The Weighing Machine
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…
Quotation Confusion
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?
Who’s Right?
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.
Weighing Things
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
- EV-to-EBITDA
- 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]
Certainly a little bit of both is involved. Predicting growth for hot new companies requires a good bit of educated guesswork, which is also going to be influenced by market sentiment. It would be hard for me to invest in the future growth of a company when current earnings aren’t stellar, but that doesn’t mean they won’t take off. One reason I like index funds, it takes my guesswork out.
Seems like you’re really focused on growth Mr. CK. Growth doesn’t necessarily make a good investment. Remember that post where I talked about Altria? It hasn’t grown in 50 years, yet it’s still the most successful stock in America. No guess work needed there…just math.
Fascinating that this quote has been misquoted. I’ve been investing for 15 years and started out trying to carefully evaluate stocks, measuring different components and trying to carefully analyze anything. It takes a ton of time and in my experience often doesn’t lead to results that are much better than throwing a dart at a list of stocks. At this point, I’ve become a big believer in the simplicity and science of index funds.
Freedom 40 Plan recently posted…Consolidating Brokerage Accounts
I think buying a business that is cash flowing and will survive when sentiment is heavily against the business is a decent strategy. Think oil and commodities in 2015 and 2016, banking stocks in 2010-2011. Now retail is being sold off with the rise of Amazon and health care is selling off but there are likely some undervalued business that may survive these changes. It’s impossible to perfectly time but DCA can help you build a position during periods of undervaluation. But you are right- if the business returns are high that will overcome most of the other factors. But usually when the growth rates are higher the P/E’s become very high.
Any layman can see that Amazon is growing much faster than Target. But from a P/E Target is trading at 11-12 and Amazon is well north of 100. Normally once a business matures the P/E goes down to 15-20, so that would imply that Amazon needs to get to be a 1.5 Trillion market cap company before maturing to steady levels for investors today to receive a payoff. That may be the case but I don’t think it’s guaranteed. That’s why I never invested in Amazon but did pick up Target. Anyway it’s many opinions that make a market so good luck whatever you decide to do.
-Mike
Well said, and well deduced Mike! A 1.5 trillion market cap seems like a pretty big stretch doesn’t it? Exactly why I haven’t purchased Amazon. It’s a fantastic business, and I love using Amazon… but it’s probably a lousy investment when considered from the perspective of the weighing machine.
Sorry- I think I didn’t explain this properly. If the market cap goes to 1.5T from current levels of 395B, current investors stand to quadruple their money. What should have said is that current profits are barely 2B right now and if AMZN shows signs of slowing down and becoming mature the annual profits should be closer to 20B per year to justify the P/E multiple… in this case the market cap would still be at $395B and the shareholder would receive no gains assuming zero dividends… Could AMZN do it? Well they could do a big rate increase for Amazon Prime, but then I wonder if they will still have the same number of members? One could say if they could do it why didn’t they try this already?
-Mike
I really appreciate you breaking these concepts down. I am still on the road to FI and want to learn as much as possible.
Thanks Marisa! I appreciate the positive feedback!
Interesting article, Mr. Tako! I never really thought of it that way.
It’s kind of like fundamental and technical analysis right? Where fundamental is like weight as it calculates and studies the company’s financial details to determine whether or not it’s a good investment and technical is like voting as it uses patterns in market data to identify trends.
Kindof. I don’t think most main street investors do much technical charting these days, nor fundamental analysis. They buy what’s popular because it’s what they know…essentially voting with dollars. They might have a positive feeling about Tesla or Amazon, but who here has even heard of Freightcar America (RAIL)? It has a PE of 7.6, a 2.4% dividend yield, and selling at only 70% of book value.
Stocks like that go completely unnoticed by Mainstreet America.
I “vote” for voting machine. As the market adage goes, “The market can be irrational far longer than you can remain solvent.” So even if you are confident that your measurement of a stock’s “weight” is more accurate than the current price, it could take a long time before you are vindicated.
Wall Street Physician recently posted…If You Must Trade, Follow These Five Rules
Well said Wall Street Physician! My own experience has backed this up — the market can be irrational for a very long time. One of the reasons I like dividends…they have nothing to do with market sentiment.
Voting machine.
I’m with you on loving dividends. Doesn’t matter if we can’t predict the underlying value (just like when people who shorted the market when Trump got elected and got screwed), as long as the dividends cover our expenses, who cares?
Definitely voting machine.
Which makes it fun for people like us. not only is there profit to be made but the shear thrill of discovering excellent companies at low prices just because their sector isn’t the flavor of the month … it doesn’t happen often but when it does, it’s a natural high for me!
The financial markets may be an incredible complexe, whirling vortex but I know that with my skill set (and it is a limited skill set) I will always be able to find some profit. It is a very comforting thought ….
It’s definitely a bit of both. Afterall, “the market can stay irrational longer then you can stay solvent” (John Maynard Keynes). As such in some ways the flow of the market as much tied to the behavior of people who vote for the price of the stock as the long term ebs and flows of the underling valuation.
Ultimately good stock valuation analysis requires a comparison to a stocks peers. The problem is that comparison is fraught with risk. Are you comparing it to a true peer is one. Amex and Visa for example only appear to be peers on the surface. Yet Amex loans people money and Visa just charges fees for their network. Another one is how they are apply GAPP to these measurements. For example a large amount of goodwill on the balance sheet can inflate book value. A real world example is Forbes had a good piece on our new president a while back and the question of his true net worth. The disagreement between them and Trump himself tied back to the value of his brand (what would be commonly called goodwill).
Full Time Finance recently posted…A Subtle Strategy to Improve your Negotiation Technique
Love your blog Mr. Tako. One day its rice cookers and lentils, and the next its a post like this. You are a renaissance man for sure.
It’s a weighing machine, but a lot of people try to be like the guy at the county fair and guess the weight before the company can fully get on the scale.
Thanks Mr. Zero!
I have an important question for you: why is the scale showing zero even with a tbsp or two of flour on it? Was there a reason to tare this out? Is it a subtle dig at being able to get book value for zero or something?
-Mike
Oh you noticed that! I didn’t think anyone would… 😉