In 1997, 39 members of the Heaven’s Gate cult committed suicide because they believed doing so was necessary to reach an extraterrestrial spaceship following comet Hale-Bopp.
In 2001, a group of terrorists flew two airplanes into the World Trade Center believing they were doing good.
A century ago, a whole nation came to believe in Hitler.
People believe crazy things.
When it comes to the stock market, stocks are priced based on beliefs.
That’s all a stock’s price represents: beliefs about a company.
Does it have a bright future? Is its future bleak?
Sometimes these beliefs are right, and sometimes they’re wrong.
Machine
In the short term the stock market is a voting machine; it votes on which companies it thinks will do well.
In the long term, however, the stock market becomes a weighing machine; it weighs companies results and prices them accordingly.
All a stock’s price is, as Morgan Housel cleverly put it, is “a number today multiplied by a story about tomorrow.”
In the short term a stock’s price is purely based on expectations—a story about tomorrow.
In the long term it’s based on reality.
It gets measured, pound-for-pound.
Price Check
In the stock market prices often get disconnected from reality.
Remember Peloton, whose stationary bikes became so popular during the pandemic? Here is a chart of the company’s stock price over the past five years:
There was a huge disconnect from reality during the pandemic. The public became enthralled with the prospects of the company. Its stock shot up by 500 percent and then violently collapsed by 98 percent, where it stands today, on life support.
On the opposite end of the spectrum, here’s Hilton’s stock (the hotel company) over the same timeframe:
Its stock collapsed at the start of the pandemic and has since rallied as people have returned to staying at hotels.
In the short term, prices are based on expectations.
In the long term, prices are based on reality.
The weight scale takes measurement.
Mass Psychology
The stock market is nothing more than a large group of people making emotional decisions about the values of businesses, which stock prices represent.
Stock prices are driven more by emotion than logic in the short term.
As a result, it’s foolish to expect stock prices to always be rational.
In fact, they seldom are.
Value
What determines the value of a business?
Simply put, the value of a business is the present value of its future cash flows.
In other words, it’s how much the business is going to make over its lifetime after paying all expenses, in today’s dollars.
Warren Buffett defined it like this:
It is the discounted value of the cash that can be taken out of a business during its remaining life.
In a changing world, calculating this value is difficult, which is why stock prices are so often wrong and subject to change.
Predictability
Businesses that can’t be predicted are difficult to value, like Peloton.
Businesses that are easier to predict are easier to value, like Hilton.
And predictability is the name of the game in investing.
If you can’t predict something, how can you value it?
And if you can’t value it, how can you invest in it?
Worth
Knowing something’s worth is critical to knowing it’s value.
And the only way to determine its worth is if it is predictable.
Which is to say you should only invest in things that are predictable.
Otherwise, you will never know whether something is under- or over-valued.
Durability
You want to stay away from the Peloton’s of the world; businesses that are subject to change rapidly.
You want to invest in businesses that have durable competitive advantages; that will be around and thrive as far into the future as possible.
Determining this is difficult—but essential.
Only swing your bat at good pitches.
No Called Strike Zone
Warren Buffett compared investing to playing baseball with a “no called strike zone,” where, as a batter, strikes can’t be called against you. You can let as many pitches fly by as you like until you find a pitch you like, at which point you swing.
Success in investing comes down to being as selective as possible.
Only swing at good pitches, good companies selling at good prices.
Bottom Line
The stock market is a mass psychology mechanism.
It is a collection of the opinions of a vast group of people.
Some of which are right, and some wrong.
Focus on good businesses at good prices, that will tip the scale in the long term.