I bought just before the market dropped

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I Bought Just Before
the Market Dropped
Has this happened to you? You are a very unusual person if you are not disturbed when your stocks are worth less than you paid for them shortly after purchase.
The purpose of this article is to help you better understand the significance of your "paper loss". If you sell your holdings, you will have an actual loss but if your portfolio is worth less than you paid for it and you do not sell; you are said to have a paper loss.
In order to aid our discussion, I am going to create a fictitious situation. Let us assume a person named Mr. Inside buys a majority of the outstanding shares in GC Corp. Mr. Inside has worked at various levels in the industry and is extremely knowledgeable. He knows that companies like CG have historically sold to knowledgeable buyers for 15 times the earnings per share. At the time of purchase, CG Corp. was earning $2 making the company worth $30 per share.
Mr. Inside was lucky because the seller, in our example, was anxious to sell and was willing to settle for a price of $20 per share. Once he made his purchase, Mr. Inside spent all his days and nights inside a building running his new business. He was only allowed to go back outside the building if he wanted to buy more stock or to sell the shares he owned. There was a crowd outside the factory building every day but they were not allowed inside. They could peer in the windows from time to time watching worker activity and they were allowed to talk to Mr. Inside on the telephone. They could also talk to other people in the industry who, like Mr. Inside, could not leave their company plants.
The crowd outside the building was made up of several kinds of people. Some of them made a living studying companies like CG and reporting their findings to their many customers who owned shares. These people are called analysts and typically did not own any stock themselves. Some people outside the building made their living by investing money for other people who did not want to do it for themselves. These people are called money managers. Some of these people owned CG shares but many did not.
Finally some of the people in the outside crowd owned shares themselves but as they had other jobs could not spend much time learning about CG. A few of the people outside had worked in the industry for a short period but none of them knew nearly as much about the business as Mr. Inside. Mr. Inside was aware of outside trading prices.
The crowd outside constantly exchanged ideas. If one of them wrote a report the contents were soon known to all. A few of them were well known and what ever they did was copied by many others in the crowd. Most important, the money managers and analysts lived or died by the accuracy of their information. If they were wrong, those whose money they managed or who relied on their advice and would try to replace them with someone more successful. The result was that the crowd outside was almost always nervous and would react sharply to new information.
Mr. Inside had to be extremely careful in what he told those outside. He knew that if they lost money based on information that he provided he could and would be sued. If he gave information to one person, he had to make it available to all or be sued by the government for violating insider information laws.
When asked about the business outlook he would typically answer in generalities, such as, "business is good but I have a policy not make earnings predictions". He would and could discuss earnings information already reported. If, nevertheless, he was asked what the company would earn next quarter he would tell the caller what the average prediction (consensus estimate) of those outside was.
Once each quarter, Mr. Inside had to report on company progress to all shareholders. His report had to follow strict accounting rules and show earnings as well the assets and debts of his company. A copy of this report was furnished to everyone outside who wanted one.
After six months of ownership, Mr. Inside felt more confident than ever that he had been smart to buy the company. Sales and earnings were coming along nicely and he estimated that in five years earnings would double from $2 per share to $4 a share. CG's share price, at this point, was around $19. Two weeks after he made that assessment, the government reported that consumer prices were rising more sharply than had been expected which could cause the Federal Reserve to raise interest rates hurting the stock market.
One morning Mr. Inside noticed a lot of activity outside the window with much buying and selling. During the night, war had broken out between Russia and Japan over the Kurile Islands. This could affect the price of many raw materials, reducing profits for American industry. Potential stock market buyers took a wait and see attitude while some sellers were willing to take any price so long as they could get rid of their shares. The price immediately fell to $14 in spite of the fact that CG had just reported higher earnings.
One member of the outside crowd, who had bought shares two weeks before at $18.50, sold his shares at $14 admitting that he had, "made a mistake". Newspapers and television carried the story of the Russian attack alongside the story of the sell-off in the stock market. Those who had not sold the day before then called their brokers to sell their shares. The price of CG then fell to $11. The people who sold at $14 are now glad they did.
Mr. Inside was not particularly worried about these developments as he had weathered many industry storms before and thought that any impact on CG would not be significant. He was interested in the five to ten year view not the view from day-to-day. He was thankful he did not have to sell then at $11 and was sorry he did not have the cash to buy additional shares. He was certain that in a sale to a knowledgeable buyer the company would still be worth around $30 a share.
Four months later, the crises was over and those who had bought at $11 were happy to sell at $15 having made a 36% profit in four months. They tell their business friends, "it never hurts to take a profit".
With the return of peace the outlook brightened, the inflation scare proved to be unfounded and stock prices recovered. Over the next several years, stock prices rose steadily and CG's price climbed to $50 a share. Mr. Inside's purchase of CG has was totally vindicated with company sales and profits rising steadily. After reporting $2.00 per share in the first year, CG earned $2.15, $2.50 and $3.00 at the end of the fourth year. It appeared the earnings per share target of $4 at the end of five years would be easily reached.
At this point, a member of the outside crowd noticed that one of CG's competitors was bought out at a price of 30 times earnings (i.e., the buyer paid $30 for each dollar of earnings) which, on the same basis, would make CG worth $90 a share.
Although there was no indication that anyone wanted to buy CG, word of the takeover spread and the price of CG began to rise eventually reaching $80 a share. When it became clear that there would be no immediate buy-out, the price dropped back to $54. By this time CG was earning $3.50 a share. At the end of the fifth year, the stock market outlook was, once again, uncertain and CG's price fell to $38 with CG reporting earnings of $4.20 a share.
Mr. Inside decided he would like to retire so he put his shares up for sale believing the company was still worth 15 times earnings. Luckily, AB Company wanted to get into this industry and was willing to pay a little extra to do it.
AB offered, Mr. Inside and the other shareholders, 18 times earnings. so the sale price was set at $75.60 a share (18 times $4.20). CG became part of the larger corporation.

Conclusions

CG Company made steady financial progress over the 5 year period becoming ever more valuable. In the beginning it was worth $30 a share and that value grew each year. It is the financial health and progress of the company that, in the end, determines the prices outside in the crowd. Earnings, which increase company assets, drive stock prices. This is what Ben Graham meant when he said that in the short run the stock market is a voting machine but in the long run it is a weighing machine.

Mr. Inside, because he had a good idea of what the company was worth and because he took the long view, did very well buying shares at $20 and selling at $75.60. In five years his return averaged better than 30% a year. Note this was true even though the share price fell way below his purchase price (i.e., to $11).

The investor who bought at $18.50 and sold a few days later during the Russian-Japanese war panic at $14 made a mistake all right but not the one he imagined. He thought his mistake was to buy something which quickly fell in price. His real mistake was to sell something for $14 a share which a little study would have shown him was worth at least $30.

Those who bought at the bottom paying a price of $11 and sold at $15 made several mistakes. They sold something worth $30 for $15, they then owed taxes on the difference between what they paid and what they received and they also had to pay unnecessary commissions.

Some of the analysts and money managers outside knew very well what the company was worth but they were distracted by other information such as the possible impact of a war, possible effects of higher interest rates, etc. In many cases their job security depended on their performance each year and they simply could not afford to have a stock in their portfolio which had dropped very much below purchase; so they sold.

There was one investor in the crowd who passed almost unnoticed and that is why I did not mention that particular investor before. We will call this investor IQ. IQ had noticed in year 1 that CG Company looked awfully cheap and seemed likely to do very well over the next several years. At the forecasted growth rate, IQ estimated CG would earn around $3.75 in five years which at 14 times earnings would make the company worth around $52. (notice that even though IQ and Mr. Inside did not value CG exactly the same way their final estimates were close.
IQ was delighted to discover that Mr. Inside was running the company and even happier to learn that Mr. Inside had paid $20 a share since IQ could then buy shares for $18. After rechecking the progress of CG Company and recalculating its' value to a knowledgeable buyer, IQ purchased more shares when the price of $13 appeared. "If it was a good buy at $18 what was it at $13", IQ asked? IQ knew that if the 5 year growth forecast for CG was even close to being accurate then any price below, say, $30 should be very profitable.
Buying more shares at $13 brought the average cost down to $16. IQ, unlike the others outside in the crowd, ignored the talk about inflation and wars concentrating, solely on the quarterly and annual financial progress of CG Company, vowing to own company shares as long as it made steady financial progress. IQ still owned the stock at the time of the buyout and tendered shares at $75.60 for an even better percentage gain than that realized by Mr. Inside.

If CG earnings had fallen to $1 over the five year period, instead of rising, then CG company value would also have fallen to around $15. Outside investors would have had plenty of warning by carefully reading the quarterly earnings reports. IQ, being an experienced investor, would have sold and probably taken a loss as soon as he realized his five year estimate of CG was not likely to be close to reality.
A paper loss is not significant unless company earnings and therefore company value to a knowledgeable buyer is also dropping. You can see that it is very important not to invest money in stocks which might have to be used when share prices are unattractive.

This account is fictitious but is a good approximation of what really happens.
About the Author
Marshall Delano is an experienced money manager. After working for serveral years as a stock broker, he managed private hedge funds investing in the U.S. stock markets for seventeen years. As a hedge fund manager, Mr. Delano shared in profits made from investing in the stock market. Since 1993, he has managed clients on a fee basis as a Registered Advisory Representative.
Mr. Delano has served as the Managing Partner of partnerships organized to invest in the stock market. He has also served as President of Registered Investing Advisory firms and is currently President of the Advisory firm, S.G. LONG & Company. His education includes a Bachelor's Degree in Economics and a Masters Degree in Business Administration.
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