Alternative Performance Benchmarks

Warren Buffett once said he "wouldn't care if the stock market closed for a year or two. After all it closes every Saturday and Sunday and that hasn't bothered me yet."8 Now it is true that "an active trading market is useful, since it periodically presents us with mouth-watering opportunities," said Buffett. "But by no means is it essential." 9

To fully appreciate this statement, you need to think carefully about what Buffett said next. "A prolonged suspension of trading in securities we hold would not bother us any more than does the lack of daily quotations for World Book or Fechheimer [two Berkshire Hathaway subsidiaries]. Eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial [in the form of shares of stock] or total."10

If you owned a business and there was no daily quote to measure its performance, how would you determine your progress? Likely you would measure the growth in earnings, or perhaps the immprovement in operating margins, or a reduction in capital expenditures. You simply would let the economics of the business dictate whether you are increasing or decreasing the value of your business. In Buffett's mind, the litmus test for measuring the performance of a private company is no different than measuring the performance of a publicly traded company.

"Charlie and I let our marketable equities tell us by their operating results—not by their daily, or even yearly, price quotations—whether our investments are successful," explains Buffett. "The market may ignore business success for a while, but it eventually will confirm it."11

But can we count on the market to reward us for picking the right economic companies? Can we draw a significantly strong correlation between the operating earnings of a company and its future share price? The answer appears to be "Yes," if we are give the appropriate time horizon.

Using our laboratory group of 1,200 companies, we can readily appreciate the relationship between earnings and share price exhibited over different time periods. (The full details of this correlation are found in Tables B.1 through B.5, in Appendix B, pages 220-221.) In summary, when we set out to determine how closely price and earnings are connected, we learn that the longer the time period, the stronger the correlation:

• With stocks held for three years, the degree of correlation ranged from .131 to .360. (A correlation of .360 means that 36 percent of the variance in price was explained by the variance in earnings.)

• With stocks held for five years, the correlation ranged from .374 to .599.

• In a ten-year holding period, the correlation increased to a range of .593 to .695.

• For the entire eighteen-year period, the correlation between earnings and share price is .688—a significantly meaningful relationship.

This bears out Buffett's thesis that, given enough time, a strong business will eventually command a strong price. He cautions, though, that the translation of earnings into share price is both "uneven" and "unpredictable." Although the relationship between earnings and price strengthens over time, it is not always prescient. ''While market values track business values quite well over long periods," Buffett notes, "in any given year the relationship can gyrate capriciously." 12 Sixty-five years ago, Ben Graham gave us the same lesson: "In the short run the market is a voting machine but in the long run it is a weighing machine."13

It is clear that Buffett is in no hurry to have the market affirm what he already believes is true. "The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate," he says. "In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price."14

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