The Value of a Solid Foundation

As the market turmoil and the volatility continues, remember that share prices on any day is just that person knocking on your door with an offer for your house.

There is no shortage of bad news these days. Inflation is on the rise as are interest rates. A strong US dollar is making imported goods and foreign travel more expensive. War in Ukraine has upended global commerce (not to mention upending the lives of millions of Ukrainians). Stock markets are in turmoil. It’s enough to want to just pull the covers over your head and hibernate until it all goes away.

Fortunately, the impact of all of this on the businesses in our portfolio is, for the most part, indirect and likely, transitory. That’s not to say there is no impact on the share prices of companies in the portfolio as there obviously is. Share prices have been under pressure for most of the year but it is important to keep in mind that the quoted price of a particular stock on a particular day is simply what someone is prepared to pay for a portion of that business on that day. It is only important to you if you have to sell it on that day or if the price reflects some fundamental change in the underlying business.

Consider the price of your house. On any day, someone could knock on your door and make an offer for your house. If you’re happy living there, if it is satisfying your need for a roof over your head, a place to raise your family, to entertain friends and to retreat from the outside world, you’d probably refuse. The offer would have to be high enough for you to afford a materially better house and overcome the emotional and frictional costs of moving. So, the value of the house to you would be different than the quoted market price. It’s also likely that the difference between a price that is clearly too low and one that you would readily accept is fairly wide.

Similarly, an investment portfolio likely has an objective value that is often different from its quoted market price. Different portfolios have different purposes but generally exist to secure your lifestyle and legacy. So long as your investment assets are able to provide the cash you need when you need it and provide sufficient capital growth over time to offset the effects of inflation and even enhance the quality of your lifestyle and legacy, the portfolio is doing its job. It would then have a value to you that may be greater than its quoted price.

Like the value of a house, the value of a share in a business is derived from its ability to satisfy your current and future needs. For a house, it’s difficult to measure this in dollar terms but it’s easier for a share of a business. Share value can be computed by estimating the amount of cash that the business could reasonably be expected to produce for shareholders over the period of expected ownership. Much like the range of values you might put on your house, and because the calculation would be based on assumptions and estimates, the result would be a range of values rather than a specific figure. As well, most of this objective value lies in results produced over many future years rather than just results for the next month or the next year. The same is true of your house of course. If you’re renovating, the house is temporarily less enjoyable to live in but you’re no more inclined to accept a random purchase offer. More likely, you’ll imagine the future years of enjoyment the renovation will bring and the value to you will increase.

Rising interest and inflation rates have a negative effect on shares of most businesses as the current value of a dollar expected to be received in the future is reduced. For good quality businesses with a sustainable competitive advantage, this may be mitigated by the ability of the business to raise prices without hurting sales volumes. While it can be gut wrenching to see share prices fluctuate significantly from day to day and month to month always keep in mind that you own pieces of good businesses. While each of your businesses are dealing with their own individual challenges these days, for the most part each company continues collecting its revenues and developing solutions for its particular issues.

As the market turmoil and the volatility continues, remember that share prices on any day is just that person knocking on your door with an offer for your house. Always keep in mind Warren Buffett’s observation that “price is what you pay, value is what you get.”

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