Wednesday, 24 May 2017

The Stock Market is Smarter than We Think

The only 2 drivers of value creation are:

  1. Return on Invested Capital (ROIC) 
  2. Growth

Return on invested capital (ROIC) and growth are the only drivers of value creation.

Activities that do not drive value creation

Managers often spend time and resources attempting to:

  • smooth earnings, 
  • meet earnings targets,
  • stay listed in a stock index,  
  • become cross-listed,
  • change the accounting rules, and 
  • do stock splits.
The evidence shows that the stock market does not reward these efforts.  

Changes in accounting rules and stock splits do not have lasting effects.

ALL the above issues do not have an effect on stock returns unless they reflect a change in fundamental value.

Listing and delisting from an index and cross-listing

Listing and delisting from an index do not seem to have long-term effects for any given firm.

Although there can be a negative effect initially from delisting, the effect usually reverses in a few months.

Furthermore, cross-listing within developed markets does not have an effect; however firms in emerging markets may benefit from cross-listing in a developed market.

Accounting Changes

Investors apparently see through accounting changes.

If investors focused on earnings, for example, a move from FIFO to LIFO would lower the share price, but it generally does the opposite because of the increase in cash flows.

Another example, mere changes in goodwill do not affect share price; however, a change in goodwill that is associated with a real change in the firm produces a reaction from sophisticated investors.

Mispricing in the Market

Two possible sources of mispricings are:

  1. the combinations of overreaction, underreaction, reversal and momentum, and
  2. bubbles and bursts.

Unrealistic expectations of continued growth, which led to excessively high P/E ratios, caused the tech bubble in the late 1990s.

High earnings that were not sustainable caused the credit bubble a decade later.  In this case, it was not that the P/E ratios were too high, but that the earnings in the ratio eventually had to fall.

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