During the last bull market, people expressed their love for investments with prospects that increase in value over the years. Nevertheless, it seems that what they really dreamed of were investments that increase their price. That’s why, now that the prices are falling downcast, they feel sad and some of them have started to panic.
For them, it is shocking to see -24% drawdowns for the SP500-35% for the Nasdaq (COMP.IND), and -78% for ARK Innovation (ARKK). The last instrument aptly describes the appetite of this new generation of investors, who have been living the illusion of the turkey, expecting to be fed forever, and finally seeing the face of the butcher.
So, should we panic or not? To find an answer, you need to go back and revisit the logic that got you into the market in the first place. Speculation and invest are two very different activities, and chances are you have, accidentally or deliberately, been speculating instead of investing. The story below will help you understand the difference and why what you may have done is “investing” in name only.
A few months ago I had a discussion with someone who told me his story about investing in an apartment. Adding price appreciation to rents, it doubled its capital in a decade. These are returns that even some equity investors would be jealous of. After this success, she considered buying a second apartment in London, contrary to the advice of a financial adviser – friend.
The adviser said she would be better off if she chose to buy something outside of London, say in the north of England, where she could get a decent return. His point of view, after his first successful experience, was that what matters is not only the rent. Appreciation made most of her gains, and she believed a flat in London would rise in price significantly in the future, as it has for the past decade.
Both opinions carry some truth. The critical point, and what I tried to explain to him, is the difference between the the pricewhich is what you pay, and the assess, which is what you will get (the rents). So, for example, if rents in London are about to double over the next decade, and continue to do so over the next few decades, this is the true future value. So if the current higher price and lower yield reflects that reality, then I really take his side. Honestly, this might be doable for a place where almost all young and ambitious professionals want to live.
But if rents in London are not to grow at a higher rate than in the rest of the country, then paying a higher price – receiving a lower yield, is not justified and means lower long-term returns. She insisted that it doesn’t matter much, as long as the price of the apartment increases significantly. I could understand the mathematical explanation, but I insisted that at some point, a “simple” price appreciation cannot be sustainable.
Both are called “growth” these days, and people, by failing to distinguish the difference, end up paying too much. In most cases, price and value, especially over the long term, are correlated. But sometimes, when something starts to appreciate abnormally, they disassemble.
Interestingly, the biggest bubbles are where there is no value, because rational investors aren’t there. They are the ones who could be potential sellers of the overvalued securities and balance the prices. A good example of this phenomenon is the crypto universe, essentially a dangerous zero-sum arena full of pure speculators and with no real investors – and perhaps no real value, dare I say.
When this happens, the people involved, even when they claim otherwise, essentially start worshiping the price, not the value. In the long term, it is catastrophic. Ideally you want to buy £1 for 50p, not the other way around. But people buy the pound for three, four, and so on, and they put more and more fuel into the madness.
Overpaying is what leads to loss, and that’s what you need to know to know how bad your position is. Ask this question: “Will the rents or income of the business increase (future value), or only the price?”. And then, “If rents/income are to increase, has the price reflected more or less than that?”.
No one knows the future and future cash flows of anything with certainty and precision. What we can do is get closer to it. The best investors in the world are not only those who can approach it best – obviously they can, but more importantly, those who can deeply understand and embrace the concept that I aim to explain in the article. This is the greatest advantage you can have in the stock market, which, believe me, is more important than IQ or great analytical skills.
Regardless of what the stock market is doing right now, think about a range of the actual value of your business. My 2020 article on Zoom (ZM) is an example of such a process. When I wrote it, I estimated the actual value at around $35 billion ($121 per share), based on the base case scenario and its assumptions. The stock was trading above $500 per share at the time and is currently trading at $113 per share.
Read more: Let’s explore the value of Zoom together
Now, if you disagree with me and the assumptions of the base case scenario, and think Zoom can continue to grow for a few more years, then the stock is a good deal. But having bought the stock for $500, only very good scenarios for the company can make you recover your initial investment.
Having a horizon of 10 years, stock market ups and downs will not affect you meanwhile, in itself. What matters is what companies will produce and the price you paid to acquire them. This is the case for every productive asset or business, call it an apartment, a factory or a startup. Stocks are elements of business, and they are absolutely no different. The fact that the majority of market participants use them for speculation is another story, and this is the main reason why they perform poorly.
Next time you visit the stock market, think of it as a place where they sell true ownership certificates. They are not selling tomatoes, but acres of fields that produce them. They do not sell cars, but fractions of the factories that build them. Somehow you’re gonna buy “wealth printers”. You want to pay as little as possible and get things that print as much as possible.
Since you realize this, these thoughts should overwhelm your mind and, therefore, you should do things differently. Low prices will not be uncomfortable, as price and value will stand out in your mind, and their distance will feel like a “river of profit” flowing from the present to the future. If they don’t, they never will, and maybe you’re not cut out for it.
Going back to the crash we are experiencing, it is true that some of the high growth companies are becoming exceptional investments at these prices. Normal growth in their income means you won’t lose money, and better growth means you’ll do pretty well.
However, I think the bulk of high growth companies are still expensive despite declines of over 50%. It is possible to see them trading even below their fair value, before value investors recognize them as bargains, which may mean more price difficulties ahead.
In short, the future real winnings define real value. If you bought below this value, you are not going to lose money in the long run and you should not worry about this crash at all. If you paid more than that, accept your losses, as it is/was a matter of time for the reality to appear. And if your stocks are still trading above their value, despite the huge drop, expect more pain.
This is the framework of a true investor. If you entered the market with a speculator frame, then ask a speculator what to do. And if you got into it for fun, accept the bill, like you do in casinos. I hope you haven’t spent all your savings on having fun.
As a true investor, don’t panic. Just diversify and always ask yourself: “Is the price I’m paying justified?”. Then relax to the sound of flowing value. Take advantage of the “rivers of profit” by cautiously buying the “printers of wealth”!
Original article on Investorblog