As stocks nosedive, don’t lose sight of the difference between price and value
A cynic is one “who knows the price of everything and the value of nothing.” This comment, by a character in one of Oscar Wilde’s plays, does not refer to the stock market. But it serves as a good description of what happens at times like the present.
When stock market prices are rising, many investors are comfortable thinking about the intrinsic value of their investments. But when prices fall dramatically, fear causes us to focus only on recent stock prices. We are inclined to become cynical about longer-term rewards. Imagine what happens to your longer-term thinking when someone shouts “Fire!” in a movie theatre. A major price decline has the same effect on your time horizon.
Advisers and financial journalists are not immune. Their commentary switches from underlying economic value to market prices. We have now, they proclaim, “officially entered a bear market,” arbitrarily defined as a 20-per-cent drop in the stock market index from a recent high. Why is a 20-per-cent drop materially worse than a 19.5-per-cent drop? And why measure it from a recent, and possibly idiosyncratic, high point rather than, say, the price one year, or five years, ago? Your answer depends on your time horizon.
At times like this, it is worth remembering that your mindset should not change with the direction of the market. If you own stocks, you have an interest in a number of businesses. The economic value of those businesses is simply the value of all their future profits discounted to the present.
The rate at which you discount those future earnings is a function of long-term interest rates, which act like gravity on the value of all income-producing assets. This includes stocks and longer-term bonds. And particularly leveraged investments such as real estate and private equity. As long-term interest rates rise, the present value of all those assets fall. This is the principal reason for the recent stock market decline.
Naturally, the reverse occurs – that is, values rise – when long-term interest rates fall. This does not happen until the rate of inflation is expected to fall – which typically requires a period of reduced, or negative, economic growth.
All this may sound a tad pessimistic. But only to those who cannot take a longer-term view. Most of a company’s value is derived from profits that will be earned more than five years in the future. So negative growth in 2023 would have less effect on the value of future profits than you might assume. And if negative growth results in lower long-term interest rates, that will raise the economic value of all businesses.
While stock prices move up and down in the shorter term, those prices will, over time, inevitably follow the economic value of the businesses higher. In addition, you will receive some dividends along the way.
History tells us that, over the long run, North American stocks will provide a total rate of return (price appreciation plus dividends) about six percentage points greater than the rate of inflation. So, if inflation averages 3 per cent over time, that would be an average of about 9 per cent a year.
Both fees and tax will reduce that return. However, assuming you are not paying a high fee and you reduce your tax by minimizing portfolio turnover (less buying and selling of shares), your average long-term return, even after fees and tax, should be more than four percentage points above the rate of inflation. Over time, the purchasing power of your capital will increase dramatically.
The issue, of course, is the phrase “over time.” Your chances of receiving at least the return described above are good over any five-year period, and extremely good over a 10-year period. And your odds improve with every additional year. But, particularly at times like this, we are all hard-wired to think short-term. What, we ask, did the market price do over the past year or the past three months?
It is precisely these worries about short-term returns that ensure public companies usually trade at a price that gives investors the investment results described above. If prices were not volatile in the short-term, they would not provide such attractive long-term returns. Publicly traded stocks remain the single best liquid, unlevered, long-term investment.
Is this a good time to buy stocks? No one knows what the market will do over the next year, but one approach that may allow you to sleep better is to invest any new capital gradually – say, one quarter of your funds every three months.
Like Wilde, Warren Buffett has spoken of price and value. “Price is what you pay. Value is what you get.” Those who can focus on economic value rather than price will be handsomely rewarded – over time.