The Business vs. The Stock

December 17, 2007 by Joe Ponzio

The markets have done some crazy things the past few days weeks months years. In fact, it is enough to make one’s stomach turn. That is, of course, until you remember the key to owning stocks: There is a business under there – and that is what drives the long term price.

As Buffett said:

You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep. No one at Gillette has trouble sleeping.

It is easy to get caught up in the stock price. We can buy a company for all the right reasons, and then begin to doubt ourselves when the price starts dropping. Did I make a mistake? What if I overvalued the company or projected too much growth? Does Wall Street know something I don’t?

There’s A Business Under There

When it comes to investing, it is critical to remember that you are buying a piece of a business. Just because you do know the daily stock price doesn’t mean you should know it?nor does it mean that the daily price is relevant.

If you bought a hot dog stand for $100,000, would you freak out every day when brokers were calling you – offering $80,000, and trying to rip you off? Would you freak out if you read an e-mail about how Americans are boycotting hot dogs? Or would you judge the health of your hot dog stand based on the number of customers coming through the door?

The above Buffett quote contains a profound message: The daily business done at your company is independent of the company’s stock price. Think about it: Did you ever pass a McDonalds last year and decide not to eat there because it was a $35 stock? Do their hamburgers taste better today at nearly $60 a share?

The Margin Of Safety Works

Why do we strive to buy $100 bills for $50? Sure, it can lead to huge profits. But there is a flip side to that coin. What if you were wrong about your valuation? What if growth won’t come in at 15% for the long term – but at a mere 7%? Enter the margin of safety.

Let’s say you estimate that your company will grow $1,000 of earnings at 15% for three years, then 12% for three years, then 10% for another four years. Finally, growth slows to 3% for the next ten. You estimate the value around $64 a share once you add in $10,000 of equity and divide by 500 outstanding shares.

Because you don’t want to overpay for this company, you won’t pay $64 a share; you wait until it is trading at $32 – a 50% margin of safety. But the future doesn’t turn out exactly how you planned. Rather than growing at a nice clip, the company grows at just 7% for the next ten years. Year 10 free cash flow comes in at a mere $1,967 vs. the $3,128 you projected. What you thought would be a $170 stock is trading at just $93 – ten years after you bought it!

Did you do the math already? Rather than bringing home an 18.8% average annual return, you eked out an 11.2% average annual return – and you are kicking yourself. Still, the margin of safety saved you. Without the 50% margin of safety, you would have had a mere 4% return after ten years had the company slowed and you bought at $64.

The Moral: Forget Today

Go back and take a look at everything that was said in this story. Notice I never once said anything about the stock price the day after, the month after, or even a year after you bought it. As a business investor, you must allow your businesses time to grow and you must allow the markets to realize their mistakes and correct them.

Let’s Return To The Legend and Coca-Cola

In the summer of 1988, Buffett began buying Coca-Cola. We don’t know the exact date, so let’s pick June 15th as the start of his buying frenzy. Over the next three months, Buffett would have seen his investment in Coca-Cola drop by nearly 8%. It would have gone south right off the bat and he would not see break-even again until early September.

And it wasn’t a smooth ride. Down 4%. Then, it threatened break-even. Back down 5%. Almost even again. Down 7%. Yep – gut wrenching. Bute he was buying a business – not a stock.

Learn To Say, “Nice!”

Every time the markets run up 200 or 300 points, people tend to get happy. The typical reaction I see: The markets are doing well, huh? Up 300 points. Nice! Here’s an exercise for you. Try to maintain that same reaction when the Dow drops 1,000 points in a week. The market’s down big. Companies may be on sale. Nice!

Even if you plan on retiring at the end of the year, you still have 20 or more years of investing in you! Don’t worry about the markets. They’ve made it through the Great Depression, two World Wars, a Cold War, numerous recessions, the Cuban Missile Crisis, and more. We’ll get through the housing bubble. And if we don’t? Then who cares what your stocks are worth? Your money won’t be worth a damn anyways!

A Note From Joe Ponzio

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