Thursday, 12 July 2012

Any price - and therefore P/E - movements that is not related to the company's earnings is transient.

The stock market is governed by a diverse set of influences.  And just as the sea is, it is predictable over the long term but not over the short term.

Probably the most widely watched reason for the long-term fluctuations of the price and P/E is the rise and fall of the stock market itself.  This can be a function of the economy's volatility.  The economy is battered by the rise and fall of interest rates, by inflation, and by a variety of factors that drive consumer confidence or buying power up or down.  Actual changes in the economy itself will cause longer-term changes in the market and the prices of its individual stocks.  Speculation about such changes has a shorter-term effect.

In the shorter term, there are the ripples and wavelets.  Every little utterance of a government official or company offer, insider buying or selling (which may or may not mean anything), rumour, gossip, and just about anything else can influence the whims of those on the street.  Many people will use these stories to try to make or break a market in the stock.

Over the life of a company, its fair P/E - the "normal" relationship between a company's earnings and its stock's price - is relatively constant.  It does tend to decline slowly as the company's earnings growth declines, which happens with all successful companies.  For all practical purposes, however, that relationship is remarkably stable.  And for that reason, it's also remarkably predictable.

When a company's earnings continue to grow, so will its stock price.  Conversely, when earnings flatten or go down, the price will follow.

The little fluctuations in the P/E ration above and below that constant (fair) value are not so predictable because they are all caused by investor perception and opinion.  Think of them as the winds that blow across the surface of the sea.

The broader moves above and below the norm are the undulations that are typically caused by the continuous rising and falling of analysts' expectations.  When a company first emerges into its explosive growth period, the analysts expect earnings to continue to skyrocket.  Earnings growth estimates in the 50% range or more are not uncommon.

As the company continues to meet these expectations, investor confidence booms along with it, and more investors pay a higher and higher price for the stock.  The P/E rises as a meteor right along with the price.  The faster the growth, the higher the P/E.  This does nothing to alter the value of the "reasonable or fair" P/E multiple.  It just means that investor confidence has risen well above that norm and that there will eventually be an adjustment.

Sure enough, one fine day when the analysts' consensus called for growth of 45%, the company turns in a "disappointing" earnings growth of only 38%.  The analysts start wringing their hands because the company has not met their expectations, and some fund manger sells.  Next, all of the lemmings on Wall Street follow suit.  And not long thereafter you get a call from your broker telling you that you've had a nice ride, you've made a lot of money on the stock, and it's time to take your profit and get out.  In the meantime, the broker has made a commission on your purchase and is hoping to make it on your sale as well.

After a while, after the price and the P/E have plummeted and then sat there for a while, some analyst wakes up to the fact that a 34% earning growth rate is still pretty darn good and jumps back in.   Soon the cycle is reversed.  The market starts showing the company some respect again.  And you get a call from your broker.

Of course, as a smart intelligent investor you didn't sell it in the first place!  Because you were watching the fine earnings growth all along, you knew better than to sell.  And you chose the opportunity to buy some more.  In the meantime, your brokers'; clients who were not so savvy has taken their profits (and, had paid the taxes on them, by the way) and are now wishing that they had stayed in with you.  By the time their broker called them again, the price had already climbed past the point where it made good sense for them to jump in again.

It is best to assume that any price - and therefore P/E - movements that is not related to the company's earnings is transient.  If the stories - not the numbers - cause the price to move, the change won't last.  What goes up will come down, and what goes down will come up.,  You have to be concerned only when the sales, pretax profits, or earnings cause the change, and then only if you find that the performance decay is related to a major long-term problem that is beyond the management's ability to resolve.

Remember also that a sizable segment of Wall Street doesn't make its money investing as you do; it makes its money on the "ocean motion."  Buy or sell, it makes little difference to them what you do.  They make their money either way.  But it sure makes a big difference to you!

No comments: