The Airplane and the Tetherball

There is a key distinction between the market price of a stock and the business underneath that market price, which investors would do well to always keep in the forefront of their mind.

To highlight this distinction, Ben Graham created a famous metaphor, which he introduced in his 1949 edition of The Intelligent Investor as an illustration "in the nature of a parable."

He asked readers to imagine a small private business in which you own a share, and to further imagine that you have an irrational business partner, "Mr. Market." Mr. Market, Graham said, often "lets his enthusiasm or his fears run away with him" (42).

Every day he proposes to tell you what your business is worth, and to either buy your share from you or to sell you more of the same, at a valuation that "seems to you a little short of silly," in the words of Mr. Graham. Graham was drawing the distinction between the business itself and the market price for that business.

Several years ago, we also developed a metaphor to help investors to understand the distinction between the market price of a business and the underlying business itself, called "The Airplane and the Tetherball." Imagine a high-performance jet aircraft, and attached to this aircraft by a long bungee-cord arrangement is a small yellow tetherball. As the airplane climbs and dives, the tetherball will be tugged along behind the aircraft. At the same time, it is buffeted about by the winds, in a most unpredictable manner.

In this illustration, the airplane represents the underlying business, and the tetherball represents the market price of that business at any given moment -- for a publicly-traded company, this price is the stock price on the exchange.

Based on the fickle nature of the winds and air currents, the tetherball can sometimes be higher or lower in altitude than the airplane itself. This is because the market sometimes over-values or under-values a business, based on a variety of external factors, many of which have nothing to do with the fundamental performance of the business itself. In Graham's "Mr. Market" analogy, he attributed these factors to Mr. Market's "enthusiasm or his fears" which often "run away with him."

Predicting the direction of the tetherball is almost impossible. However, one thing is certain: because it is attached to the airplane, if that airplane continues to climb in altitude for several years in a row, the ball eventually will be dragged higher by the airplane. It still may be overvalued or undervalued relative to the airplane itself, but it will be higher than it was before.

In the diagram above, we have depicted a hypothetical business, marked by an airplane climbing on a trajectory indicated by the dotted blue line. The stock price of that business, represented by the solid red line, fluctuates quite erratically, sometimes being above the line of the airplane 's trajectory and sometimes below.

There can be a long lag between business performance (a climbing airplane, or a diving airplane) and the stock price (the tetherball, attached by a long elastic bungee-cord). Studies indicate that the longer the period, the greater the correlation between fundamental factors (such as operating earnings) and stock price.

The important lesson for investors is to focus on the underlying business (the airplane) and its trajectory, which is the "primary mover" in the illustration, rather than the market price (the tetherball), which is secondary. This advice seems obvious, but the reason it is difficult to follow is that the wild daily movement of the tetherball gets an enormous amount of attention. Also, a huge percentage of those in the "investment" industry pursue strategies that is based on some sort of timing of the movements of the market, rather than a strategy of owning businesses through the various short-term market fluctuations.

This is why our discussion of buying shares in businesses, as well as selling them, emphasizes the performance and prospects for the business itself, rather than the market's movements. Your analysis should be focused on determining which businesses are climbing at strong rates or are likely to do so, and you should be prepared to sell companies when you determine that they are leveling off in their trajectories, or even turning over and beginning to dive.

Incidentally, fundamental analysis of businesses using the criteria that we have used for many years and discussed in various places on this blog indicate to us that there are more good companies with market prices well below the fundamental value of their businesses than at almost any time in recent history.

Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.

For later posts on this same subject, see also:

• "Market prices and business performance" 01/29/2010.