BUFFETTS BOOKS ACADEMY: BASIC COURSE
LESSON 9: WHAT IS THE STOCK MARKET
LESSON OBJECTIVES
- Understand what a stock market is.
- Understand how the stock market works.
- Understand what a limit order and a stop order are.
- Understand Benjamin Graham’s Mr. Market.
LESSON SUMMARY
First we learn that the stock market functions like every other market. The prices are determined by supply and demand. In simple terms, it means that if a market has more sellers than buyers, the price will decrease and vice versa. In the end, the price depends on the seller and buyer’s agreement.
We learn about different types of orders including stop and market orders. With a stop order, you are secured to either buy or sell at a fixed price, whereas a market order is either buying or selling at the best current price for that stock. A third type is a limit order. Here, a seller could put out a minimum sales price (called offer), but can still benefit from a potentially higher price. A buyer would put out a maximum purchase price (called bid), but will still benefit from a potentially lower price.
At the end of the day, no matter what type of order we talk about, there is one important factor to take away from lesson 9 – for every single trade there is a buyer and a seller.
The core of value investing is also discussed. Just because something is traded at a given price does not mean that it is the value. This is also why Warren Buffett says: “Price is what you pay – Value is what you get”.
Finally we learn about Mr. Market. According to Benjamin Graham who was Warren Buffett’s professor at Columbia University, Mr. Market is an irrational person who offers good and bad deals, depending upon his mood. We need to understand that Mr. Market comes up with a new offer every day, so if we are calm and competent, we can take advantage of the situation. Warren Buffett attributes his investment success to Benjamin Graham, and unarguably knows Mr. Market better than anyone else, which is why he says, “Mr. Market is your servant, not your guide”.
There is no better way to understand Mr. Market than reading Benjamin Graham’s book that changed the investment world. It is called “The Intelligent Investor” and the foreword is written by none other than Warren Buffett himself.
NEW VOCABULARY
Stock Market
The stock market is actually a compilation of listed companies. If the prices on the stock market are increasing in general, the market is known to be bull. If prices are dropping it is known as a bear market.
Stop Order
When an investor puts in a stop order, for instance $65, there are two possible outcomes – either the stock is sold or bought for $65, or it isn’t traded at all. The price can never be lower or higher.
Limit Order
A limit order is the minimum or maximum price a buyer or a seller is willing to trade a stock for. A buyer can still benefit from a lower price, and a seller from a higher price.
Market Order
A seller or a buyer can put out a market order and will get the current “best price” for the stock. For a buyer, the best price is the lowest price for a stock, and for a seller it is the highest price anyone is willing to pay.
Mr. Market
Mr. Market, as described by Graham, is a very emotional person who could offer great deals on one day and bad deals the next. The investor should trust his own valuation or the stock and not be influenced by what others are doing.
LESSON TRANSCRIPT
Here are two demonstrations to start with:
- The market where people trade money for food
- The market where people trade money for proportional ownership of real companies
Picture a mother with her little boy where he wants to buy a peach from a vendor. He asks about the price of one peach and the vendor says that it’s $1. Who determined the market price of the peach if the boy decided to buy it for $1? Was it the vendor or the boy? It was both of them. The boy had to agree to the price the vendor wanted. The value of something is only what people are willing to buy, sell, and meet in the middle.
How will the price of that peach change if we changed the sellers? Let’s assume that there are 5 different peach vendors lined up next to each other, competing for one consumer – the little boy. Every vendor wants to sell his peach to him. The more vendors with the same product, the more options the boy has. The boy can say, “You want one dollar, but the vendor beside you wants 90 cents. Can you beat the price?” Sellers compete with prices and the little boy has the control, simply because he is the buyer.
Now, if there’s just one peach vendor and there are a hundred little boys who want peach, the seller now has the ability to control the market price. This is what we call the buyers’ market versus sellers’ market.
The stock market is exactly the same. There are buyers and sellers. When the sellers outnumber the buyer, it is called the buyers’ market. When there are fewer sellers than buyers, it is called the sellers’ market. In the last scenario where there are fewer sellers than buyers, the sellers are changing the value of the company or the shares. That’s something you need to understand because it is fundamental.
One share and one seller. You’ll see how stock markets really work. Here’s an example of what determines the market price:
A shareholder named Amy has one share from Johnson and Johnson, which she wants to sell for $65. She has the option to work with the broker, the bank. This could be a trade, e-trade, or just any other broker. Brokers break the deal by linking a seller and a buyer who will soon exchange their assets. Amy has the ability to put it on the market for one day for her $65$ share or set it up for a 30-day trade where she has 30 days to find a buyer.
First type: The stock order is when somebody is willing to buy Amy’s share for $65. Amy will say, “Broker, you are not allowed to trade my share, unless somebody is willing to buy it for 65$.” If she had a hundred shares and wanted to sell all of it, she would put it on a stock order of $65. If the first buyer only wanted to buy 10 shares for $65 and then another buyer wanted to buy the remaining 90, but is only willing to buy it for $64.90, Amy’s shares will all be executed under that stock order. Even though she set it for $65 and not all shares are executed in the first order, it will be executed in the second order, regardless of the difference in price because that’s what the buyer wants.
Let’s assume that, Trevor, a buyer, comes in and puts up a stock order of $64 for Johnson & Johnson. Amy is trying to sell it for $65, but Trevor doesn’t want it to buy at $65, which means that there is a discrepancy.
Assume that all the sellers in the market want to sell their shares for $65 and if every single buyer would only buy it for $64, no trades will happen in this particular stock. For every transaction, the buyer and the seller both have to agree on the trading price for a trade to occur and the market price to display that.
Assume that Amy and Trevor stick to their stock order – Amy at $65 and Trevor at $64. All of a sudden, Kurt, another seller, wants to sell his share of Johnson & Johnson. He’s on the same sellers’ side as Amy. Instead of putting in a stock order, he puts in a market order. Kurt is basically saying “Any buyer willing to buy one share of Johnson & Johnson from me will get it for whatever amount someone is willing to sell it for”. Since Kurt does that, the trade is executed between Kurt and Trevor for $64. Amy is still sitting there wanting to sell her share for $65, but the market price will now be displayed at $64 a share.
Let’s look at this from the opposite perspective. Amy is the only seller offering her one share for 65$. Trevor and Linda are buyers and though Trevor has the stock order for $64, it’s not what Amy wants. Linda comes along and puts in a market order saying “I’ll buy a share at whatever price the seller wants.” Linda executes the share at $65 and this makes the market price move to $65.
Both sellers have executed their shares. While Kurt sold his shares to Trevor, Amy sold hers to Linda. During that cycle where we saw three shares being traded, the market price went to $64$ and then to $65. Does this mean that the company is worth $65 a share, or did people trade it for $65 and now it’s nothing more than the trading price? Most value investors argue that the latter is just a price that people establish. However, considering the number of owners out there trading their shares, the conclusion is that they agree with the market price or else they won’t be selling or buying their shares. Just because something is trading at $65 a share, it doesn’t necessary mean that the company is worth $65 a share. Value investing is determining what the share is worth. It’s about identifying people who are willing to buy and sell it and capitalizing on that.
Here is a demonstration of a limit order. Let’s assume that Amy still wants to sell her share for $64 or higher. If the price is $65.10, she will still sell it. As long as the price is higher than $65, she wants to sell her share. Now, Trevor wants to buy one share and he puts in a limit order for $64. If he wants to buy, it can’t exceed $64, which means that he won’t pay a penny more than $64. In this scenario, there was the only seller and the only buyer of that one share. You’d see no trades executed because they can’t agree on the price. Once again, Kurt enters and puts a market order saying he’s willing to sell his share for any amount the buyer wants. Now, the market price displayed is $64.
For every single trade, there’s always a seller and a buyer. For Amy, she sold her share because she couldn’t make any money off it. Linda buys it, because this company will make a lot of money, according to her. They trade the shares and while one thinks it’s a piece of junk, the other thinks that it’s a great company that makes lots of money. Kurt was selling his share because he needed money. Although he still thinks that the company is great, he sold it because he needed the money. Trevor buys it because he thinks it makes money. You see, sellers have different reasons, but buyers only have one: “I’m buying this because this is a good company.”
The majority of people don’t determine the price, but only a few do. When you notice that it’s going up and down, it’s because sellers don’t want to sell their shares for any less than what they could make, and buyers don’t want to buy their shares for any more than what they would have to pay for.
One of the things Benjamin Graham taught in his class with Warren Buffett was this idea of Mr. Market. Mr. Market is his emotionally disturbed business partner and you can’t change his behavior. All you can do is react to it. Mr. Market is your servant, not your guide. Graham describes him this way: Mr. Market might come out and say, “Hey, guys! Buy stocks and make lots of money!” He creates these plans and motions behind the market, telling everybody that he’s not just making tons of money, but his neighbors are benefitting as well. Mr. Market can also be someone who has horrible attitude. “Watch out, I’ll take all your money, and tomorrow is even worse than today! Don’t even ask. If you thought you’ll make money in the stock market, you’re just kidding yourself!” These are the personalities Mr. Market has.
Never follow Mr. Market’s emotions, because he’s fooling you. What you have to do is go in there and look at what Mr. Market is offering you. Remain calm and competent. Figure out what the company’s worth and don’t get wrapped up behind the illusions he creates. Mr. Market is your servant, because he either provides you with very good deals or really crappy deals. He’s not your guy so you don’t fall for his emotions. Capitalize on what he’s doing. The market sometimes gives you great deals, and you just got to take them. Other times it gives you horrible deals, and you can’t be fooled by the emotions of everybody else. You have to determine the value of the stock.
In Unit 3, Lesson 1, we learned what a stock market is. Although many people might not view a stock market the same way as a food market, they’re actually more related than you might think. Like any market, in order for a trade to occur, there always needs to be a buyer and a seller.
The selling and buying of 1 share leads to the methods investors use to conduct trades. We first learned about a stop order, where buying or selling a stock stops once the price of the stock reaches a specified price, known as the stop price. Before using a stop order, investors should consider the following:
Short-term market fluctuations in a stock’s price can activate a stop order, so a stop price should be selected carefully. The execution price an investor receives for this market order can deviate significantly from the stop price in a fast-moving market where prices change rapidly. An investor can avoid the risk of a stop order executing at an unexpected price by placing a stop-limit order, but the limit price may prevent the order from being executed. Some brokerage firms have different standards for determining whether a stop price has been reached. For these stocks, some brokerage firms use only last-sale prices to trigger a stop order, while other firms use quotation prices. Investors should check with their brokerage firms to determine the specific rules that will apply to stop orders.
A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.
Example: An investor wants to purchase shares of ABC stock for no more than $10. The investor can place a limit order for this amount that will only execute if the price of ABC stock is $10 or lower.
As buyers and sellers move the market price of a stock through the use of these orders, the market will offer great deals or very expensive prices. Graham used the idea of Mr. Market to represent a stubborn business partner who offers great deals sometimes and horrible deals the next. Your job as an intelligent investor is to determine which deals are of great value.