UW-P
INVESTMENT
CLUB
LESSON 2: FACTORS IN MARKET MOVEMENT
Fall Semester:
1
2009
Material
Lesson 2
Factors in Market Movement
Now that you know how the stock market works, we are going to take a closer look at the individual factors that cause
wild fluctuations in stock prices. Understanding this concept will help you to take advantage of the manic-depressive
behavior that sometimes seems to affect your portfolio. The last part of Lesson 2 will focus on explaining Ben Graham's
famous metaphor "Mr. Market".
Before reading the lesson, you should write down or print these vocabulary words and their definitions. They are
concepts and terms that are used every day in the financial world and are relatively simple to understand.
Vocabulary
Bear Market: Slang for when the stock market is in a general, prolonged period of falling stock prices. Opposite of a bull
market.
Broker: A person who buys or sells an investment for you [stocks, bonds, commodities, etc.] in exchange for a fee,
called a "commission"
Bull Market: Slang for when the stock market is in a general, prolonged period of rising stock prices. Opposite of a bear
market.
Dividend: A dividend is a portion of a company's earnings that is paid out to shareholders on a quarterly or annual
basis. Most dividend policies are set by the current management.
Exchange: An exchange is a place in which options, futures, and shares in stocks, bonds, indexes, and commodities are
traded. The most famous in the United States is the New York Stock Exchange.
Index: An index is a benchmark which is used as a reference marker to which financial performance is measured and
compared against. The Dow Jones Industrial Average and Standard & Poor's 500 are examples.
Institution: A word used to describe any company, brokerage house, or entity that is not an individual.
Margin: A margin account lets a person borrow money from a broker to purchase securities. The difference between
the amount of the loan, and the price of the securities, is called the margin.
Market Maker: A market maker is a person, brokerage, bank, or institution that maintains a permanent firm bid and ask
price on a certain stock. This means that they are standing and prepared at any moment to pay a particular price to buy
or sell a stock.
Mr. Market: An investment concept created by Benjamin Graham in the early part of the 20th century. Will be
discussed in this lesson.
Sector: A group of stocks that are in the same business [e.g., the "Utilities" sector would include Water and Power &
Light companies].
Volume: The number of shares of stock traded during a particular time period.
Introduction
In the last lesson, we established why stocks came into existence. In this essay, we are going to examine how the
stock market actually works - everything from what drives stock prices up and down to how stocks are purchased on an
exchange. Perhaps more importantly, we will discuss one of [if not the] most important investment concept of all... Mr.
Market.
What Makes Stock Prices Go Up and Down
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In the introduction to the first lesson. I wrote that the entire purpose of these essays was to reach the average investor
that it is possible to look at the financial statements of a company and determine what the stock is really "worth".
Ideally, the investor is looking for companies that are trading below their "true" (or intrinsic) value, with the belief that
someday the market will realize these securities are undervalued and the stock will rise. This reveals one of the selfevident quirks of the stock market. Sometimes companies will trade for half their value, while at other times, they will
trade for 2, 3, 5, 10, or 20 or more times more than they are really worth. While this creates wild price fluctuations
(known as "volatility" in financial jargon), it is the very thing that allows us, as investors, to make money.
For a moment, we are going to discuss the 4 most common things that cause these price-swings. (In other words, we
are answering the question "Why do the stocks of good businesses sometimes sell below or above their intrinsic value?)
They are:
1.) The investor vs. the speculator
2.) The commodity nature of stocks
3.) Life (it sounds general, but it will make more sense later)
4.) Temporary Problems
First, let's look at the Investor vs. Speculator.
The Investor vs. Speculator
Over the course of the past several decades, the term "investor" has been used for anyone who owns a share of stock.
It is important that you understand this is not the case. When a person buys a stock, they are doing it as one of two
people: either an investor or a speculator.
What's the difference? An investor is someone who carefully analyses a company, decides exactly what it is worth, and
will not buy the stock unless it is trading at a substantial discount to its intrinsic value. They are able to say, for example,
that "Company 'X' is trading for $48 per share, but it is worth $62 per share." They make their investment decisions
based on factual data and do not allow their emotions to get involved. A speculator is a person who buys a stock for any
other reason. Often, they will buy shares in a company because they are "in play" (which is another way of saying a
stock is experiencing higher than normal volume and its shares may be being accumulated or sold by institutions). They
buy stock not on the basis of careful analysis, but on the chance it will rise from any cause other than a recognition of its
underlying fundamentals. Speculation itself is not necessarily a vice, but its participants must be absolutely willing to
accept the fact that they are risking their principal. While it can be profitable in the short term (especially during bull
markets), it very rarely provides a lifetime of sustainable income or returns. It should be left only to those who can
afford to lose everything they are putting up for stake.
How do these two different types of activity affect stock price? The speculator will drive prices to extremes, while the
investor (who generally sells when the speculator buys and buys when the speculator sells) evens out the market, so
over the long run, stock prices reflect the underlying value of the companies. If everyone who bought common stocks
were an investor, the market as a whole would behave far more rationally than it does. Stocks would be bought and
sold based on the value of the business. Wild price fluctuations would occur far less frequently because as soon as a
security appeared to be undervalued, investors would buy it, driving the price up to more reasonable levels. When a
company became overpriced, it would promptly be sold. Speculators on the other hand, are the ones who help create
the volatility the value investor loves. Since they buy securities based sometimes on little more than a whim, they are
apt to sell for the same reason. This leads to stocks becoming dramatically overvalued when everyone is interested and
unjustifiably undervalued when they fall out of vogue. This manic-depressive behavior creates the opportunity for us to
pick up companies that are selling for far less than they are worth.
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This leads to a fundamental belief among value investors that although the stock market may, in the short-term, wildly
depart from the fundamentals of a business, in the long-run the fundamentals are all that matter. This is the basis
behind the famous Ben Graham quote "In the short-term the market is a voting machine, in the long-term, a weighing
one." Sadly, some reject this basic principle of the stock market. Several months ago, I received an email from a reader
who asserted that "the economic fundamentals of a company have no relation to the stock price." This is completely
false. My response was a simple message that read "If fundamentals don't matter, what if Coca-Cola never sold another
bottle of Coke? How long do you think the stock price would stay at its current level?" When put in this light, the folly
of the "fundamentals don't matter" becomes evident. The next time someone preaches this, simply ask "what happens
to the stock if the company can't make its payments and defaults on its loans?" When they answer "it goes bankrupt",
simply smile and walk away. Fundamentals do matter.
Unfortunately, countless investors believe the myth this gentleman does. The perfect example of this is the dot-com
boom of the late 1990's. Companies that generated no profit and had very little, if any, book value were selling at
astronomical levels. "Surely this would prove that fundamentals mean nothing," some would argue. On the contrary, it
proves our point entirely. Only a few short years after the initial stock market bonanza, the economic realities of these
companies came back to haunt them. Most fell 90% or more from their highs, with many more going bankrupt,
ultimately worth less than the paper their stock certificates were printed on.
The Commodity Nature of Stocks
One of the elements that contribute to the fluctuation in stock prices is the nature of the stock market itself. In lesson
one, I explained the stock market is, at its core, "a large auction where ownership in various companies is up for sale to
the highest bidder." Since there are only a set number of shares available at any given time, any buying activity will
drive the price of these shares up. Selling will drive share prices down.
In this respect, stocks are no different than a commodity such as oil. They are subject to the same laws of supply and
demand. When there are more shares available than demand, each of those shares is worth less. The opposite is true
when there is more demand than shares available. This explains why institutions and very wealthy individuals build up
positions1 in their favorite stocks slowly. If someone wanted to buy several million dollars worth of stock in a company
and they simply placed on massive order with their broker [this is known as a block trade2], the stock price would
skyrocket because there wouldn't be enough shares available at the time to fill the order. The same is true when a
wealthy individual or institutions wants to sell a large chunk of stock in a company. If they were to dump them on the
open market all at once, there would not be enough buyers to buy the stock they were selling. This would cause the
stock to immediately tank, wiping out huge amounts of market capitalization, even though the underlying economics of
the company haven't changed.
1 When someone is said to be "building up a position" it means they are slowly accumulating shares in a company.
2 A block trade is generally considered to be anything over $100,000 or 10,000 shares.
Life
This leads us to the third factor that causes stock price fluctuations. Life. Say, for example, that a wealthy individual dies
and his family needs to sell of a substantial amount of stock for tax purposes. Or maybe a large company or institution
runs into financial difficulty, wants to build a new production facility or pay down debt. It will sell its shares and stock
holdings to cover this expenditures. In both cases, large amount of securities are going to be sold, none of which are in
connection to the company performing badly. Even though the stock may be an excellent investment, suddenly there is
a large sell order that will drive the price down. This sort of event is, in most cases, unpredictable and can help drive a
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wonderful business to a selling price below what it is worth. These are the type of investments we are looking to make;
great businesses that have been temporarily driven down to unjustifiable lows.
All three of these factors work together to help drive stock prices to either extreme. Once an investor understands
them, he or she is free to take advantage of them.
Temporary Problems
Before we continue, there is one more factor that occurs fairly often and can move a stock to extremely low levels.
Generally it goes something like this; a good company runs into temporary trouble that neither endangers its life or
affects long term profitability. Wall Street nonetheless overreacts in its characteristic way, and punishes the company
by driving the stock lower.
This was the case with American Express in 1963. The company had revolutionized travel with the introduction of
traveler's checks, and had tremendous success with the introduction of the American Express card. The business ran
into trouble when one of its subsidiaries, a warehouse in Bayonne, New Jersey, was the subject of massive fraud. A
company known as Allied Crude Vegetable Oil Refining parked tanks of vegetable oil in the warehouse in exchange for
receipts which guaranteed the tanks existed and contained what they were said to. Allied used these receipts as
collateral on loans. The problem began when Allied defaulted on its debt. Creditors moved in to take possession of the
vegetable oil stored in the American Express warehouse. When they went to open the tanks, they found that they
contained not vegetable oil, as American Express had guaranteed and issued receipts for, but sea water, which is worth
far less. The creditor's collateral was worth $150 million less than thought, and American's subsidiary was partially to
blame for issuing the guaranteeing receipts. Although the company may not have been forced to pay anything [since
the mistake was made by a subsidiary and not the parent company itself], the then-CEO Howard Clark felt the business
was "morally bound" to try to make up the different. He offered $60 million to Allied's creditors. The stock was driven
from $60 per share to $49 1/2.
Although the loss of sixty million dollars was nothing to be scoffed at, it certainly was not going to ruin the company.
Wall Street had overreacted and punished the stock more than was called for. The stock would eventually return to its
previous levels, and in ensuing years, climb much higher, making a substantial profit for the investor who was wise
enough to recognize that 1.) the company was not in serious danger, and 2.) he or she could take advantage of the
temporary situation and Wall Street's folly in over-punishing the business, and pick up the stock for a cheap price.
This leads us to to the final point of this lesson: Mr. Market. We have now established why stock prices are sometimes
driven to highs and lows. Now we are going to go one step further and explain how the investor should think about the
price swings of the market.
Mr. Market
As I've made clear in these essays, an investor should treat each of his or her stock purchases as if they were going to
buy the entire company. In most cases, you don't need to worry about the economy or even the stock market as a
whole. The only requirements of a relatively successful investor are the ability to value a business and the right
psychological approach to stock prices. We are going to firmly establish the second of these valuable skills in this
portion by explaining the concept of Ben Graham's "Mr. Market". This relatively simple metaphor will forever change
the way you look at stock prices, and if employed correctly, increase your investment returns noticeably.
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The concept of Mr. Market goes something like this: imagine you are partners in a private business with a man named
Mr. Market. Each day, he comes to your office or home and offers to buy your interest in the company or sell you his
[the choice is yours]. The catch is, Mr. Market is an emotional wreck. At times, he suffers from excessive highs and at
others, suicidal lows. When he is on one of his manic highs, his offering price for the business is high as well, because
everything in his world at the time is cheery. His outlook for the company is wonderful, so he is only willing to sell you
his stake in the company at a premium. At other times, his mood goes south and all he sees is a dismal future for the
company. In fact, he is so concerned, he is willing to sell you his part of the company for far less than it is worth. All the
while, the underlying value of the company may not have changed - just Mr. Market's mood.
The best part of this entire arrangement: you are free to ignore him if you don't like his price. The next day, he'll show
up at your door with a new one. For your interest, the more manic-depressive he is, the more opportunity you will have
to take advantage of him [don't worry, he doesn't have feelings or mind being taken advantage of.] As long as you have
a strong conviction of what the company is really worth, you will be able to look at Mr. Market's offers and reject or
accept them... the choice is yours.
This is exactly how the intelligent investor should look at the stock market - each security that is traded is merely a part
of a business. Each morning, when you open up the newspaper or turn on CNBC, you can find Mr. Market's prices. It is
your choice whether or not to act on them and buy or sell. If you find a company that he is offering for less than it is
worth, take advantage of him and load up on it. Surely enough, as long as the company is fundamentally sound, one day
he will come back under the sway of a manic high and offer to buy the same company from you for a much higher price.
By thinking of stock prices in this way - as mere quotes from an emotionally unstable business partner - you are free
from the emotional attachment most investors feel toward rising and falling stock prices. Before long, when you are
looking to buy stock you will welcome falling prices. The only time you want to invite high stock prices is when you are
eager to sell your securities for some reason. Thankfully, in most cases [except those caused by "Life" which we
discussed earlier], you are free to wait out Mr. Market's emotional roller coaster until he offers a price that you consider
equal to or higher than intrinsic value. This is perhaps your greatest advantage in your investments.
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