A previous version of this article appeared on our website July 21, 2013. Refreshed and updated throughout, as of July 2018.
By Brian Nelson, CFA
After earning my MBA at the University of Chicago Booth School of Business and training stock and credit analysts from large organizations over the past decade or so, I have heard just about every question (though I admit I am still surprised by many things and remain a very humble student of the markets). I’ve also spent years perfecting the discounted cash flow process for large research organizations such as Morningstar and studied under one of the most famed aggressive growth investors of all time, Richard Driehaus.
My knowledge runs the gamut from value through momentum investing and generally everything in between, but I continue to be surprised at how frequently investors can be misled this day and age. If you follow me on social media, you can see how my ideas differ from mainstream concepts. Sometimes I wonder if all of the readily-available (and free) information out there is actually a bad thing. Hopefully, the 16 steps below, which should be read in order, will help investors understand what the stock market and stock investing is all about. This piece is meant to be more conversational, with much less financial jargon. I hope it’s helpful!
Note: This is a working document, and readers should expect updates in the future.
1) The Stock Market Is a Market. Let’s start with the very obvious. The stock market is driven by the actions of people. People are imperfect. People make mistakes. People have biases. Some people are greedy; some people are fearful. I think when individuals first start to invest, they believe that the stock market is orderly, calculated — that it may be as precise as accounting, as in assets equal liabilities plus owners equity, for example. In other words, new investors think that if a company does well fundamentally, then its stock should do well, too. Unfortunately, the stock market is often nothing like this, and even good, “moaty,” competitively-advantaged companies with strong brand names can make for bad stocks, if bought at the wrong price.
The stock market and the price of a company’s stock will always be based on, or a function of, the future expectations of the company’s earnings or fundamentals, and more specifically its future free cash flows, estimated long into the future and discounted back to today. While this is the case when it comes to estimating value that influences investors’ behavior, only the actual buying and selling of the stock on the basis of future expectations will be responsible for market-driven price changes (excluding stock splits and the like). Said differently, if the earnings of a company advance 10% in a particular year, for example, it is almost equally plausible that the same company’s stock price may have gone down 10% or up 10% or stayed flat for that same year (on the basis of buying and selling). Even if earnings for that company have gone up over a 10-year period, the stock price could still be lower than it was at the start of that 10-year period (though this is somewhat unlikely, it is not improbable). This concept is very important for new investors to understand.
The stock market will always be a market filled with individuals making decisions about what to buy or sell on the basis of future expectations (or implied through future fundamentals), and these buy and sell decisions — and only these buy and sell decisions — move the stock price — not the reporting of historical earnings or dividends, but an actual purchase or sell order. If there is one experience that I think every investor should have, it would be to watch a small/micro-cap company’s share price move after a large buy order is filled. Or see a company “break out of a base” as technical investors pile into the stock with purchase orders. Most sell-side analysts have never seen this; most buy-side analysts have never seen this. And certainly, most individual investors have never seen this. The market moves because investors move it with their buying and selling activity.
Only through these experiences (or the understanding that these dynamics exist) can the investor tear off the shackles of deception that so many investors want so desperately to believe. We as individuals try to make rational what is not: We want good companies to be good stocks, but this isn’t always the case. We try to find complex answers for things even though at times they are so simple. In this case, in the first step of 16, the stock market is just a market. And it doesn’t get simpler than that. Key takeaway: The stock market is neither rational nor precise, and it is driven by the buy and sell decisions of participants (including your doctor, lawyer, shoe-shiner, and yes, even your taxi cab driver-or should I say, limo driver). But it is also because of this dynamic that opportunities in the market exist!
2) There is No Long Term. The financial industry loves long-term investors–and rightfully so for them: there is lower flight risk of your assets if you are a long-term investor, or perhaps better described as a holder of stocks for a long period of time. It just sounds so good, too: “investing for the long term.” And so innocent! But to some market participants, the long term is nothing more than just more fees–not to mention, that the concept is one of the stock market’s biggest fallacies.
Long-term investing, in my opinion, is not leaving your assets in one place for a long time, but instead, it is considering the long-term earnings/fundamentals and free cash flows of a company in your investment analysis. At any point in time, for example, the stock price of a company will be based on (imputed from) the expectations of future earnings and free cash flows. In 10 years, the stock price of the company will still be based on expectations of future earnings/fundamentals and free cash flows at that time. We, as investors, will never reach the long term — in fact, when it comes to the concept of expectations theory and stock prices, there is no long term, even as we say that all of the value of any asset today is based on expectations of its future earnings/fundamentals and free cash flows over the long term.
Please understand that this concept is much different than the saying that “in the long-term, we are all dead” — coined by John Maynard Keynes, which means that the long term isn’t as important as the short run for decision-making. The long term does matter, and in almost all cases, it is more important than the short term. But what I’m saying in Step 2 is that stock prices will always be based on current expectations of future earnings/fundamentals and cash flow over the long term (at any point in time in the future). There is no magic switch 10 years from now that will change the market from a discount mechanism of future earnings/fundamentals and free cash flows to a precise mechanism that translates earnings one-to-one from the company to the shareholder. If this does happen, the stock market will no longer be a market (it will be some pass-through entity).
Long-term investing is based on analyzing the long-term dynamics of a business and making a stand that at some point other investors will drive the stock toward your intrinsic value estimate (over the long haul). It does not mean that all of a sudden the company will be valued differently because we’re now 10 years into the future. Or that the stock price will be higher 10 years from now because earnings have expanded or fundamentals have improved. If you’re willing to hold a stock for 10 years, it is very simple: you could have a winner or loser (or something in between). The difference is how the price will react to expectations of future earnings/fundamentals of these companies at a point 10 years in the future.
Let’s try this example. Many investors may consider 2050 to be the long term, about 30 years from now. But the value of a stock in 2050 will be based on the market’s expectations of the company’s future earnings/fundamentals and future free cash flows in 2050 and over a “new” long term, not from today through 2050. A brand new long-term has been “created,” of which the stock price in 2050 is then based on. The long-term was never reached. In this and every example, the long term will remain elusive — always in the future and never attainable. Key takeaway: The core of stock investing will always be based on expectations of future earnings and cash flow at any point in time in the future. There is no long term.
2a) The Psychology of the Markets
“The stock market is a discount mechanism of future expectations. Period. Sometimes prices are rational and based soundly on reasonable future fundamental expectations and sometimes they’re not.” – Brian Nelson, CFA
Stop thinking chronologically, and start thinking psychologically (expectations theory).
Many investors believe that they can just buy any old stock that pays a growing dividend and hold it for decades, and that’s long-term investing. Selection bias aside, this has worked in the past for many an investor. There are hundreds of examples of this. But I think it is incredibly important for investors to understand how to think about the long term, regardless of your investment time horizon. The long term is generally taught and presented chronologically (i.e. hold a stock for years), but instead it is a far more psychological phenomenon.
First, any intellectual conversation of the long term must consider the discounting mechanism of stock prices in how they discount future information, whether it is risk through the discount rate or value through the magnitude of free cash flows. The long term, therefore, is a far more complex concept than many make it out to be. In the future, for example, stock prices will reflect the expectations of a “new” future at that point in time, not the fundamentals of the past or performance from the past to present. This is why in “The 16 Steps to Understand the Stock Market,” we say the “long term” can never be attained. It’s fallacious to think so. As time passes, there will always be a new “future,” and a new “long term,” and stock prices will always change to reflect the moving target of these changing long-term expectations.
Apple (AAPL), for example, is/was/has been a great performing stock because its future today has a larger free cash flow stream expected in it (and perhaps lower risk ascribed to it) than that of the future of its past. Its future value today is larger than what it was in the past. The present value of expectations of its long term, a “new” long term, have changed over time. This is very important to understand. It is not necessarily the passing of time (chronologically), per se, why stock prices advance/decline, but instead it is the change in the market’s future financial/fundamental forecasts of the company (free cash flow and the like) +\\- net cash on the books at any point in the future that causes the stock price change (driven by buying and selling activity based on these changing expectations).
It’s psychological based on expectations theory, not chronological. Because expectations of the future are always changing, and the future is inherently unpredictable, there can theoretically never be a determinate or definitive “long term.” In fact, there is only a series of iterative expectations of the long term that drive the stock prices of today and stock prices as time passes. If you understand this, you’re moving closer to understanding what makes the markets tick.
3) Stocks Do Not Magically Converge to Intrinsic Value or to a Target Price. Often, investors hear that a stock is undervalued (“underpriced”) or overvalued (“overpriced”), and this informs their investment decision as if some magic wand will cause the stock to magically converge to their intrinsic value estimate. Stocks can stay overvalued for decades, and stay undervalued for decades, or stay fairly valued for decades. Only when there is buying or selling in the stock based on its undervalued or overvalued state does a stock actually converge to intrinsic value.
In other words, it doesn’t matter if you think a stock is undervalued or overvalued. It matters if others (after you) think a stock is undervalued or overvalued, and then they buy or sell that stock driving it higher or lower–only then will it converge to intrinsic value. The market is not magic–other people have to eventually agree with you (and vote with their money) for your ideas to work out. As an investor, you are highly dependent on what other people think. You must hope that they eventually come around to what you believe. Or else your stock will never converge to intrinsic value.
The only reason why famed investor Warren Buffett, for example, may not want to “talk his book,” per se, and/or want a stock that he holds to decline is so he can buy the whole company (and more importantly, its future free cash flows) on the cheap. For stock-market-only investors, we want the stock of the companies invested in to eventually go higher. Key takeaway: Stocks do not have to converge to intrinsic value. Only buyers and sellers can drive a stock to intrinsic value. We, as investors, are highly dependent on what other people think of our ideas in the future.
4) Everything in the Stock Market Is a Self-Fulfilling Prophecy. I hope you’re still with me because this step is so very important. I cannot tell you how many times I have heard that technical analysis (chart reading) is a self-fulfilling prophecy because it is driven by the actions of buyers and sellers reacting to or anticipating patterns in a chart. Those same individuals then claim that value investing or growth investing is not a self-fulfilling prophecy. Once I hear that, I know that most value investors haven’t read Step 1 above. If you have, you already know more about the market than they do.
Please understand: technical analysis works sometimes because people buy and sell based on technical analysis, driving a stock higher or lower respectively. Value investing works sometimes because people buy and sell based on value principles, driving a stock higher or lower respectively. The same can be said about growth investing or other widely-followed methodologies. The more people think that a firm is truly undervalued, the more it will be bought and its price will be driven to fair value. The more people think that a firm is truly overvalued, the more it will be sold and its price will be driven to fair value. This is the “price discovery” function of the markets.
Stock prices converge to intrinsic value because investors collectively think the stock is worth its intrinsic value and vote with their capital to drive the stock price to its intrinsic value. If nobody thought a stock was worth its intrinsic value, it would never reach its intrinsic value. If everybody thought a stock was worth its intrinsic value, it would trade precisely at its intrinsic value. If you think a stock is worth intrinsic value, but nobody else does or ever will then I’m sorry you have an underperformer on your hands. It is this self-fulfilling mechanism that makes the stock market what it is. Key takeaway: The stock market is and always will be a self-fulfilling mechanism. If all investors think one thing, it will be true in the stock market.
5) The Stronger the Competitive Advantage the Lower the Stock Return. This can’t be! No way! You refuse to admit it! Everybody can’t be wrong! But what about Buffett? Well, you don’t have to take my word for it. Ask one of the most well-known investment firms out there that does Warren Buffett’s economic moat analysis. All else equal, the firm concluded that companies with wide economic moats underperform stocks with narrow economic moats, and that stocks with no economic moats had the best returns, over the time period studied — Source: Miller, 1/1/2013, Morningstar. This relative outperformance of no-moat stocks is driven more by the context of valuation as opposed to any competitive-advantage assessment. The “value” of higher risk stocks, by definition, will advance at a higher annual pace than lower-risk stocks over time, all else equal (they have higher discount rates in a discounted cash-flow process to reflect their heightened risk profile – think risk premium).
But there’s also another dynamic at play. As markets remain benign through up-cycles, riskier stocks are re-priced higher using lower discount rates (credit availability is improved). The longer duration cash-flow profile of higher-risk, no-moat companies is then magnified when the cost of borrowing is reduced. This makes no-moat firms very volatile through the credit cycle, but it also is responsible for their significant outperformance during good times. Moaty stocks are less impacted by credit availability, and therefore, their discount rate and intrinsic value does not experience much volatility. Investors sometimes like stocks with moats because they tend to be less volatile, not necessarily because they are better performers. Most investors cannot sleep at night, for example, if their portfolio experiences wild swings, and moaty stocks, by definition, should generally be less volatile through the course of the credit cycle than no-moat stocks. Investors accept lower volatility for lower returns over certain market cycles.
As empirical research has concluded over recent history, wide moat stocks tend to underperform no-moat stocks across almost every valuation bucket. In the context of valuation, investors should expect the values of (not price of) stocks to advance at the discount rate in an enterprise discounted cash-flow model less the dividend yield over the long term. This percentage is higher for no-moat stocks (most don’t pay dividends) than it is for wide moat stocks, and both empirical and academic research supports this view. Investors should probably expect a long-term annual value advance of about 5%-8% for moaty stocks and long-term annual value advance of about 8%-10% for no-moat stocks, theoretically of course and on the basis of value, not price (expected price returns can be far different based on measurement periods). Investors shouldn’t only consider stocks with the worst fundamental qualities either. There’s individual bankruptcy risk and the potential evaporation of equity in higher-risk small and micro caps that may occur under tightening credit cycles.
That said, however, investors may do well with a basket of no-moat undervalued stocks over a long-enough time period, but without broad diversification across firm-specific risk, an individual investor can be harmed should any particular no-moat equity fail — that is, if a firm declares bankruptcy and equity holders are wiped out. A concentrated portfolio of fundamentally poor companies is simply a bad idea, in our view. For us at Valuentum, the simulated Best Ideas Newsletter portfolio seeks to attain low levels of volatility while capturing significant outsize returns — the best of both worlds. Read more about the simulated Best Ideas Newsletter portfolio here (pdf). Thus far, the Valuentum strategy, as revealed by the simulated Best Ideas Newsletter portfolio, has generated significantly more return for the level of risk taken. Key takeaway: Competitive advantage analysis alone will not lead you to the best-performing stocks. It actually has been shown that it will lead you to underperformance.
6) Earnings Surprises Are Analyst Misses Not the Company’s. A company is not doing better or worse just because an analyst or a group of analysts (consensus) fails to accurately predict quarterly results. Companies beat or miss earnings expectations because analysts are wrong with their forecasts. Nothing against analysts (I am one of them!), as it’s nearly impossible to accurately predict quarterly earnings all of the time, but this is an important point.
Let’s ask ourselves these two questions: What if a company continues to miss earnings expectations every quarter into infinity? Will its stock price keep going down forever until it reaches 0? The answer simply is no. Stock prices are determined by expectations of future earnings/fundamentals and free cash flow. A company will still have value even if it continues to miss earnings. If a company that has exceeded earnings estimates in the past has been a strong performer, it has to do with the idea that expectations for future earnings/fundamentals and free cash flow have increased — not because it has exceeded historical earnings estimates. Consensus estimates and even “whisper numbers” move around often, and I’ve even heard of speculation/rumors that some analysts may raise their target prices and lower earnings estimates (at the same time for the same company), so that specific company can beat estimates (and hopefully traders drive the stock price higher to their target price). Well-seasoned market participants may have encountered this potential conflict of interest that I speak of.
Still, it is the future that matters. Once a company reports numbers in a quarter, the quarter is over (and it is history). The only thing investors care about is the future. Stock prices will always be determined by expectations of future earnings/fundamentals and free cash flow over the long haul. Key takeaway: Earnings beats and misses offer very little value to the investor. Stock prices are determined by future expectations of earnings and cash flow.
7) The Recent Trend Toward Dividend Investing May Be Good (and Bad) for the Individual Investor. On one hand, individual investors that are interested in dividend-growth investing find strong, stable, dividend-paying companies such as Johnson & Johnson (JNJ) or Procter & Gamble (PG), and this is great. It prevents them from getting involved in speculative, high-risk companies (remember the dot-com craze), which in many cases is the last thing a retiree is interested in doing.
But on the other hand, dividend-paying companies have in many cases been transforming into speculative companies. Many master limited partnerships (MLPs) and mortgage/residential real estate investment trusts (REITs) remain overly-dependent on the healthy functioning of capital markets, necessitating global credit health for survival. And many investors are stretching for those 10%+ yielding entities that may not survive for long. This is not a good thing at all.
Many die-hard dividend-growth investors may not want to embrace this reality, but dividends are just a component of cash flow distributed to shareholders, and a company’s intrinsic value is based on its entire future free cash flow stream. Investors can seek yield, but a total return consideration should never be ignored. Key takeaway: Dividends are just a component of cash flow, and a company’s intrinsic value is based on its entire future earnings and free cash flow stream.
7a) Dividends Are a Symptom, Not a Driver of Intrinsic Value
“The ‘dividend’ has done more to confuse investors about investing than anything else in modern-day society.” – Brian Nelson, CFA
Dividends are a symptom of value, not a driver of intrinsic value. The intrinsic value of a company is generally based on a company’s net cash position on the balance sheet and what it generates in future free cash flows, discounted back to today. All other qualitative factors (management, strategy, new products, and the like) must translate into future income/cash flows to have any monetary intrinsic value.
Because a company pays a dividend out of free cash flows (or net cash on the books) and not from earnings per share (which is an accounting measure, not a cash measure), the dividend is an output to the valuation of the company (it is a symptom), not a driver behind it. To hit this point home, for example — there are many companies that could be considered fantastic investments that pay no dividends at all. Warren Buffett’s Berkshire Hathaway (BRK.B) is perhaps the best example.
We pay close attention to a large number of different variables in our work at Valuentum, but the price-to-fair value variable is probably one of the most important, if not the most important. If an investor can buy a stock for $0.70 (price) on the $1.00 (value), that’s a good deal, and what we consider to be the cornerstone of investing. Estimating the company’s value range correctly is one of the most important things investors can do, and that’s outside the context (independent) of the dividend. Can you imagine if investors refused to own Apple during its massive stock price run just because it didn’t pay a dividend at the time?
How dividends impact valuation: /20140114_1
8) The Price-to-Earnings (P/E) Ratio Is a Short-Cut and Used Incorrectly. Unfortunately, many investors are not mathematically-oriented. This is not meant to be offensive in any way. But remember all of your friends that hated math in school? Well, the fact of the matter is that the stock market is highly mathematical. It combines math, accounting, finance, psychology, economics, and pretty much every discipline out there (depending on the sector you’re investing in from energy to healthcare).
Many investors, however, don’t like the math “part” and think the P/E ratio (the price-to-earnings ratio) is a substitute for calculating an intrinsic value on the basis of future discounted earnings and free cash flow, or using a research firm that applies intrinsic-value analysis. It’s not. The fact of the matter is that a P/E ratio is just a short-cut discounted cash-flow model, but instea