Kennon-Green & Co. Global Asset Management and Value Investing

Mr. Market

Benjamin Graham’s Famous Value Investing Allegory

In his classic treatise, The Intelligent Investor, Benjamin Graham, the father of value investing, created an allegory to help new investors understand how to think about stock prices and value investing in general.

By using it, you can help protect against overpaying for a stock, panicking when the market crashes, or doing foolish things resulting from emotional reactions to the nightly news.  Along with the margin of safety concept, Mr. Market is a cornerstone of the value investing strategy.

Your Business Partner, Mr. Market

Benjamin Graham recommended that someone who wanted to become a disciplined, successful investor imagine a scenario every time he or she wanted to buy or sell shares of stock, which, to Graham, represented ownership in a business, not just pieces of paper that moved around on the ticker tape.  Picture yourself in a partnership with a man named Mr. Market.  Now, Mr. Market is a manic depressive fellow and sometimes he is euphoric about the state of the economy and specific stocks, bonds, real estate, or other assets.  Other times, Mr. Market believes the world is ending and doesn’t want to own anything for cash.

Benjamin Graham, the father of value investing, recommended that intelligent investors imagine they have a business partner named Mr. Market who is manic depressive and wants to either buy your interest or sell you his every day at wildly different prices. This is probably the single most famous allegory in the history of finance
Every day, Mr. Market knocks on your office door and comes in offering to buy or sell his share of the company to you.  He’s rather agnostic on which you choose because he has set the price based on his mood.  Sometimes, Mr. Market is close to what you, a far more rational investor, believes is the true, or intrinsic value, of your company.  Other times, he offers ridiculously low prices or unjustifiably high prices.  What should you do as his business partner?

You have three choices, based upon how much cash you have available:

  1. If Mr. Market offers a stupidly low price, you can buy more shares, increasing your ownership in the business.
  2. If Mr. Market offers a stupidly high price, you can sell him your shares and cash out.
  3. If Mr. Market offers a fair price or you simply don’t have a lot of extra cash, you can do nothing.  Continue owning what you own, collecting dividend and interest income.  Sooner or later, he’ll change his tune and you’ll be able to take advantage of the situation.

Mr. Market Provides an Intellectual Framework

Ordinarily, investors, even those practicing value investing, panic when stocks crash because they see the money they’ve lost on paper.  Yet, if they were using the Mr. Market allegory, and actually sitting down, picturing their business partner coming into their office, they wouldn’t have this reaction.  They would pull the financial statements, value the business, and decide whether he was having another one of his manic days.

A perfect example is General Electric.  Prior to the Great Recession of 2007-2009, GE shares fell from more than $50 per share to as low as $5.77.  This represented a 90% loss on paper.  A close look at the facts, however, showed that investors were being forced to liquidate their positions as the asset bubble popped and they couldn’t refinance their debt.  GE expected that once things had returned to normal, it would continue to earn $2 to $3 per share, and pay cash dividends of $1 to $1.50 per share.  That would result in an intrinsic value of between $22 and $40 per share, providing a massive margin of safety.  Anyone who bought GE at those prices could be virtually assured of a good long-term rate of return.

Within only a few short months, GE skyrocketed back to $15 per share, where it sat for quite some time.  That would have represented a 250% return for savvy value investors that continued to pick up shares as the market collapsed.  Those who sold their shares at $6 each were doing so because of “other peoples’ mistakes in judgment” as Benjamin Graham explained.

Mr. Market Can Help You Buy or Sell Any Investment

The beauty of the Mr. Market allegory is that you can use it in any business field, whether buying equipment, building a law practice, buying or selling a hotel, building rental houses, trading art, launching a vineyard … the list is endless.  By applying a value investing strategy, you can protect yourself from overpaying and making foolish emotional mistakes.  It is another testament to the genius of Benjamin Graham and his value investing strategy.