Mr. Market isn't so foolish, after all

Ben Graham's analogy is beguiling but inaccurate

John Rekenthaler 14 January, 2020 | 12:24AM

Crowd of people

An emotional fellow
You and Mr. Market jointly own a private business. Each day Mr. Market announces the amount that he believes the business is worth. You may pay him half that figure to become the full owner, cash out of your stake, or do nothing.

This arrangement strongly benefits you, because while Mr. Market determines the amount, you alone possess agency. You, not Mr. Market, decide if a transaction will occur, and if so, in which direction and at what price. Better yet, Mr. Market is an idiot--the proverbial sucker at the table. When he's giddy, he "can only see the favorable factors affecting the business," and thus "names a very high buy-sell price." Other times, "he is depressed and can see nothing but trouble ahead … on those occasions, he will name a very low price."

The story of Mr. Market originated with Ben Graham and was further popularized by Warren Buffett, whose words I cite. That passage was among my first investment lessons. I was so taken with the Mr. Market metaphor that my imagination reworked it. In my adaptation, Mr. Market became a dressmaker, who puts his creation on the floor each day, then sets a price that matches his mood. Successful investing meant not paying retail. Wait to buy until Mr. Market is glum; the identical dress will be offered at a lower price.

(It seems that I have a thing for dresses. This film enraptured me.)  

Good vs. Evil
There's less talk these days about Mr. Market. However, the underlying concept remains intact. In a year-end commentary in The Financial Times, former investment manager (and current fellow at the London School of Economics) Paul Woolley depicted the equity markets similarly. "Active investing comprises two main strategies. One is based on the expectations of the cash flow each asset can generate. The other responds to short-term movements and ignores fundamental value."

To restate, Mr. Market's business has an immutable value that can only be known with certainty by The Lord, but which can be estimated by top investors. However, that fixed value is buffeted (so to speak) by the actions of the rabble. The One True Price will bobble, sometimes sharply. This behavior frightens the masses but represents an opportunity for those who resist the popular confusion.

It's a morality play. Good investors are those who hold stocks solely for their future cash flows, regarding them exactly as they would private businesses, except that public stocks may be bought and sold far more conveniently. Every other type of investor is bad. Fortunately, justice is served, as the virtuous profit and the wicked do not. 

The messy reality
I no longer believe such a thing to be true. Over the years, I have come to realize that the two-investor scheme is hopelessly oversimplified. The marketplace contains far more participants than merely 1) fundamental buyers who invest dispassionately, valuing companies based on their expected future cash flows, and 2) nonfundamental investors who are driven by their emotions, or something else silly.

For example, some investors seek earnings surprises--companies that declare higher-than-expected quarterly results. They buy stocks after their companies release unexpectedly good announcements, then exit when the news becomes less positive. Such investors do not belong in the second category, as their decisions clearly rely on business fundamentals. But neither do they place in the first category, because they don't discount expected cash flows. They are something different altogether.

So, too, are those buyers who are guided by macroeconomic conditions. Investors who decided early in the 1970s that inflationary pressures had become too high, and that it was best to trade their inflation-sensitive utilities stocks for oil companies, were fundamental investors. Their analysis did not involve specific businesses, but it was nonetheless rational and related to corporate earnings.

"Emotions," would state Graham and Buffett, when confronted by trades that lay outside their two-investor structure. "Trends and momentum," wrote Woolley. However, neither critique consistently holds. Investors frequently trade their equity shares for defensible reasons that don't involve recalculating a company's expected cash flows.

A question: Are those who buy companies that have increased their dividends in each of the past 10 years "fundamental" investors? Probably not by Mr. Market's standards, if they discovered the approach by torturing a stock database until it confesses. On the other hand, only high-quality companies can raise their dividends every year. That attribute does inform about their underlying businesses. It seems to me that such quantitative tactics are just another way of getting at what Graham, Buffett, and Woolley advocate: attempting to gauge the accuracy of Mr. Market's prices.

Who’s the sucker now?
That's the optimist's view of stock market behavior. The pessimist would turn this discussion on its head. True, some investors seek earnings surprises, others make macroeconomic forecasts, and still others buy "investment factors" (such as rising dividends, low price/book value, or relatively small stock market capitalizations). Yes, those reasons are seemingly rational. Unfortunately, those investment tactics generally don't work, because so many others are already making similar trades.

I think that the pessimist is largely correct. In the 80s and 90s, several prominent funds thrived by investing in earnings surprises. Their performances have since slowed. Mutual funds that invest based on broad macroeconomic themes have fared even worse. As for investment factors, hundreds of strategic-beta funds currently mine those fields. Most of them trail their benchmarks. 

But there's the problem: The same argument applies to beating Mr. Market by traditional means. Woolley is correct when he writes that "few professional portfolios are actually invested exclusively for long-term cash flows." What he doesn't mention is that the percentage of such portfolios that outperform the indexes isn't any higher than with portfolios that use less-virtuous tactics.

In summary, when Mr. Market discounts his dress, he probably realizes something that you do not. He may realize that its style is on the wane, and that six months after buying the dress you will realize that you no longer wish to own it. Or he has learned that the fabric frays. The dress looks fine on the rack, but word is spreading that it doesn't wear well.

It's comforting to regard Mr. Market as the gullible party, but unrealistic. More often than not, the overconfident investor is the true sucker at the table. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

 

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John Rekenthaler

John Rekenthaler  John Rekenthaler is Vice President of Research for Morningstar.