Rahul Shah Uses Jeremy Grantham's Dot-Com Incident to Impart a Timeless Investing Lesson

Co-head of Research at Equitymaster and the editor of Exponential Profits, Rahul Shah recently shared a timeless lesson with his premium readers.

Using the example of feathers, he explained how it can help understanding stock price movements and more.

Here's Rahul Shah:

Imagine there's a strong wind blowing and you go at the top of a 50-storey building with a bag full of light weight feathers.

You stand bang in the middle of the terrace, open the bag, and let the feathers fly in all directions.

Here's what would happen next -

Few feathers may drop right at your feet, few may land a some meters away, and few more may land on a rooftop few blocks away.

Some of them may even travel a few hundred kilometres and get swept away all the way to a nearby city or a small town.

Of course, it will be impossible to tell before-hand where each feather will fall. But one thing is certain. Every single feather will eventually fall to the ground.

Now, let's think of the feathers as stocks, the strong wind as the stock market, the distance that they travel as share prices, and the ground as the fair value or the replacement value of these stocks.

Isn't this a great analogy to explain stock price movements and their relation to their intrinsic values?

Stock prices have a habit of trading significantly higher or lower than their respective intrinsic values. The positive or the negative momentum that persists in the stock market, can take these prices either marginally away from their intrinsic values or significantly away.

In some cases, the stocks can trade at a huge premium to their intrinsic values and can even stay there for a long period of time.

Eventually however, an adjustment takes place and just like gravity pulls the feathers down, a bear market pulls the stock prices back to their intrinsic values.

This wonderful analogy was given by noted investor Jeremy Grantham, who found it as a great way to explain how stock prices move away from their replacement values or intrinsic values in varying proportions.

He further argued that the feathers don't always land on the ground with perfect timing. Sometimes the feathers land quickly and sometimes slowly.

In stock market language, there is a great deal of uncertainty about how long stock prices would take to reach their intrinsic values and that is the rub.

He further observed that most clients do not have patience beyond 3 years. Thus, if the stock prices don't mean revert by then i.e., they don't get back to their intrinsic values or lower, clients may dump you for another fund manager.

And this is precisely what happened with Jeremy Grantham during the dot com bubble of 1998-99. As per Grantham's own admission, they lost as much as 60% of their business in just 2.5 years.

Yes, majority of their clients dumped them because they did not like that Grantham was warning about a huge stock market bubble being formed, especially in tech stocks.

They believed that Grantham and his team was totally wrong, and they continued their investments in high growth stocks.

The good news, in real life, is that eventually reality speaks. And the reality is that every stock or an asset class for that matter, has a replacement value or what we know as intrinsic value.

And while the stock prices may deviate a lot from this intrinsic value and for a long period of time, these prices do work their way back to intrinsic values.

The tech bubble as we all know, did eventually burst, and almost all the stocks did return to their intrinsic values. However, for Grantham, the long period of irrationality proved costly as they lost a lot of clients.

Thankfully though, Grantham survived, and the firm is now much stronger than before.

To recap, markets turn inefficient from time to time and different stocks deviate differently in price from their true value or their intrinsic value.

At times, they deviate too much and do not return to their fair values fast enough. However, eventually, they almost always do.

Thus, as an investor, your job is to invest in those stocks where the current price is significantly below this fair value and stay away from those where it is the opposite i.e. the price is significantly higher than the fair value.

This simple rule can help you steer clear of a lot of danger in the stock market and set you up nicely for good long-term returns.

Happy Investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...