"You pay a very high price in the stock market for a cheery consensus."
So said no less than super-investor Warren Buffett.
And he wasn't just talking about the price per share, or even the earnings multiple. High P/Es can crimp your future returns, especially if they fall — because absent serious profit growth, they almost always mean lower share prices.
But Buffett was also talking about your subsequent returns. Woolworths (ASX:WOW) has been a wonderful business for a couple of decades. It's fair to say the shine has come off lately, but recent share price falls reflect a change in sentiment far more than a change in the underlying earning power of the business. Yes, the latter has also fallen, but it's a recognition that the future will be less rosy than expected that's responsible for most of the near-50% share price fall.
High P/Es happen when investors — in large number — expect good times to roll on forever. Sometimes, as with Corporate Travel Management (ASX:CTD), for example, that's a justified expectation. But in Woolies' case, the market was paying a very high price for a consensus that was all-too cheery.
But you don't even need a profit collapse to undermine your investment results. Microsoft's (NASDAQ:MSFT) share price went precisely nowhere between 2000 and 2012. It was US$24 on January 4, 2001 and US$25.56 on December 29, 2011. That's a very, very ordinary return. So you'd expect profits were flat, too, right? No. Profits in the 2011 financial year were around US$7.5bn. And in 2011 hit $23.1bn. So how does profit rise more than threefold and not boost the share price?
When the share price was too high to start with. Or, as Warren Buffett might say, when you've paid a high price for a cheery consensus. And note here, too, Buffett doesn't say that consensus is right. Indeed, when a consensus is universally cheery, there's a very, very good sense that it's wrong.
When everyone has bull market fever, we should — to steal from Buffett again — be fearful.
The flipside, of course, is that we pay a low price for a miserable consensus. When the world was presumed to be going to hell in a handbasket, stocks were cheap. Flight Centre (ASX:FLT), for example, spent a decent amount of time trading around $3-$4 — 80% – 90% below its pre-GFC highs.
And while bear markets, panic and fear provide a wonderful opportunity for bargain hunters, they have a bad side effect for the novice and nervous alike — they can force those people out of the sharemarket in fear and pain. Many of them never return.
Part of our job — along with doing our best to bring you market-beating investment ideas, of course — is to help you understand the market, and to manage your emotions. We want to prepare you in the good times, so you're ready for the bad times. And when those bad times come, we'll be here to guide you through it (and to share in your pain).
It'll be — frankly — brutal, at times. You'll question yourself. You'll question us. And you'll be tempted to give in to fear and pain.
Consider this recent snippet from Motley Fool CEO Tom Gardner when he was in Australia last week. Paraphrased, Tom said:
"As an investor, you'll earn a superior return if you're right 6 times out of 10. But we know from psychological studies that humans feel the pain of loss up to three times as much as we enjoy the gains. So if we have 6 wins, and 4 losses, emotionally that'll feel like a 6:12 ratio (6 wins, to 4 losses that we feel three-fold)."
Is it any wonder that humans find investing so mentally and emotionally taxing? Even if you're good, it'll still feel awful. If you're great, say 7 times out of 10, it'll still be 7:9! You'll still feel more pain than gain.
So, unless you're hyper-rational or masochistic, even good investors will struggle emotionally with the task.
The first step to dealing with a problem is admitting you have one. So repeat after me:
"Investing will feel tough at times, and I'll occasionally feel like giving up".
Next:
"When things are tough, I'll remember 'this too, shall pass' and that long-term investing has historically delivered extraordinary compound returns"
And lastly:
"I'll make the market my servant, not my master"
In other words, "I won't let moving share prices dictate my mood or action, but rather my understanding of the business, its future and its value."
Fool on!
