Let’s assume you buy Disney at 100 and one year later it trades at 130. A 30% return in one year, isn’t that great!
Some time ago I used to cheer when my stocks rose to new highs. It felt great to count the paper profit but as a long-term investor this logic is irrational. Why? Because the only time you would want a highest possible price is when you sell. If you have no plan to sell, it means you either are a future net buyer or just holding your shares. Under both scenarios you would want the share price to not trade above intrinsic value.
This might be a bit counterintuitive for many investors (for me as well), but it makes perfect sense and the logic is simple. I let Warren Buffett explain:
If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
The above quote is taken from page 7 of Berkshire’s shareholder letter of 2011. At the time of writing Berkshire had taken a big position in IBM, in hindsight a mistake, and Buffett made the comment that they hoped IBM’s stock price would languish throughout the next five years. He expected IBM to continue buying back shares, and obviously the shareholders increase their ownership the more shares are bought back.
Let’s look at four different scenarios to show why this logic makes sense:
- You have no intentions of selling nor be a net buyer in the future. Still, you would want the share price to not exceed intrinsic value because many companies buy back shares, and obviously it’s better to buy back at for example 100 per share instead of 125. The more shares bought back, the more you own of the company.
- You have no intentions of selling but are reinvesting the dividend. Again, it’s much better to reinvest at 100 and not on 125. (I don’t recommend DRIP – read this article).
- If you are a net buyer in the future, obviously you want to pay as little as possible for that earnings.
- If your plan is to sell in the immediate future, this is the only time you want the share price to be as high as possible.
Warren Buffett has spent his whole life attracting the “correct” shareholders. I believe a rational shareholder base is an underrated asset of any company, because without a competent ownership it’s difficult to have the proper investment horizon. I assume most companies end up with the shareholders they deserve, and that’s why it makes sense to attract and educate a knowledgeable investor base to make sure the share price does not deviate much from intrinsic value – either up or down. An overvalued stock has the potential of attracting the wrong shareholders and this in turn might lead to overreactions on the downside.