Besides being the father of value investing, Ben Graham is famous for creating a great number of powerful investing ideas. His tale of a deranged business partner named Mr. Market is a fantastic story frequently used to teach new investors about markets.
I’m a big fan of Graham, and I own several of his books. You’ll find his book “The Intelligent Investor” over on my book recommendations page. When it comes to investing, I believe Graham’s ideas really are that important.
Recently though, I noticed a strange discrepancy in some of his investing advice. In particular there’s one quote attributed to Graham that’s quite famous:
“In the short run the market is a voting machine and in the long run it is a weighing machine.”
I’m sure you’ve all heard this one before. The same quote has been echo’ed by Warren Buffett a number of times over the years… adding to it’s significant fame.
As it turns out, that famous quote might not be entirely accurate…
The details about what Graham actually believed can be found buried in a copy of Security Analysis:
“In other words, the market is not a weighing machine, in which the value of each issue is registered by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are partly the product of reason and partly the product of emotion.”
If Graham is saying the market isn’t a weighing machine, how did the earlier quote get attributed to Graham?
It turns out, the bit about the market being a “weighing machine in the long run” is most likely attributable to Warren Buffett himself.
As a student and employee of Graham, Warren was probably exposed to his ideas on a regular basis. Over time, those ideas probably morphed into the very quote Mr. Buffett is known for repeating…
Fascinating stuff, right? There’s even a Bogleheads forum thread devoted to this little mystery.
I find it amazing how these important investing concepts can be so easily distorted by time…
So which is right? Graham or Buffett? Is the market a voting machine or weighing machine?
I think they’re both right. In my mind, the market works like a voting machine most of the time. Stock prices will be over or under the true intrinsic value of the business all the time…depending upon Mr. Market’s mood on any given day.
If this concept of the “voting machine”holds true in the present, so should it a week or a few years into the future… the long term nature of the investment shouldn’t change that.
What Buffett was getting at with his weighing machine isn’t wrong either. Stock prices will eventually follow the rise and fall of intrinsic value as it changes over time. If the intrinsic value of a business rises, so should the stock price to match the change in intrinsic value. The problem is, the business value might not be correctly reflected in the stock price on any give day. It could even take 10 to 15 years for the true value to be realized!
I once waited nearly 10 years for the value of a business to be fully realized by the market….it took forever. But eventually the market does come to its senses. Patience is key.
Given enough time, the two values eventually track together. In this sense I think Buffett was dead right — given enough time the stock price will roughly reflect the “weight” of the underlying business.
Another of the world’s greatest investors (Charlie Munger), boiled down both of these concepts into one that I think is a simple and profound idea:
“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”
Everybody get that?
In a previous post, I showed this concept was true using a real world example. Yes, buying a stock when it’s a good value helps. But over enough time. the returns of the business matter more than trying to buy a business at a discount to intrinsic value.
Different Methods Of Investing
Don’t get me wrong, you can make money by investing in “popular” stocks too. You know — the ones with the huge PE ratios on the evening news every night. Those guys.
You could buy those “popular” growth stocks and realise good returns. It’s also possible you could overpay and lose a bunch of money in the process.
But that’s not the only way to invest… There are all kinds of ways individual investors can put their money into the stock market and still earn good returns:
- Investing in high-growth “popular” stocks. The kind of stocks the voting machine likes best. Usually this kind of investor is hoping that growth continues long enough to justify the high price paid.
- Investing in “bargain” priced value stocks. These investors seek out a bargain hoping to sell once the voting machine comes to its senses, and the price rises to more closely reflect intrinsic value.
- Investing in stocks with high returns on capital. These are good businesses at fair prices. Hold them long periods of time and you are bound to do well.
- Go buy an index fund. For many investors this might be the easiest course of action. If you don’t enjoy the process of investing, then this is a great way to get started.
- Hire a financial advisor to do your investing and and never think about it again. (Yes, people actually do this.)
Which investing method you choose is entirely up to you (of course), but I tend t0 shy away from the more “popular” stocks. In general, I prefer Munger’s “higher return on capital” stocks wherever possible.
So how do we “weight” a stock before investing? Honestly, it’s kind of complicated. There are literally dozens of metrics a individual investor can look at to estimate a stock’s true intrinsic value:
- Discounted Cash Flow
- Price to Book Value
- Price to Earnings
- Price to Free Cash flow
- Price to Sales
- Return on Invested Capital
- and many more….
So, which metrics should we use? Well, that depends entirely upon the nature of your investment.
If you asked someone who went to business school, they might tell you that calculating Discounted Cash flow is the way to correctly value a business.
In other industries, (reinsurance for example), price to book value is a very common way to value the business. Generally speaking, the stock prices of reinsurance companies typically track the rise or fall in book value per share.
Even Buffett himself has tracked his performance as a percent change in book value per share for the last 50 years. (Since 1965!).
For other industries, it’s all about earnings. Share prices will rise or fall completely based upon the growth or decline in GAAP earnings. Find a company that can consistently grow earnings at a low P/E ratio, and you might have a winner.
Thoughts on Investing
Valuing a business with any kind of precision is tough. The process is fraught with problems and unknowns. It requires deep knowledge of growth rates, industry knowledge, and guesses about future earning potential. It’s easy to make mistakes.
Even professionals goof it up sometimes…
But don’t get discouraged — Just because something (like investing) is hard doesn’t mean we shouldn’t try. We should try…but also try to limit our mistakes.
Start small, and learn. Don’t create false precision.
Where possible, make use of Charlie Munger’s advice — Try to find good businesses, with good returns on capital, and hold them for a very long time. If you manage to do this long enough, mistakes in your purchase price aren’t going matter.
As Warren Buffett is famous for saying, “Time is the friend of the wonderful business, the enemy of the mediocre.”
What do you think — Is the market a voting machine or a weighing machine?
[Image Credit: Flickr1]