Rational investors can benefit from emotional Mr Market

The current market sell-off has all the hallmarks of the cycle of irrational panic that grips emotional investors

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I recently came across an article in a local newspaper titled JSE nears worst monthly performance in 10 years. When headlines like these start appearing, I always think of the cycle of irrational panic that times like these trigger amongst those investors who succumb to emotions.

Generally, significant price declines trigger fears in investors. They are unable to think rationally, to the point where they’ll happily avoid any potential of further loss – so they sell low. However, this point, when the fear is at its strongest and prices are at the bottom of the cycle, is exactly where the potential upside is the greatest.

As a result, these investors find themselves in a similar position at the top of the cycle. The fear of missing out on good returns is too strong, so they succumb at the peak and buy back.

Events that spook the market very seldom affect a company’s ability to grow shareholder value

Currently there are several global events that are creating fears among investors: the effect of trade wars between the US and China, Brexit, Italy splitting up Europe, a higher oil price, and higher US interest rates (to name a few). Although these problems are real, the issues investors are fretting about are already reflected in valuations. In fact, the market normally overstates the effects that events will have on company earnings. Our research has highlighted that sell-offs vastly exaggerate the potential impact of a crisis on a diversified portfolio. It also shows the minimal impact that crises have on the earnings potential of quality companies, thereby creating opportunities for the intelligent investor.

Emotional Mr Market provides the Intelligent Investor with great investment opportunities

‘The Intelligent Investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him – but only to the extent that it serves your interests.’ Benjamin Graham

Benjamin Graham in The Intelligent Investor used the concept of manic-depressive investors to explain how they provide rational, intelligent investors with great opportunities. As a student of Graham’s, this made a big impact on the young Warren Buffett, who today often refers to the emotional Mr Market:

‘In the short term, Mr Market will quote wildly diverging prices depending on whether he wakes up in a manic phase or a depressive phase. This makes the market very inefficient in the short term. But we know that over the long term the market is efficient and will reflect the true

The Intelligent Investor overrides emotion with objective research and analysis

The Intelligent Investor invests in a company because he believes that it is well positioned to generate good and consistent growth in shareholder value for many years, due to various factors.

He knows that few investors really perform adequate research before investing in a company. He also knows that ‘the average man is not blessed with an analytical mind . . . that his reasoning powers work in a rut from which he finds it painful if not impossible to escape, that many of his emotions and some of his acts are merely automatic responses to external stimuli…’ (adapted from The Psychology of the Stock Market by GC Selden, thanks to Michel Pireu, Street Dogs). This gives him the confidence to take advantage of Mr Market’s emotional behaviour.

Intelligent Investors understand the businesses in which they invest

This is especially critical in times of market turmoil. The combination of insufficient homework, acting on emotions, and poor understanding of what drives markets are lethal to investment success.

As an example, I’ve selected Essent Group (a US mortgage insurer in which our Sanlam Global Financial Fund and Sanlam Global Best Ideas Fund are invested). This is a great company that has a good track record of consistently growing net asset value or shareholder value (as shown in Figure 1). However, Figure 1 also shows that, every now and then, Mr Market gets emotional and pushes the share price down based on negative news flow. Nevertheless, these declines prove to be insignificant over the long term, providing Intelligent Investors with attractive investment opportunities.

Intelligent Investors stick to timeless investment principles that underpin sustainable, long-term returns

These investors:

1Understand what drives a company’s earnings.

2. Understand the value of the company.

3. Do their homework.

Whether you are investing directly in a company or a fund managed by someone else, it is important to understand and commit to the way that management or the portfolio managers invest and think. This helps you trust them despite inevitable short-term noise (and especially when there is the odd crisis).

4. Think long term.

5. Have patience.

I cannot write about the Intelligent Investor and not mention compounding. Charlie Munger of Berkshire Hathaway says about compounding, ‘Those who understand it benefit from it and those who don’t pay for it’. Compounding in investing can be incredibly powerful, but it needs patience. Needless to say, the higher the rate at which your investments compound, the more powerful the result.

6. Diversify.

Because the future is uncertain and we cannot predict what will happen, it’s important to diversify.

7. Accept volatility and live with it.

Know that markets regularly overreact and that news flow is mostly irrelevant in the long term. Share prices simply reflect the emotions of other investors, not shareholder value.

There will always be exceptions, which is why diversification is critical

Successful investing follows a process. In our case, this entails investing in companies with good track records when they are undervalued, which we believe will generate good returns over time.

Does this mean you should ignore share price movements? What about Steinhoff and African Bank? These are exceptions, and one shouldn’t base an investment philosophy on exceptions. That is why it is vital to make sure you understand what you are investing in and to always diversify, diversify, diversify. Why? Because none of us can ever have absolute certainty.

The question is not ‘When to invest?’, but ‘What are the fundamentals that underpin the investment decision?’

Many investors want easy answers, but you can never be 100% certain you are making the right investment decision at the right time. It’s about the balance of probabilities and processes. If you invest in quality companies when their valuations are attractive you will generally be rewarded over time.

Because the market generally operates in cycles, it pays to remain invested

Studies of markets show that a decline is normally followed by a rise in prices. This generally happens when emotional shareholders have sold out. It helps to have a catalyst, but often the catalyst is simply attractive valuations. To benefit from market weakness, it is sometimes best to remain invested, or better, to add to those investments that have been under pressure. When newspaper headlines shout poor market performance, Intelligent Investors will be reassured that the odds of attractive returns are in their favour. Mr Market is busy creating worthwhile investment opportunities.

 

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