Mr. Market and its 'now sullen' and 'now ecstatic' moods

In the previous note, we talked about Warren Bufffett's views on identifying the value of a stock and the concept of margin of safety that he inherited from his mentor Benjamin Graham. But if the market is efficient at all times, there cannot be margin of safety, right? Wrong!

Mr. Buffett is often heard saying that when investing, only two skills are of paramount importance:

One, is that of valuing a business, and Two, is knowing how to think about market prices.

In fact, this is what he had to say on the topic in his 1996 letter to shareholders.

Sorry, that's too academic!

Mr Buffett says, "To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - 'How to value a business?' and 'How to think about market prices'."

Earlier in this guide, we learnt how one should go about valuing a business. Now we focus on the second aspect i.e., 'How to think about market prices?' Here too, Mr. Buffett turns to his mentor Benjamin Graham, whose famous 'Mr. Market' analogy has immensely helped value investors and others to take advantage of the irrationalities that prevail from time to time in the stock markets.

But before we move ahead, let us understand who is a "value investor"?

The discipline of investing in stocks that trade at a significant discount to its DCF based value (also knows as intrinsic value) is known as value investing and the investor who follows this discipline is known as a 'value investor'. This is one of the several acceptable definitions out there for value investing/investor. Benjamin Graham is widely believed to be the father of value investing, having introduced it at a time when a proper investment framework was yet to evolve in the field of investing. Mr. Buffett is known as the foremost proponent of value investing and reckons it to be the safest mode of investment around.

Coming back to Mr. Market, what is this 'Mr. Market' analogy? In his 1987 letter to shareholders, Mr. Buffett has explained the concept in detail.

Mr. Buffett and the incurable Mr Market

Mr. Buffett says, "Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his".

Mr. Buffett further says, "Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him."

He further states, "Mr. Market has another endearing characteristic - he doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manicdepressive his behavior, the better for you."

"But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice - Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game."

Thus, Benjamin Graham's concept of 'Mr. Market' seems to have its roots in the psychology of an average investor, who tends to overreact on either side. When excessive optimism prevails in the market, the investor will drive up the price of a stock beyond its intrinsic value and when excessive pessimism prevails, the very same investor drives down the price much below the intrinsic value.

Mr. Buffett has urged investors to take advantage of these idiosyncrasies so that attractive returns can be generated over one's investment lifetime. Mr. Buffett's own success can be attributed to taking advantage of the same idiosyncrasies. Hence, the next time the stock price of a firm crashes, do not forget to ask 'Is the fall justified or is Mr. Market being overly pessimistic today?'

Mr Market's Indian adventures

In conclusion, we would like to quote two examples from our own observations of the Indian stock market where in the first case, Mr. Market became so pessimistic that even the fundamentally strongest stocks started to look like absolute bargains. And in the second case, he (Mr. Market) became so optimistic that even the fundamentally weakest stocks started trading at way above their intrinsic values.

A solid infrastructure financier feels the pinch

The recent stock market meltdown, which enveloped markets across the world, also had a severe impact on the Indian markets, pulling down market caps of most blue chip companies drastically by a few percentage points. One such company that bore the brunt was IDFC, one of India's largest infrastructure financing companies known for its excellent management quality and having brilliant growth prospects. However, Mr. Market had turned so pessimistic during that period that the market cap of the company tumbled by nearly 60% from its highs. Given the fundamentals of the company, such a fall was indeed not justified. But Mr. Market was in such a depressed mood that he just dumped the company's shares, resulting in a sharp fall in the stock price.

Later on, when rationality returned, Mr. Market finally came to senses, he realised the folly and started giving the company its due. Slowly and steadily, the stock price of the company inched upwards and has now made up for most of the lost ground, edging higher by more than 80% in a short span of few months! Nothing much has changed in the company fundamentally, but it was the victim of Mr. Market's selling frenzy.

The 'power'ful crash

Moving to other extreme of Mr. Market's mood, few years back, the power sector was his blue-eyed boy. In fact, so happy was he with the sector's 'growth prospects' that it had led to market cap of most companies in the sector recording a manifold rise in their stock prices in a matter of few months. However, amidst all the euphoria he forgot that the sector has huge gestation period and hence, there could be a lot of roadblocks along the way. Indeed, when such roadblocks appeared, the stock prices of the same companies came down as fast as they had gone up.

Thus, as we saw in the above examples, Mr. Market will not always appear rational and it this irrationality that value investors should try to capitalise on while making investments.

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