Streetwise

Lauren Rudd

Sunday, March 16, 2014

Small Events with Large Ramifications

There is an often quoted saying that a butterfly flapping its wings in one part of the world could cause a disruption in the weather a thousand miles away. While many take this aphorism at face value despite its incredulous facet, there lies within a basic nugget of truth.

Originally titled “The Butterfly Effect,” the concept originated with MIT meteorologist Edward Lorenz.  In 1961, while an assistant professor at MIT, Lorenz created an early computer program to simulate weather. One day he changed one of a dozen numbers representing atmospheric conditions, from .506127 to .506.

That tiny alteration utterly transformed his long-term forecast, a point Lorenz wrote about in his 1972 paper, "Predictability: Does the Flap of a Butterfly's Wings in Brazil, Set-off a Tornado in Texas?"

Lorenz’s butterfly effect was merely intended to illustrate the concept that small events can have large, widespread consequences. As such the butterfly effect has become a metaphor for the existence of seemingly insignificant moments in time that alter history and shape destinies.

Fast forward to the recent decline of the S&P 500 index after the start of the Ukraine's crisis was triggered last November by the then Ukraine president Viktor Yanukovich's refusal, under Russian pressure, to sign deals on closer political and trade ties with the European Union.

The Crimean peninsula now has the potential to become a history altering altercation. Adding to global distress, China is increasingly mired in an economic morass of its own making. As I wrote last week, the world has no shortage of crises. However, you do not want to become distracted by those who sermonize on Armageddon.

Maintaining a pragmatic vista does not imply any lesser degree of concern. Rather you simply want to avail yourself of the opportunities created by irrational panic flows of capital. The Street’s woeful antics should never be an impediment to your investment strategy.

Consider a brief paraphrase from Warren Buffett’s latest letter to his shareholders. On the subject of panic selling, Buffett wrote, “Why would I sell off stocks that are small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they are certain to do well. Could anyone really believe the earth is going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?”

Moreover, listening to market predictions is a waste of time. As Buffett repeatedly points out, doing so may blur your vision of the important facts. When he hears TV commentators glibly opine on what the market will do next, Buffett writes that he is reminded of Mickey Mantle's scathing comment, "You don't know how easy this game is until you get into that broadcasting booth."

Every stock has an intrinsic value (generally a discounted cash flow evaluation) to which its price is anchored, although share prices will fluctuate due to the daily ebbs and flows of supply and demand. What is decidedly more important is that the price of a stock will converge toward its intrinsic value.

If you can sensibly estimate earnings out five years, and if the stock sells at a reasonable price in relation to the bottom boundary of its intrinsic value, then a purchase is a reasonable decision, otherwise move on to other candidates.

Investment timing is important only to the extent that the timid or inexperienced investor will enter the market at a time of extreme exuberance only to become disillusioned when the market declines and paper losses occur. This is an age old dilemma. The antidote, as Buffett points out, is to accumulate shares and never sell when the news is bad and stocks are well off their highs.