5/4/2022
In difficult market environments, it pays to have the mindset of a long-term investor. Famed investor Benjamin Graham is famously attributed with saying, “In the short-term, the stock market is a voting machine; in the long-term, it’s a weighing machine.” We’d like to explore what Graham meant by this, as well as how it applies to the current market environment.
A voting machine and weighing machine simply refer to what is driving current stock prices. A voting machine refers to short-term movements in the stock price, which can be driven by short-term reactions (both positive and negative) to temporary or one-time events.
On the other hand, the weighing machine refers to long-term movements in the stock price, which is where investors should focus their attention. In the long run, stock price action depends less on their popularity and more on the substance of their company; by substance, this can refer to revenue growth, earnings growth, profitability, and other fundamental measures of a company. Let’s look at a real-world example of the voting machine versus the weighing machine.
In 2000, Jeff Bezos released a letter to all Amazon shareholders in which he addressed the stock’s recent price action. For context, Amazon’s stock price had risen 3,786% since it went public in 1997, clearly benefitting from the popularity of the “voting machine” during the Dot-Com craze. However, once internet companies began to crash, Amazon was now on the other side of the “voting machine”, with the stock price down over 80% at the time of Bezos’ writing.
In the letter, Bezos mentions how Amazon’s fundamentals had improved in 2000: number of customers served had increased by 43%, revenue had increased by 68%, and gross profit had increased by 125% compared to 1999. Sure enough, a company like Amazon who had the fundamentals for the “weighing machine” to observe responded with strength following the Dot-Com Bubble.
While the Dot-Com Bubble may be a unique circumstance, significant drawdowns in stocks with quality fundamentals is a regular and healthy occurrence.
In the table below, we looked back at the top five megacap tech names that make up FAAMG: Meta Platforms (Facebook), Apple, Amazon, Microsoft, and Alphabet (Google). We decided to observe the number of instances that each of these stocks had experienced a -20% or worse drawdown from its 52-week high.
As you can see, these sizable drawdowns have been a relatively frequent occurrence in their history. In fact, Amazon investors have experienced a -20% or greater drawdown nearly every year in its 25-year history. However, even with these frequent drawdowns, Amazon has still averaged a historic annualized return of roughly 34%.
When you look at the other companies, it is the same story: even with frequent sizable drawdowns, the upside performance has more than made up for these drawdowns due to their strong fundamentals. Even if uncomfortable, sizable drawdowns come with the territory of owning individual companies, which is why it is important to “weigh” how the underlying business is performing- buy and do your homework.
In drawdowns like the one we are currently experiencing, it is normal to see stocks across all asset classes correlate, regardless of how the underlying company is performing; in a market drawdown, the “voting machine” can deem all stocks as unpopular. It may be impossible to know which companies will be the next megacaps, but investors can still track the fundamentals of companies to try and find companies that the “weighing machine” will approve.
In short, while it is important to track stock prices, they can be irrational in the short-term. To be a successful long-term investor, it is imperative to track the underlying business to ensure that the stock has substance underneath the surface. In simpler terms, long-term investors should watch the business- not the stock price.
