This post is totally out of sync with my 1950s & 1960s Buffett discourse; however, Night ran into a problem that needs fairly quick solving. His sister gave him a sum of money to begin investing and, after explaining how the markets work, that price follows value, etc., he purchased a stock for her. In just days, she was down 15% (though it rallied again after hours to bring her loss to just 1% or 2%.
How can he convince her to stay the course over the long term? Buy her a Happy Meal!
Without letting her know why you are going, take your sister (or loved one) to a McDonald’s – preferably a busy one around lunch time. Buy her lunch and enjoy 30 minutes or so of her company. Then, lay it on her.
Night: Do you know why I brought you here?
Sister: Uh, no.
Night: Do you see everyone in line, waiting to throw money into the register for the chance to eat a sub-par hamburger?
Sister: Yeah. So?
Night: Now, let me ask you a question: If you had the chance to own McDonald’s – I’m talking, the entire company here – would you want it? Would you want to be the sole owner of the entire company – and all its $21+ billion in sales?
Sister: Of course!
Night: Well, you can. If you wanted to buy McDonald’s – the entire company – you would have to pay some $67 billion today. That’s what the stock market is pricing it at.
Sister: I’ll keep that in mind if I come across $67 billion.
Night: But wait…over the past year, the stock market has priced McDonald’s – the entire company – anywhere between $50 billion and $75 billion. So, another question: Is McDonald’s – the entire company – worth $50 billion, $67 billion, $75 billion, or more? Or even less?
Sister: I don’t know.
Night: But I do. Right now, McDonald’s is worth about $65 billion. (No need to go into the details of the valuation) In essence, at today’s price of 57-and-change, McDonald’s is a very fairly priced company.
Of course, I don’t know if it is worth exactly $65 billion. It might be worth closer to $70 billion; it might be worth closer to $60 billion. Now, here’s the funny part. Over the last year, you could have bought McDonald’s – a $65 billion company – for $50 billion. Sound like a good deal?
Sister: If I had $50 billion.
Night: And what if I told you that you could have bought the $65 billion business for $75 billion. Still sound smart?
Sister: (Her cocky, “no-duh” expression says it all)
Night: Now you see my point when buying stocks. We can’t predict when the markets will price our $65 billion companies at just $50 billion. When they do, we’ll jump on them. Will we buy at the absolute bottom? Probably not. Still, if McDonald’s – the $65 billion company – is a good buy for $50 billion, wouldn’t it be an even better buy at, say, $45 billion?
Sister: Yeah, but that makes sense in theory. But Uncle X lost millions in the stock market when it crashed. I remember – they were saying it was because interest rates went up and we went into a recession. Aren’t we headed for that now? Maybe I should wait.
Night: Do you know why Uncle X and crew lost so much money? They were buying $65 billion businesses for $70 billion, $100 billion, even $200 billion plus. They were focused on price and had no idea what the values of the companies were.
Take Microsoft for example. Big, huge company. You can buy it today for $320 billion. But eight years ago, Uncle X – like most others – were willing to pay $500 billion for a company that, at the time, was worth less than half that amount. People were paying $100+ a share for a company that, at the time, was only worth about $30 a share.
I’ve said it before – and it’s not my thing, a lot of rich people say it – price follows value. For Microsoft – just like in so many other companies at the time – the price was well above the true value of the company, and only one of two things could happen: 1) the price would fall to a level closer to the value; or, 2) the value would rise to meet price.
More times than not, result 1 happens and people lose their shirts. Make sense?
Sister: I get it – sort of.
Night: Let’s turn back to McDonald’s. The stock price is about $57 a share, down some 10% from its high over the last year. You see all those people in line? They’re still buying hamburgers even though the stock price is down. Why? Because there is a business that operates completely independent of the stock price.
24 hours a day, McDonald’s is selling hamburgers around the world – steadily and consistently. And every day, the stock price jumps around like crazy – usually for no reason. Why was McDonald’s selling for $17 billion less over the past year? Because people are nuts. I can tell you that McDonald’s – the company – didn’t grow 30% (from $50B to $65B) in the past year.
Instead, the markets went crazy – going from optimistic to pessimistic and back as they’ve done for 100 years and as they will do in the future.
Sister: Yeah, but McDonald’s price went up. My stock(s) is/are going down.
Night: Sis, we can’t control the markets. Our goal is to buy companies like McDonalds when people are willing to sell it for 20%, 30%, even 50% less than what it is worth. Then, we have to let time do its thing – convert the market’s pessimism towards McDonald’s into optimism. It won’t happen overnight. In fact, it may not happen for a few years. But so long as the company is growing, the price will eventually follow.
So long as people are buying hamburgers – or in your case, shopping at American Eagle Outfitters – your business is sound. I’ll (Night) keep an eye on what the business is worth, regardless of the stock price. If the business is starting to suffer or show warning signs, I’ll get you out. Until then, let’s wait until the markets turn their pessimism in retail into optimism.
Then, Night, let us know what happens. Just don’t be discouraged – some people will never get it.
Filed under: How to Think About Investing
Thank you, thank you, thank you!!!!
I have been toying around with thinking about how stocks work. Yes it is nice to see a stock go up in a short amount of time, get out, find the next one and so on…but it is hard. And I am not too good at that. By the time I realize it, it has made its move.
What I am good at is finding a good business and knowing if it is on sale or not. To reap the rewards of that might take a longer time. But it fits my style.
I went to return some clothes a few days after Christmas this year. I was astounded on the mark downs on clothing..( I have not been shopping in a few years….marriage, children, work..etc..) I saw a nice college named jacket on sale. The original amount was $110….on sale for $44. I said to myself, “That is a nice jacket!! But who in their right mind would pay $110 for it!!! It is worth maybe $60 at best.” And there it was on sale, marked down to $44.
I didnt’ buy it, not becuase something was wrong with it….I just didn’t need jacket.
Would I invest in the company that made the jacket…probably not. But I know good merchandise when it is on sale.
Now if I can just think the same way about stocks!!!
Dan
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Great post. I try to tell people all the time about investing, and how stocks are on sale now, and now’s the time to be buying. There is one lady here at work who keeps moving her money in and out of the mutuals in her 401k every time it drops. I tried explaining that she hasn’t “lost” anything, until she sells. But she just can’t handle the stress of it all. I told her if she can’t sleep at night then she needs to put all her money in a money market/stable value fund and leave it there and don’t ever look at it again. The sad part is, she would sell the day the market dropped, (which of course, wouldn’t take place until the next day) then the next day the market would go higher. She just didn’t get it either, and it was making her sick – so some people just aren’t made to be in the stock market.
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Thank you very much for this post, Joe. This is exactly what I said to her–I had practice explaining it to friends and family members right before (3 out of 3 of whom it really clicked for.. I’m directing them to resources such as this blog and some books:)). Unfortunately, it went straight over my sister’s head.
Apparently when I was asleep last night when my uncle was over they put in a market sell order for AEO & changed the password on her account. I asked her to give me a week to try and sell AEO at not-rock-bottom prices (below $18 IMO). Oh well. I tried. She lost somewhere between $2,000 & $2,500, now my uncle wants me to be responsible for her losses. Once again, she only freaked out this bad because of my uncle’s freaking out–I would of been able to convince her otherwise.
Just a crap situation in general. I recommend to never try and assist family with investment; except as a very detached 3rd party. Anything more? Atleast have it in writing.
Anyway, I too will keep a close eye on the stocks I own! Haha
But sorry for harping on and on everyone & thanks for the support!
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When it comes to family and close ones, it is best NOT to tell them which stock they you bought for them.
Just as Buffett did in his early partnership (and still does with BRK?) he releases performance figures only once a year.
Pabrai also only releases performance figures 4 times a year.
Keep your investing a black box to those that dont understand and it will benefit both parties.
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Good lesson here, thanks Night. Although I am sorry how it turned out for you. Chances are she will continue to watch the stock price and when it turns for the better then she will be ready to listen.
In the future I will explain in GREATER detail to my friends and family the idea behind buying a wonderful business at a low price and being patient enough to wait for the market to catch on. If they don’t seem to understand before I manage their money then I will give them the “You are not ready grasshopper” and politely decline.
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MCD P/E is way too high a speculative play with no magin of safety!!! YES it has durable competitive advantage and a great product moat but trading at almost forty times earnings there are a lot better companies to invest in. Graham states clearly there are no good stocks only cheap ones and expensive ones. I would wait until MCD P/E comes down to earth or just avoid it and not buy it just because the price keeps going up!!! A “speculator” mentality intuition is to buy a stock because it is rising playing right into the Mr. Market mentality talked about in the Intelligent Investor. People will always eat at McDonalds and it is a well run business but the stock is also well run UP!!! The whole restaurant sector is “toast” with rising fuel and commodity prices so wait for a huge buying oppurtunity P/E less than 17 and then you will be thinking like BUFFET!!! I try to think like BUFFET a lot and only eat cheeseburgers and drink 4 cherry Coca-Colas every day and my portfolio was up about 20% last year with no TECH,margin of safety,durable competitive advantage and product moat; all priciples of BUFFET and GRAHAM!!! CASH IS KING!!!
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Secret Agent Man (inside joke for geno),
I wasn’t recommending MCD (as Night said). In fact, if you reread the post, you’ll see that I explained how fairly valued McDonald’s was – give or take a few billion dollars. Since we are looking to buy when the companies in on sale at 50% or more, MCD is clearly a pass at these prices because we can’t be certain about the future and we don’t want to gamble that our assumptions are dead-on.
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Wow, I think this is one of the best things to show someone that has no idea how the stock market works.
If anyone asks me one day why I am fully invested in stocks, I’ll point to this thread.
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