One of the best feelings in the world is buying shares of an individual stock and seeing the price jump. You pat yourself on the back and say, “I am an investor.”
Perhaps you followed the advice of former Fidelity mutual-fund manager Peter Lynch to invest in what you know so you bought into a company that you think has great products because you use them. The company’s revenue is soaring and coverage in the financial press is favorable.
Maybe you followed the advice Warren Buffett gave in the Berkshire Hathaway 1996 annual letter to evaluate a business within your circle of competence. Your goal in doing so was “to purchase at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”
What you probably didn’t say when you bought the stock is, “I am right about this stock, while most investors are wrong.” Such a statement sounds arrogant, but buying an individual stock is an arrogant act. Billionaire hedge-fund manager Seth Klarman said, successful investors “have the arrogance to act, and act decisively, and the humility to know you could be wrong.”
Purchasing an individual stock is arrogant because the investor is saying the current stock price is wrong. That the price investors have agreed to transact at is too low.
The intrinsic value of a stock (which is another way of saying its correct price) is the value in today’s dollars of the stock’s future dividends, which represent the portion of profits paid to shareholders. Each stock has an embedded growth assumption for the company’s expected revenue, profits, and dividends. Only stocks that grow faster than what the consensus of investors has assumed will outperform the overall stock market.
Each day the market is littered with stocks whose shares plummeted because the companies missed their earnings estimates or made an announcement to suggest the consensus of investors had been too optimistic about the companies’ future prospects.
In his 1996 letter, Buffett should have added four additional words regarding the goal of individual stock investors. The goal should be “to purchase a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now” than what investors expect.
Who are these other investors whose expectations determine the market price of stocks? What might they know that we don’t?
In 1949, renowned value investor Benjamin Graham published “The Intelligent Investor,” a book that Warren Buffett read when he was 19 and says is “by far the best book about investing ever written.”
In the book, Graham wrote, “If you have formed an opinion about the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data or reasoning are right.)”
During the 1940s, when Graham was writing and publishing “The Intelligent Investor,” more than 75% of U.S. stocks were held directly by households. That means when Graham bought a stock after having done his research he usually knew more about the company than the household or other entity that sold the stock to him. He knew more than the crowd and earned superior returns.
Today, households directly own less than 38% of the U.S. stock market. Most of their stock exposure comes through their ownership of mutual funds or ETFs or their participation in work-sponsored retirement plans. When you buy an individual stock, the likely seller is an institutional investor, including algorithmic traders.
Before we invest, we should first ask, “Who is on the other side of the trade?” Who are the entities that dominate trading in that particular asset category? For the U.S. stock market, the answer is institutional investors including hedge funds, high-speed quantitative traders, and large portfolio management teams. This group of investors who collectively determine the price of individual stocks have far more knowledge, capacity, and resources than we have as individual investors to determine a stock’s intrinsic value.
Of course, the consensus is often wrong. Individual stock prices are not always correct. The price of a security does not always reflect its intrinsic value. But do we have the skill to identify those mispriced securities? Are we smarter than other investors? Most professional investors fail to outperform the market, as measured by benchmark indexes such as the S&P 500 index or the Dow Jones Industrial Average. Still, some professional investors do outperform, as do some individuals.
Warren Buffett in that same annual letter wrote, “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
Of course, we can choose not to follow the indexing path, but we should at least recognize the arrogance in choosing to do otherwise when we invest in individual stocks.