Rational Advisor

“If you wait for the robins, spring will be over,” - Waren Buffett, NYT Oct 2008

When the stock market goes up one day, and then goes down for the next five, then up again, and then down again, in no discernible pattern, that’s what you call stock market volatility. , and it’s usage causes people to panic and refrain from sticking to their well thought out plans. They want to “wait” till “IT “recovers.

Most first time investors perceive the stock market to be more volatile because of its typical sharp, sudden price swings. That perception is often reinforced by a simple but often overlooked mathematical relationship. The higher the Dow Jones Industrial Average (DJIA)is, the same percentage change in the index today reflects a much greater move in terms of points. For example, with the DJIA at 800, a 2% change reflects a move of only sixteen points (not very newsworthy). But with the Dow at around 11,000, the same percentage change represents 220 points, and the media focuses on the 220 point drop, not on the percentage.

Irrational Investors due to their emotions, get caught up in these swings and panic waiting for things to improve before they will invest. Always waiting as if there will be some green signal that identifies the bottom of a market.

And in so doing, they miss out on great opportunities. Recently Warren Buffett in a note in the New York Times said “If you wait for the robins, spring will be over,” He’s trying to say that if you’re looking for signs of improvement to invest, it may be too late. “Bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.” That’s the crux of his investing strategy. To take advantage of bad news and fright in the markets. And this is just the opposite of what our emotions want us to do. When we feel fright, our caveman emotions want us to run away from it. When in fact, it’s better to understand the reasoning and then to take advantage of it.

In our discussions with sound and rational investment managers there are three investing principles that came to mind:

1. Ignore the stock market. The stock market is just providing a price on businesses based on the mass psychology of the investing public, and usually is not a good indicator in the short term of the businesses true value. If you plan on having an investment program for a number of years, what happens in the market on a day-to-day basis is pretty much irrelevant.

2. Don’t worry about the economy. Stop discussing and debating whether the economy is poised for growth, or tilting toward a recession. Wise investors like Buffett and David Dreman dedicate almost no time or energy to analyzing the economy. Instead they focus on the underlying businesses that they are investing in and their revenue and cash flow.

3. Most good rational investment managers are buying businesses, and not the stock. They look for consistent operating history and favorable long-term prospects. What about its management? Is it rational, candid with shareholders, and able to avoid the herd mentality? Look at the financials, focusing on return on equity, not on earnings per share. These managers seeks out companies that generate cash in excess of their needs and companies with high profit margins, which reflect not only a strong business but a management with a tenacious spirit for controlling costs. Other financials to look at: retained earnings, estimated cash flows, and the value of a business. Once they have determined the value of a business, the next step is to look at the stock price. Most of these managers rule is to buy the business only when the stock price is at a significant discount to its value. Note that only at this final step do they look at the stock’s price.

Savvy investors don’t follow the herd: they have a game plan. And that’s exactly why they’re successful.

Stock market volatility will always be a part of investing, but a focused strategy will help weather the more stressful periods when the market is more volatile, since you’ll be focusing on the bigger picture. Success in the market does not depend on predicting the future. Volatility is more dependent on mass hysteria—fear and greed—than on underlying economic or financial events. Those are not reliable emotions on which to base long-term investment decisions.

And remember, don’t wait for the Robins to indicate that Spring has arrived.

“The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”- Warren Buffett, 1990 Chairman’s Letter to Shareholders

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