Summary
- Both common sense and logic would dictate that future
investment success and results are dependent upon possessing an accurate
understanding of the most relevant factors that drive future stock
movements.
- In the long run - Earnings Determine Market Price.
- In the short run - Emotions Determine Market Price.
Introduction
I believe that it
behooves all investors that invest in common stocks to have a coherent
understanding of what I consider the most important principle regarding
investing in stocks. Moreover, a cogent awareness of this principle
relates to having a relevant and valid answer to the following important
question: What drives the future price of a common stock?
Both
common sense and logic would dictate that future investment success and
results are dependent upon possessing an accurate understanding of the
most relevant factors that drive future stock movements and their
direction - in the long run. Otherwise, how could an investor ever
determine whether investing in a given company (common stock) makes
sense, or if it represents an attractive investment opportunity?
Therefore,
I offer this article as a dissertation on the primary factor that
drives the future stock prices of a publicly traded common stock.
Moreover, this same factor is the driver that creates the value of all
businesses, public or private. In other words, with this article I am
endeavoring to illuminate the primary principle that generates current
and future value to business owners.
Admittedly, most of what I
will be discussing I consider as "stating the obvious." However, as it
is with many investing principles and financial jargon, the obvious is
often overlooked or missed. More plainly stated, over my long career in
the financial services industry, I have observed a penchant for making
simple concepts complicated. In Western Pennsylvania, where I grew up,
this was commonly referred to as "complicating a one-car funeral."
"It's the Earnings, Stupid"
With
the above in mind, I respectfully ask the reader to allow me to state
the obvious. It is simply the earnings power of any business that gives
it value, past, present and future. The more earnings power a business
possesses, the more value it is capable of delivering to its owners.
Once again, this simple and obvious truth applies to every business,
public or private. Consequently, if this is truth, and I contend that it
is, then doesn't it make sense for investors in, and owners of,
businesses to focus on earnings, first and foremost?
Frankly, I
believe it does make sense for an owner of a business to focus primarily
on the company's earnings power. However, my extensive experience in
the investing industry suggests that most investors focus too much on
price movements over profits. I believe this is a mistake, and yes, I
believe it is an obvious mistake that can, and should, be avoided.
The 2 Faces of a Stock's (Business) Performance
I
have long used the simple acronym - EDMP - to keep me focused on this
important principle regarding the primary driver of a common stock's
price. So much so, that I named the money management firm I co-founded
based on it. The acronym EDMP stands for Earnings Determine Market Price
(in the long run).
Fortunately for me, this principle was burned
into my brain by my Economics professor in college. My professor's name
was Alvin F. Terry, and every day, he started the investment course he
taught in the following manner. Once we are all settled in our seats,
Prof. Terry would walk up to his desk and literally and vigorously pound
the table with his fists while shouting -
EARNINGS DETERMINE MARKET PRICE! Every day, without fail, class was started with this fanatic ritual.
Needless
to say, thanks to my passionate and enthusiastic professor, the obvious
long-term driver of a common stock's price became forever imprinted
into my psyche. In fact, his antics made such an impression upon my
young mind, that it became the focal point of my life's work. My entire
career, that now spans more than four decades, has been dedicated to
validating Prof. Terry's thesis. Moreover, I am happy to report that my
research and experience has proven to me that his simple and obvious
hypothesis was both valid and true. Soon, I will present evidence
supporting the truth behind my professor's words.
However, before I
do that, I believe it's important to present and discuss a complicating
factor that causes many investors to overlook the obvious. My research
also uncovered that there is an evil twin sister - EDMP - that applies
to the shorter run. Emotions Determine Market Price, in the short run,
and it is this fact that creates the primary reason why investors often
lose their focus and miss the obvious.
As human beings, we are
emotional creatures, and when our emotions are in a heightened state,
critical thinking goes out the window. This applies to all aspects of
life, and certainly applies to how we handle or invest in our stock
portfolios. In other words, in the short run, it is easy to become
blinded by the two most powerful emotions that investors are often
forced to deal with - fear and greed. Of the two, I believe that fear is
both the most dangerous and most powerful emotion that investors must
deal with. Fear is associated with anxiety, and when we are frightened,
we are most likely to cast reason aside.
What this all boils down
to is the reality that there are two faces of performance. To me, the
true and most important performance face of a business is its
operating performance.
This is most commonly evaluated based on a company's bottom line, i.e.
its earnings. Consequently, since I'm a long-term investor, I have also
trained myself to pay more attention to the business behind the stocks I
own, and less attention to the daily gyrations of their short-term
stock prices in an auction marketplace.
Unfortunately, this is
apparently difficult, or as I stated earlier, overlooked by many, if not
most, investors. Instead of trusting their company's bottom line, they
instead either obsess or worry about their investment based on whether
the price of their stock is going up or down. And as I stated many times
before, if the price of a company's stock is falling, it's a bad stock.
In contrast, if the price of a stock they own is rising, it's a good
stock. But most pertinent is the actuality that these judgments are
often made with no informed regard to the fiscal health and strength of
the underlying businesses they own.
The problem with this kind of
emotional behavior is that all too often it motivates people to buy a
stock they should be selling, and sell a stock they should be buying. A
great company's stock price falls, and instead of recognizing it as the
opportunity it is, they panic and sell. This often results in selling a
valuable asset for significantly less than it is truly worth. This
behavior caused more people to lose money during the Great Recession,
than the Great Recession itself. Personally, I believe it's virtually
always a bad idea to sell a valuable asset for less than its intrinsic
value just because you are scared by the temporary actions or behaviors
of others.
Real-world Examples of the Importance of Earnings
As
I previously mentioned, my finance professor's passionate teachings
inspired me to dedicate my life to evaluating his common sense thesis.
However, with the investment world almost universally focused on stock
price movements, I was frustrated at almost every turn as I looked for
evidence to support the logical notion that earnings determine market
price. Therefore, I took matters into my own hands and developed
F.A.S.T. Graphs™, the earnings and price-correlated, fundamentals-based
stock research tool.
Once armed with my creation, I was empowered
to examine the long-term earnings and price correlation, and I now
contend functional relationship on thousands of companies over many
decades. The evidence supporting the importance of earnings is both
overwhelming and incontrovertible. No matter whether earnings go, up,
down or sideways, on graph after graph, earnings and price will move in
tandem. Moreover, if the stock price strays away from its
earnings-justified valuation (over or under), inevitably it will come
back into alignment with earnings. Therefore, not only is this a common
sense hypothesis, it is supported by a preponderance of undeniable
real-world evidence.
Since a picture is worth a thousand words, I will offer the following examples via the
F.A.S.T. Graphs™
research tool to illustrate the veracity of what I have thus far
written. Importantly, the reader should note that the focus of the
following exercise is on the long-term relationship between earnings and
stock price. Consequently, even though some of the following examples
do pay dividends, they will be excluded from the following presentation.
More clearly stated, this is not a total return exercise, instead it is
an exercise to illustrate that in the long run, earnings drive stock
prices and trump price volatility.
(Note: In all
examples, where possible, I will present my maximum 20-calendar year
graphs. On any graph over 15 calendar years, only every other year's
data is typed onto the graph, but all data is plotted.)
International Business Machines (IBM)
International
Business Machines Corporation provides integrated solutions, such as
consulting, delivery, and implementation services; enterprise software;
systems; and financing for clients.
I chose IBM as my first
illustration, because I feel it represents a quintessential example, or
poster child for the good stock when prices are rising and bad stock
when prices are falling notion. With the first IBM graph, I plot
earnings per share since 1996, to include estimates for 2014 and 2015.
Clearly,
IBM has been an earnings powerhouse over that time frame, with the only
exception being 2002. To reiterate and focus on my thesis, the first
face of IBM's performance, earnings, present a true picture of this
company's valuation. Earnings have grown at an average annual compound
rate of 10.6%.
(click to enlarge)
Interestingly,
IBM has recently been a much-maligned company, as evidenced by many
recent articles published here on Seeking Alpha. Simply search with its
ticker symbol, and you will find many recent examples of negative
articles on this blue-chip technology company. Therefore, we see
evidence supporting IBM as a bad stock based on its poor stock price
performance over the last two years or so. Ergo, price-wise,
IBM bad stock, bad stock.
In
contrast, this is in spite of the fact that the company's earnings have
remained solidly in an uptrend, and are expected to continue advancing
over the next several years by the consensus of analysts following the
company (yellow highlights). However, a quick review of the earnings and
price-correlated graph below illustrates that IBM's stock price has
followed earnings over the long run.
Moreover, we see clear
evidence that the best time to purchase IBM was during those times when
its stock price fell below its earnings-justified level. In other words,
when many investors thought it was a bad stock because its stock price
was down. We see that in the beginning of 1996, again at the end of 2008
(The Great Recession), and once again today. These are times when the
evil twin sister, EDMP (Emotions Determine Market Price-in the short
run) dominates investors
' minds. On the other hand,
we simultaneously see evidence supporting the true performance
generator, EDMP (Earnings Determine Market Price-in the long run).
(click to enlarge)
Bank
of America Corporation, a financial institution, offers a range of
banking, investing, asset management, and other financial and risk
management products and services to individual consumers, small- and
middle-market businesses, institutional investors, large corporations,
and governments.
With my second example, I review the earnings
history of Bank of America. I chose this example because it provides
clear evidence not only of the importance of earnings, but also to the
idea that where earnings go, stock price is sure to follow. With the
first Bank of America graph, we see strong earnings growth for the first
11 years, followed by a collapse of earnings and somewhat erratic
results thereafter.
(click to enlarge)
Consequently,
when you overlay monthly closing stock prices to the earnings graph,
the importance of earnings as a driver of stock price is clearly evident
and undeniable. Where earnings went, stock price followed in the long
run, up, down, and sideways.
(click to enlarge)
LKQ
Corporation provides replacement parts, components, and systems needed
to repair cars and trucks. The company has operations in the United
Kingdom, Canada, Mexico, and Central America.
With my final
example, I present LKQ Corp. as a quintessential example of a pure
growth stock. Unlike my previous two examples, this company does not
pay, and never has paid, a dividend. Therefore, the sole source of
return that owners (shareholders) of this rapidly-growing business
receive, or currently can expect to receive, is based purely on the
company's earnings power.
I also chose this example because it has
only been publicly traded since October 2003. Therefore, by looking at
the horizontal EPS (earnings per share) column at the bottom of the
graph, each year's earnings per share is both plotted and typed on to
the graph. The earnings power of this company has been both exceptional
and consistent, averaging 24.5% per annum since going public.
(click to enlarge)
When
we overlay monthly closing stock prices to LKQ's earnings, we discover
as pure a long-term correlation between earnings and price as you will
ever see. Moreover, we see evidence that when the company's stock price
rose above earnings (the orange line), as it did in 2007 and 2008, that
price soon came back to earnings. Once again, we see evidence supporting
the idea that it's more important to focus on a company's earnings
power over the long run than it is to focus on short-run price
volatility.
The earnings power of a business is tangible and
reasonably predictable. The investor can review important fundamentals,
such as the balance sheet, profit margins, sales growth, etc., and
derive a reasonable evaluation of the strength and health of the
business behind the stock. In contrast, stock price volatility is
ephemeral and often a pathological liar. In other words, price cannot
always be trusted.
(click to enlarge)
The Moral to the Story
Serendipitously, Warren Buffett published his 2013
Letters to Berkshire Shareholders
as I was preparing this article. What follows are a few excerpts of his
letter that speak directly to the importance of focusing on long-term
business results over short-run stock price volatility. These excerpts
are based on the section of Warren's letter titled:
Some Thoughts About Investing. Appropriately, he starts this section off with a quote by Benjamin Graham from his book The Intelligent Investor, as follows:
"Investment is most intelligent when it is most businesslike."
In
order to illustrate the importance of thinking like a business owner,
Warren utilized examples of two small non-stock investments he made in
mid-1986 and 1993. One was a farm 50 miles north of Omaha, Nebraska that
he purchased in 1986, and the other was a New York rental property
adjacent to NYU that he made in 1993. He used these as focal points on
why he believes that investors in common stocks should ignore price
volatility. My first excerpt is as follows:
"With my two small investments, I thought only
of what the properties would produce and cared not at all about their
daily valuations. Games are won by players who focus on the playing
field - not by those whose eyes are glued to the scoreboard. If you can
enjoy Saturdays and Sundays without looking at stock prices, give it a
try on weekdays."
Then, Warren Buffett goes on to say:
"There
is one major difference between my two small investments and an
investment in stocks. Stocks provide you minute-to-minute valuations for
your holdings whereas I have yet to see a quotation for either my farm
or the New York real estate."
Then, he goes on to put it all in perspective with the following rather extensive excerpt:
"It
should be an enormous advantage for investors in stocks to have those
wildly fluctuating valuations placed on their holdings - and for some
investors, it is. After all, if a moody fellow with a farm bordering my
property yelled out a price every day to me at which he would either buy
my farm or sell me his - and those prices varied widely over short
periods of time depending on his mental state - how in the world could I
be other than benefited by his erratic behavior? If his daily shout-out
was ridiculously low, and I had some spare cash, I would buy his farm.
If the number he yelled was absurdly high, I could either sell to him or
just go on farming. Owners of stocks, however, too often let the
capricious and often irrational behavior of their fellow owners cause
them to behave irrationally as well. Because there is so much chatter
about markets, the economy, interest rates, price behavior of stocks,
etc., some investors believe it is important to listen to pundits - and,
worse yet, important to consider acting upon their comments.
Those
people who can sit quietly for decades when they own a farm or
apartment house too often become frenetic when they are exposed to a
stream of stock quotations and accompanying commentators delivering an
implied message of "Don't just sit there, do something." For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.
A
"flash crash" or some other extreme market fluctuation can't hurt an
investor any more than an erratic and mouthy neighbor can hurt my farm
investment. Indeed, tumbling markets can be helpful to the true investor
if he has cash available when prices get far out of line with values. A
climate of fear is your friend when investing; a euphoric world is your enemy."
Clearly,
legendary investor Warren Buffett and his partner Charlie Munger
understand the importance of focusing on the intrinsic value of the
assets you invest in, while simultaneously eschewing short-term price
volatility.
Summary and Conclusions
The
performance of common stocks truly is two-faced. One face, the
important one, represents the face of reason and focuses on the true
driver of economic value to investors. The second face, is quite often a
pathological liar, and for the most part, full of heightened emotion
and simultaneously often devoid of logic. Yet somehow, and inexplicably
to me, most investors are prone to trust the liar more than they do the
face of truth and reason.
Judging your common stock investments
based solely on whether the price has recently risen or fallen is
madness. As Warren Buffett has tried to teach us for many years, it is
wiser to invest in businesses than it is trying to time or play the
market. These principles are especially important and relevant to those
retired investors who are dependent upon the performance of their
portfolios to support their livelihoods. Our futures and the futures of
our families are simply too important to trust to hysteria and lies.
In
conclusion, what I've written about in this article was solely focused
on what drives the long-term stock prices of common stocks. Price action
is only one component of total return, the other is dividend income.
However, just as earnings drive long-term stock price performance, they
are also the source of dividend income. Therefore, focusing on the
earnings power of any publicly traded business you choose to invest in
just seems like common sense action to me.
