Last Thursday was my 5-week-old son Asher’s first Halloween. My wife and I dressed him as a Korok from The Legend of Zelda: Breath of the Wild, one of our favourite games (don’t worry, there’s a picture at the bottom of the article). Given his age, his general dislike for the costume and the horrible weather, we didn’t take him trick or treating. His older cousins did go trick or treating, though, and they brought home a more than respectable bounty. Watching them sort through their haul reminded me of one of my first lessons in investing and economics.
I like Tootsie Rolls. My two older brothers do not. When the three of us were at the right ages to all go trick or treating, we’d come home and pour out each of our pillowcases full of candy onto the floor of the living room. After some organization, we’d start to trade with each other. One Reese’s Peanut Butter Cup for a Twix, or a bag of chips for an O’Henry. The barter system would reveal the “price” for which each piece of candy would trade. Certain snacks would be higher valued than others, and that created the possibility of lopsided trades. My brothers ascribed almost no value to Tootsie Rolls, since they didn’t like them, so they were willing to trade them for Cherry Blasters at a steep exchange rate. I recall nabbing six Tootsie Rolls for one more coveted piece of candy. I realized at this point that bartering not only reveals makeshift prices to the market participants, but that those prices can be out of whack with one’s perception of the goods’ (candy’s) value. This is a fundamental lesson of economics, and why having currency as a medium of exchange makes trading so much more efficient – particularly when prices are publicly available and participants have access to more information.
Eventually, I started taking this lesson a step further. When visiting a house while trick or treating, I might be able to get a Tootsie Roll or two from the basket of candy, or another piece of candy of my choosing. Instead of getting Tootsie Rolls at the “basket” exchange rate – in which you were usually limited by the number of pieces you took – I could instead play the market inefficiencies to my advantage. I could seek out sweets my brothers preferred, and trade them for all the Tootsie Rolls I could handle, with plenty of leftover Smarties and Crispy Crunch bars (my favourite) on the side. Tootsie Rolls, to me, were the most undervalued asset. I viewed them as a good piece of candy, trading at the rock-bottom price of a box of raisins or one-sixth of a pouch of Cherry Blasters.
In essence, this is what value investors try to do every day – identify mismatches between a company’s true value, and the value for which it’s available for purchase in the market. When we analyze a company, we try to determine what it’s really worth, based on its industry, growth potential, corporate governance, management, profits, and more. Then we compare it to the prevailing market price. Often, the company’s stock price is close to what we consider its true value, and I can think of many examples of companies that have much higher stock prices than we think the company is really worth. But sometimes we find a good quality company that’s trading at the valuation of a lesser quality company – then we’ll buy it, and hopefully our initial assessment of its value turns out to be correct, and its stock price appreciates as other investors come to agree.