Make Your Loved Ones Get It

January 10, 2008 by Joe Ponzio

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.

A Note From Joe Ponzio

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