Consensus is what you pay; the relationship between consensus and value determines what you get.

The foundation of “value investing” is built on a narrative that price and value are two distinguishable components. Benjamin Graham, also known as the father of value investing, is often credited as the first author of this narrative. The best evidence for this, if we exclude the The Intelligent Investor and Security Analysis, is a quote from one of his famous disciples:

“Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” – W. Buffett [2008 Berkshire Shareholder Letter]

The “Price is what you pay; value is what you get” phrase has become one of the most quoted expression in investing. It has also become, in my opinion, one of the most misunderstood and misused quotes in investing. Still, I would argue that it is the most important quote in investing. This is what this post will be about.

We are all value investors, but…

I have previously made the argument that independent of our investment approach, fundamental analysis, technical analysis, indexing or pure speculation to buy low and sell high, no-one will buy something for more than what they think it is worth (i.e. the basic premise of what constitutes value investing). In other words, all investors have the intention to make money when they buy an asset. The opposite would be oxymoronic and although I believe that we humans are not very rational I also believe we are not irrational. There is a difference. My point is, all market participants strive to be value investors. It is inherent in our DNA, whether we like it or not.

But let us take a step back and consider this:

Not all successful investors call themselves value-investors and not all investors that call themselves value-investors are successful.

or if I haven’t convinced you with my “we are all value investors” argument:

Not all successful investors call themselves [insert investing philosophy]-investors and not all investors that call themselves [insert investing philosophy]-investors are successful.

First of all, I make the statement above to point out that there exists no need to put investing-labels on ourselves or to fight on Twitter with a purpose to defend our investment-style-turf. I have been there myself and I can honestly say that nothing fruitful come out of these discussions. I think that is true for anyone involved. Outside Twitter the same phenomena exist in books on investing, in blog posts and podcasts on investing etc. Again, I have to admit that I too have been a contributor to this with my blog posts. That is not to say that this phenomena of labelling ourselves and that we defend our turf with nails and claws is not interesting. To the contrary, this is extremely interesting!

What fascinates me is that it almost seems like we have an inherent urge and need to belong to a certain tribe of investors. An urge and need to subscribe to a certain investing philosophy with the simultaneous exclusion of other approaches although we might share some common ground. I think the same phenomena can be found in discussions about politics, sports, religions etc. In the case of investing, I would argue that this urge and need makes us blind for the path towards the holy grail of investing. It makes us forget about the only question an investor needs to focus on. That is the question of:

What determines the success of an investor?

The holy grail of investing

I can assure you, answering the question above and you have attained the map to the holy grail of investing. Answering the question and you have almost figured it all out. The answer is “simple but not easy” as Mr Munger has famously said about investing in general. Let me give you the answer:

The success of an investor is determined by the exploitation of price and value, i.e. buying assets for less than they are worth. 

This conclusion goes back to my argument that we all strive to be value investors. With the help of inversion; if we buy something for more than it is worth we will be unsuccessful investors. However, the simple answer is not easy to implement successfully. The reasons for that are multiple. On an overall level, I would argue that it has to do with a basic misunderstanding of the value/worth component as it relates to the price paid for an asset.

The quality-fallacy

The basic misunderstanding is this:

Buying good things ≠ Buying things good

or said differently:

Quality ≠ Value

What I mean with the two statements above is that quality characteristics of an asset (good things) is not a substitute for buying assets for less than they are worth (buying things good). I would argue that investors fall for this “quality-fallacy” all the time. All else equal, it is far easier to buy and own what is considered to be of quality (good asset) than what is considered non-quality (bad asset). The problem though in investing is that the quality of an asset is not a determinant for the value you will get. This is a mistake that people make all the time in investing. This is even true if one isn’t careful to think about what the quote that started this post “Price is what you pay; value is what you get.” really implies. Let me explain.

A simple misunderstanding

What people don’t understand or misinterpret about the quote is that the value component, “what you get”, is a residual. The value, the residual, is the difference between the price paid for an asset in relation to the value of that asset. That is the value you will “get”. Again, I would like to point out that value in this quote is not a synonym for the quality of that asset, as some people would like to believe. Making this mistake is not something to be ashamed of considering how the quote was framed by Mr Buffett. I would even argue that Mr Buffett made a quality-fallacy argument when he quoted Mr Graham:

Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” – W. Buffett [2008 Berkshire Shareholder Letter]

I know that buying quality companies has been key to Mr Buffett and Mr Munger (Berkshire’s) success. However, people forget that they have still bought those companies at a price below their worth. Too often I see their philosophy for what constitutes a good investment dwarfed into an argument that a “good company = good investment”. Although their methods for determining value were different from those used by Mr Graham they never deviated from the lesson of what determines the success of an investor, i.e. buying assets for less than they are worth.

Evolving the quote

In order to make what I consider the most important quote in investing a bit clearer and to summarise this post I thought I would end with an evolved quote. In order to fully understand it I would like frame it with the help of two other favourite quotes of mine. These quotes will help to explain the “price” component and the drivers behind what makes an investor not only successful but more successful than everybody else. Both quotes are from the famous investor Howard Marks:

The price of a security at a given time reflects the consensus value. The big gains arise when the consensus turns out to have underestimated reality [value], or to have miss-estimated reality [value]. To be able to take advantage of such situations, you must be able to think in a way that’s away from the consensus. You must think different and you must think better. It’s clear that if you think the same as everybody else, you’ll act the same as everybody else, and have the same results as everybody else. – Howard Marks

[value] has been inserted by me in the quote above.

Note that Mr Marks is not saying ‘different and right’ in the quote above, he is saying different and better‘. 

Superior performance does not come from being right, but from being more right than the consensus. You can be right about something and perform just average if everyone is right too. Or you can be wrong and outperform if everyone else is more wrong. – Howard Marks

Based on what I have concluded in this post and what Mr Marks has helped to explain above:

“Price is what you pay; value is what you get.”

evolves into:

Consensus is what you pay; the relationship between consensus and value determines what you get.

One thought on “Consensus is what you pay; the relationship between consensus and value determines what you get.

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