Benjamin Graham: Voting Machine, Weighing Machine

 When Benjamin Graham said: 

"the stock market is a voting machine in the short-term, and a weighing machine in the long-term"

What did he mean by that?

Well, he meant that in the short-term, the stock market (and stock prices) are the result of the collective whims of individuals participating in the stock market (i.e. buyers and sellers), bidding up or down the price of a share or stock. However, in the long-term, the fundamentals of a business - whether the business is profitable, growing, and will continue to grow, ultimately determines a stock's value (or in other words the value of a share in that business). So how does this play out in simple terms?

The stock market is a voting machine in the short-term: People don't need to buy things out of reason. Some, or even most of the time, people will buy things because they like them or they feel like buying it. To be quite honest, no one really needs a good reason to do anything. Of course, you want to be rational with your decisions most of the time, and make good decisions consistently; but no one really is fully rational all the time, and besides, no one ever has all the information to make a completely 'good' decision. And a 'good' decision is perhaps subjective, or at least different for different people, which depends on each persons own goals, wishes, expectations, what they want to achieve etc. Anyway, so how does the whims of people translate to stock prices? Well, people buy and sell in the short-term based on emotions. They may feel good one day about the prospects of a business, and think "its amazing!", so they buy the stock and this pushes the price of the stock up. The next day, they think "the stock price has gone up too much!" and they sell, this pushes the price of the stock down. The day after, they think "the stock is cheap, the business prospects are still good!" so now they buy again and this pushes the price up. None of these decisions were really made using careful analysis. They were based on the whim of what the investor 'felt' at the time. At the very least, the decisions weren't made using substantial evidence. Though their gut feeling might be right from time to time, the research involved was not very deep. It's like saying, "well, I think that x baseball team is going to win tonight, I just have a gut feeling, I think they have good players, and I mean they're the home team and I really want them to win!". Meanwhile, the stats, the win percentages, the opposing team, and their record all say differently. All things a professional sports bettor would have reviewed. So, back to the stock market, in the short-term, is full of these whims - people buying and selling, not necessarily knowing what the underlying company is really like. They kind of just know that it can go their way, or not, and they have a gut feeling that it will go their way. So this alone makes the stock market very unpredictable in the short-term, which goes with they saying "you can't time the market". As a trader, you're kind of just sitting there trying to figure out where the collective whims will go from one day to the next. Thus, its said that the stock market is a voting machine in the short-term: people will bid up, or down, the prices for a company based on emotional whims.

The stock market is a weighing machine in the long-term: My guess is that this is where people get lost the most. How is it like a weighing machine in the long-term and how do the mechanisms play out that make it so? What did Graham mean by weighing machine? By weighing machine, Graham meant that a company's shares (or stock) will ultimately reflect the business' worth, substance, or value over time. In other words, if you own good and growing businesses, then your stock (or your share in that company) will naturally increase in value as well. In other words, it is the substance of the business that grows in value, not the share (or stock price). The share (or stock price) is only merely a reflection of the underlying business. So to put it all together, in the short-term, the stock market can act like voting - people buying and selling on emotion, liking or disliking a stock, and prices can go up and down (sometimes quite violently). But in the long-term, the stock market will act like weighing - the price or value will reflect its substance and the underlying business' success.

So how does this play out in the real word. Let's take an example of a bad business that's declining and shrinking. In the short-term, people can like it, they can say "they're going to turn this business around!" or that "the price is really cheap now compared to the price before!". At the end of the day, a bad business is a bad business. The price you pay for it today might be more than what its going to be worth in the future. As a rule of thumb, you want to own things today that will be worth more in the future. So how does this all play out? Of course, there could be good business prospects in the future, and they could turn this business around. But anything can be said now given no one knows what the future holds. But what happens if the prospects don't work out? How does this translate back to the stock price? Let's use this case study: So the business is shrinking and the business isn't profitable. The trajectory is bankruptcy. If a business isn't profitable, it eventually has to get funding from somewhere or someone. A business can only take $1 and lose $0.50 so many times before it goes broke. So if the business isn't profitable, someone is going to have to keep funding the business in order to for it to keep it alive. In other words, someone is going to have to give that business another $1 for it to keep going. Businesses get funding from two main sources: its creditors/debtors (i.e. taking on debt or borrowing) or finding more business partners (i.e. finding more partners to 'share' in the business or in other words give the business more money and they'll give you a share in the business). In general, creditors/debtors, need to be paid back, and it usually comes at an interest rate. On the other hand, Business partners never have to be paid back. After all, as a partner, the situation is "I lose, we all lose" and vice versa. Generally, all shareholders or partners 'share' in the business' ups and downs - that's what a share is. So back to the case study - the business is losing money, and needs funders. They can always go to the debtors/creditors to borrow, but the business is already losing money, borrowing more money at this point will just take the business down faster. Besides, no one in the right mind will lend them money because they're not profitable. Why would lend money to a losing business. The debtors know they're never getting the money back if they lend to them. So the debtors/creditors say "no way". So what's next, the business says "ok, we'll find more partners to fund the business. If we don't we're pretty much done. We need to convince other people to put money in this business so that we can keep going with this take $1 and lose $0.50 business". In other words, they need to do a really good sales job. The best part is that since shareholders are partners, they never need to get paid back - remember: "I win, we win; I lose, we lose - we share the gains and losses" that's what partners are. Sounds like a great way to get funded right? Well, not really. So what happens to the original shareholders or partners? Let's say you were 1 of 4 friends that started this business. All of a sudden, the business needs funding and has to find 4 additional partners (i.e. find 4 more people, shareholders, to share in the business), just to keep this business going. Well as one of the original partners, you're now 1 of 8 partners after the 4 additional partners (shareholders) were added. This means your overall share of the company just decreased (from 1-of-4 to 1-of-8; instead of sharing the company with 4 other people you now have to share it with 8). As the business keeps losing money, it needs to find more funding and more shareholders. As a result, your share of the company gets smaller and smaller. Maybe next time around, they will need to sign 100 new shareholders to keep the business going. Now, your share of the company has become 1 of 108 (the company is shared amongst 108 people) - a tiny fraction. This is why unprofitable businesses are not good investments or are good to be shareholders (or partners) in. Because losing businesses will require more and ever more funding to keep it alive. They can't sustain themselves, and in the process, your share of the company becomes worth less and less as they have to find new partners to fund the business (and you have to share it with more people). And as your share becomes less and less, the price of your share becomes less and less. Again, the share price is merely just a reflection of the underlying share of the business. This is how it all comes together and translates to stock (or share) prices. Of course, the flip side is that the business could turn things around. They could become profitable, self-sustaining, and make a lot of money. In the eventual case, they make so much money that they are able to pay their partners (shareholders) some of that profit (as a dividend), and when that happens, your share (or stock) in that company is worth more (than it was before, it shows that the business is successful and they might even be able to pay out more profits in the future!). If not shareholders benefitting from a dividend, the business might make so much money that they can afford to buy out some partners (or shareholders). They might be able to say "ok, instead of  having 4 partners, we're going to pay out 2 of the partners to part ways", and the result is that the remaining partners will own 1 of 2 (half) of the company (only share the company with 2 other people) whereas before they were 1 of 4 (a quarter; shared the company with 4 other people) - this is called a share buy back.

This was a lengthy explanation of Graham's voting and weighing machine. Hope it helps and makes sense. Leave comments, rebuttals, below.