At a recent talk I gave at the Australian Investors Association’s National Conference, I received one question more than any other: “Is it time to buy BHP?” Obstreperous commentators - paid by commissions on activity rather than returns – are incentivised to make headlines calling the bottom of the resource slump.
Price contains no information about value
Highly leveraged commodity producers with negative free cash flows, like America’s largest coal producer Alpha Coal, have filed for Chapter 11 bankruptcy protection, amid a steel oversupply emanating from China, and slumping commodity prices. This is the shot-across-the-bow for Vale and Fortescue, and places a darkening cloud above the prospects and future returns for BHP and Rio because highly leveraged producers must produce even more of the commodity amid declining prices to meet their interest expenses.
But these arguments are in fact superficial. At the core of the question is a lack of understanding of the difference between price and intrinsic value. Value is not presented simply because a share price has fallen. Price information is free and the reason it is free is because it contains no information about value.
Predicting share prices, which is in essence what the resource commentators are trying to do, is impossible to do consistently well, at least in the short-term.
Intrinsic value is the vessel that helps navigate the sometimes tempestuous changes in share prices. If you have formed your view on the intrinsic value of a company, you can navigate clearly through the thunder and high seas, the gloom and the hype.
Your share portfolio may still be buffeted around by the twin tides of fashion and sentiment, but with each rise and fall you are able to strengthen it, buying more below intrinsic value and perhaps selling when share prices are well above.
Suppose you have your eye on a company and its shares fall from $15 to $12. Should you buy now? What if you buy at $12 and the shares fall to $10? Suppose you decide to buy more. What if they then decline even further to $8 or even $6? When exactly do you buy?
Only if you are confident that the business is actually worth $15 per share are you able to see a fall in the share price – from $12 to $6, for example – for what it is: a terrific opportunity. The right response is to buy more. If you’re like me and you like chocolate, then surely it is rational to order more when your favourite block is on ‘special’ at the supermarket? It’s the same with shares.
Shares are like groceries
Treat buying shares the same way you buy groceries. You actually want the share price to go down so that you can buy more. Share price declines, particularly those that are produced when everyone around you sees only doom and gloom ahead, are precisely what you want.
But how do you know the shares are cheap? Without the beacon of intrinsic value, how do you know whether to buy more or to panic? Many investors don’t know the value of their shares. They frequently panic when shares fall, and also suffer from the consequences of paying too much.
I have often asked an audience of investors the following question, ‘If the shares of (insert your favourite company) were trading at half price today, would you buy them?’ The response is both rapid and enthusiastic, ‘Yes!’ And yet, sometime later, when the share price does indeed fall 50%, only a small handful of the original group ever buy the shares. Why is that? It is because share prices only fall 50% when there is bad news, either about the company being considered or about the economy or market more generally. And unfortunately, such news often perverts good ideas to bad ones. What was seen initially as a brilliant opportunity becomes a high risk ‘play’ that should be avoided until there is more certainty (and a higher price of course).
Your mother probably told you that first impressions are usually correct. She may not have been talking about shares on sale, but she was right again. What is good advice for choosing friends is also good for selecting shares.
The challenge is knowing when to buy
The easier part of investing is knowing what to buy. For example, is it really so difficult to see that CSL is a better business than Slater & Gordon? Is it that challenging to see that an investor should favour the fund manager Platinum Asset Management over Qantas?
The challenging part of investing isn’t identifying good businesses that you would like to own. The challenging part is knowing when to buy, while the prices of all these companies are gyrating amid noise and influences that may or may not ever impact their businesses.
Nobody should miss out on buying shares in great businesses because of the fear that the shares will go down even more. And there is no need to panic and sell at depressed prices either. But such rational behaviour requires you to have something other than the price to look at. You need to know the value of the business and its shares.
Of course in order to value a company’s shares, one needs to be aware of and have appraised the prospects for the business and its products or services. When the price of iron ore was $140 per tonne, we challenged the notion that the long run average would bear any resemblance to the then recent prices. Indeed at $140, we thought $40 per tonne was more likely to eventuate. We now believe the prospects for Australia and the resource sector are likely to worsen and so we arrive at valuations for resource companies that are much lower than current prices.
Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific needs of any investor.