrive at the same present value for the business in question and, hence, require homogenous expectations of cash flows and risk. Given the huge number of variables which impact on the present value of a business, it is highly unlikely this will occur.

A more practical approach is to define and measure these concepts independently of each other: price is what you pay and value is what you receive. To achieve long-term investment returns it is vital not overpay for businesses you acquire. Benjamin Graham, the father of value investing, in his watershed book ‘The Intelligent Investor’, distilled the recipe for successful investing into three words: margin of safety. This is the central idea employed by his disciples and former students, such as Warren Buffett. Although Buffett originally utilised the diversified cigar-butt implementation of this concept, which was advocated by Graham at the time, he subsequently took an increasingly quality-based, focused approach where he now purchases great businesses at fair prices. Hence, although his implementation of the concept changed, his reliance on the margin of safety to reduce his probability of permanent loss remains central to his success.

As most investors are aware, day-to-day share price movements are far more energetic than the underlying economics of the businesses they represent and the industry structure in which they operate. Generally, these conditions improve or degrade at a far slower pace. Hence, like any other business enterprise, there is always room for an entrepreneurial investor, willing to put in the time and effort to find mispriced securities, to profit.