Why Don’t Value Investors Always Buy the Dips?

In the short run, the market is a voting machine; in the long run, it’s a weighing machine.

For fun, let’s assume you’re a value investor looking at GM in late 2015.  Like all good value investors, you want to make decisions based on “intrinsic value” – that is, what a company is worth, not where the stock trades today.  Taped on your wall is Benjamin Graham’s quote, “In the short run, the market is a voting machine; in the long run, it’s a weighing machine.”  You think like a business owner, not a trader.

You trawl through the financial statements to understand GM’s earnings and, more importantly, cash generation.  You’re on high alert for anything in the footnotes that suggests accounting gimmickry.  You study industry dynamics.  Management’s focus on shareholder value gives comfort that they won’t destroy it through vanity acquisitions.

To determine intrinsic value, you create a financial model with cash flow estimates out multiple years.  You carefully articulate your assumptions, like cars sold, revenue per car, costs of goods sold, debt servicing, shares outstanding, etc. etc.  You calculate a weighted average cost of capital for the company, discount the cash flows back to the present and estimate that the company is worth $50 per share (this analysis is purely hypothetical).  With the stock trading at $36, you buy it with a nice margin of safety.

Now January rolls around.  The market sells off 8% and GM is down 15%, below $30 a share.  Ironically, the market drawdown is driven by a collapse in the price of oil, which should be great for GM.  Logic suggests that you should back up the truck.  A bargain just got cheaper.

In practice, though, this often doesn’t happen.  Why?  Most importantly, intrinsic value is not static.  The $50 per share valuation relies on dozens of implicit assumptions about the state of the world:  no hard landing in China, no widespread bankruptcies in the oil patch, no banking crisis and many other things.  We assume unlikely bad things won’t happen; we round down to zero.  When oil dropped to the mid $30s, many of those concerns couldn’t be ignored.  Change the assumptions, and maybe intrinsic value is now $40 and $28 isn’t a no brainer.

The second issue is how you react to losses.  Seeing GM decline shakes your confidence.  Did you miss something?  $30 per share seemed impossibly cheap a month ago, but now $25 or even lower is in sight.  Losses on the position are still manageable, but what if you’re catching a falling knife?  You can’t help thinking about value stocks that went down 80% or more during the crisis.  Some stocks are “cheap and built to stay that way.”

The final issue is that you don’t invest in a vacuum.  As Keynes noted, “the markets can remain irrational longer than you can remain solvent.”  You might not have a job by the time GM stock reaches its intrinsic value.  Even if buying more stock is rational, you may hold off.

This quandary then highlights three important themes in the investing world:  fundamental valuations are dynamic, behavioral biases influence investment decisions, and agency issues can lead to economically irrational decision making.

January 20, 2016