Stock Market Volatility: Remember the teachings of Benjamin Graham

 


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The stock market can be intimidating. If you find it unpredictable and irrational at times, you’re right! It moves up and down based on past company performance, expectations about future company performance, buyer/seller emotions, and external pressures. Bubbles develop (stock prices reach overly high values) when investors are emotionally exuberant. Bubbles pop (stocks prices fall, sometimes to unjustifiably low values) when investors become overly pessimistic. However, over the long run, the stock market tends to price stocks fairly.

The market has been volatile and pessimistic lately. Reviewing the work of Benjamin Graham, one of Warren Buffett’s mentors, may be helpful.

Graham’s approach:

1. Graham emphasized understanding the financial statements of a company. Graham primarily valued companies based on their earnings yield and book value. Graham recommended buying stocks when they traded at a discount to the company’s actual value. Buying at a discount provided a margin of safety for investors. To follow this first principle of Graham requires a basic understanding of accounting.

2. Graham also emphasized understanding whether there is a competitive advantage possessed by the firm. This is less attributed to Graham than others, but can be found in his discussion of barriers to competitor entry. The basic idea is that companies with great earnings and high stock values will attract competitors who want a piece of the profits. Thus, unless a company has some sort of competitive advantage, such as a strong brand, profits and stock price will likely decline over time due to competitor entry.

3. Finally, Graham provides an early discussion of behavioral economics when describing the volatility of the stock market. Graham makes use of the fictional character “Mr. Market” who experiences emotional ups and downs before providing a daily stock price. Sometimes Mr. Market optimistically quotes a high price after reacting to good market news, such as a change in interest rates. Sometimes Mr. Market quotes a pessimistically low price after reacting to bad market news, such as a slightly lower than expected quarterly earnings. Overly optimistic pricing can lead to bubbles. Overly pessimistic pricing can create opportunities to buy stocks at a bargain. Graham’s point is that the investor needs to do their own analysis of the company’s merits rather than relying on Mr. Market to value the company.

Conclusion: When stocks rise or fall dramatically, it can be helpful to remember Mr. Market. Sometimes Mr. Market quotes a price that accurately represents the value of the company. However, it is up to the investor to determine Mr. Market’s accuracy. Analysis of financial statements and competitive advantage can assist the astute investor with this process.

References:

1. Graham B. Zweig J. The Intelligent Investor (revised ed). Harper Business: 2006.

2. Graham B. Dodd D. Klarman S. Security Analysis (7th ed). McGraw Hill: 2023.

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