Exploring Dislocations Between Market and Business Value

Business gains dictate investment gains over the long run.

“A horse that can count to ten is a remarkable horse - not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company - but not a remarkable business.” - Buffett, 1985 letter to shareholders.

This marks the 9th installment of our Buffett Letter series. You can read past entries here. This week we turn our focus to a very important piece of Buffett wisdom: over the long term, “investor gains must equal business gains.”

This means that a stock’s performance should roughly mirror the performance of the underlying business over the long run. For example, over the past ten years (2011-2021), Google has compounded earnings per share and FCF per share at about 21%. Over the same time period, the stock price compounded at roughly 25%. Over the same time span (FY’11-FY’21), Apple compounded EPS and FCF per share at about 19%, and the stock price compounded 25% annually. Thus, while share price gains in these two cases have outpaced business gains, they generally have mirrored each other. I would argue the outsized stock performance relative to business gains, more notably in Apple’s case, can largely be attributed to an expanding multiple environment and inflated valuations across the board. Naturally, Apple is a beneficiary of this environment given it’s one of the strongest, if not the strongest, businesses in the world.

Taking advantages of dislocations

While this reality is true over the long term, market swings in the short term create large disconnects (high or low) between market values and underlying business values.

To make this point concrete, consider that over the course of its history, Apple has experienced three drawdowns (peak to trough) of more than 70%. You might argue the drawdowns were justified given they occurred between 1983-’85, ‘92-’97, and ‘00-’03 when Apple was a less-established company. However, even in the last decade (2010-2019), Apple experienced a ~40% drawdown between ‘12-’13. Amazon experienced a 90% drawdown between Feb ‘00 and Sep ‘01, and a 25% drawdown between August 2018 and December 2018.

More broadly, it’s common for individual stocks to experience 15% plus drawdowns multiple times a year, a 20% plus pullback in most years, and a 50% plus decline once or more a decade.

Certain levels of drawdowns are undoubtedly justified given companies are often bid up to irrational valuations in the first place. However, after irrationally bidding up a company, the market isn’t required to drawdown to sane valuations. Instead, it’s more likely that the market will swing to the opposite extreme and irrationally sell off. My guess is that as the market increasingly becomes influenced by large institutions, algorithms, and passive flows, dislocations between value and price will be more frequent and extreme. Buffett was aware of this dynamic in 1985 when he compared Berkshire’s stock price movement relative to other public companies:

Over the long term there has been a more consistent relationship between Berkshire’s market value and business value than has existed for any other publicly-traded equity with which I am familiar. This is a tribute to you. Because you have been rational, interested, and investment-oriented, the market price for Berkshire stock has almost always been sensible. This unusual result has been achieved by a shareholder group with unusual demographics: virtually all of our shareholders are individuals, not institutions. No other public company our size can claim the same. You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued.

If this hypothesis is true, it will create chances for the truly long-term focused investor that has the gumption, patience, and liquidity to withstand, and the foresight to see through extended drawdowns, to find very attractive opportunities in the market. Apart from a willingness to endure pain, the ability to hold through drawdowns will come from conviction in the quality and durability of the underlying economics of the business you’re invested in.

A word of caution: dislocations happen to the upside as well as the downside. Don’t overpay, otherwise drawdowns will merely wipe away market value that had insufficient underlying business value to support it.

As the Gospel says, “And the rain fell, and the floods came, and the winds blew and beat on that house, but it did not fall, because it had been founded on the rock. And everyone who hears these words of mine and does not do them will be like a foolish man who built his house on the sand. And the rain fell, and the floods came, and the winds blew and beat against that house, and it fell, and great was the fall of it.”