Equity markets – Don’t rationalize the irrational

Equity markets – Don’t rationalize the irrational

It is said that most equity investors know the price of everything but the value of nothing. The markets are obsessed with price. In the short-term, price is determined by marginal opinion. As John Burr Williams in his book The Theory of Investment Value says, “Today’s opinion will make today’s price, tomorrow’s opinion, tomorrow’s price!”

Today, world over, rapid changes in opinion lead to rapid changes in price. One key reason for rapid opinion change (hence price change) is global integration of economies and markets. Take India for instance. Here, we have –

• Low import tariffs, leading to landed-cost dollar pricing for many products
• Limited capital account controls, leading to free inflow and outflow of FII and FDI monies
• Real-time global news flow, thanks to the internet.

These factors combine in various ways to keep creating short-term noise, influencing short-term stock prices. However, the underlying businesses that these stocks represent are not that volatile. Their value changes at a price which is unaffected by short-term noise and more influenced by longer term fundamentals such as –

• Quality of business – competitive landscape, return on investment, etc
• Quality of management
• Growth in medium- and long-term earnings.

 Equity markets tend to be highly irrational in the short-term but fairly rational in the long-term. So, investors are advised NOT to rationalize the short-term irrational prices of stocks, but instead, focus on the long-term rational value that their underlying businesses deserve.

Winner in equity markets = Strong emotional construct + Time-tested investment philosophy

Warren Buffett has said, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” Thus, in equity markets, winners will be those with a strong emotional construct, especially when managing public money.

A strong emotional construct will need to be complemented by a time-tested investment philosophy, a simple and clear investing process, and most important, courage and discipline to practice the philosophy/process through vagaries of the market.

In conclusion

The above discussion is aptly captured by Benjamin Graham in The Intelligent Investor, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Going forward, short-term irrationality may go to extreme levels. As investors, we must capitalize on these opportunities. We have to sharpen our techniques not only to buy right, but also to sell stocks at irrational extremes.