There is a theory in finance that claims that stock prices are “efficient.” By efficient they mean that everything known and knowable is built into the price. Future conditions. Competitors actions. Cost of financing. Obsolescence. Demographics. Tax rates. Government regulation. Everything.
The theory, of course, is nonsense day to day. Nonetheless it has value for investors like me, who do not know everything.
Start by holding reasonable expectations.
When you buy a share in a corporation you buy a fraction of the company. For example Microsoft has 8.33 billion shares outstanding and they sell between $32 and $33 each. About $265 billion of total value. When I think $32 could be $50 pretty easily I am making a mistake. For my $32 to become $50, everyone’s $32 has to become $50. Microsoft would need to be worth around $415 billion to make that happen. It is not easy to add $150 billion of value to anything, never mind a business. $150 billion is about what Bank of America is worth. If you said to yourself, all the prices make sense and for me to make 50% on my shares, Microsoft will need to add value equal to the value of Bank of America.
Without having been there I am pretty sure that creating a new Bank of America might be a challenge, so therefore adding 50% to my Microsoft stock might be hard too.
Same with Apple. Worth $425 billion. To double they must add value equal to Walmart, Intel, Hewlett Packard and Dell combined. A good trick, that.
If you want to be a day trader, know the fundamental background points too.
Fluctuations can be profitable but you need to know the fundamental value driver beneath. Prices are noise, you need to know the signal. For example, Bill Gates stock value went up about a billion dollars the day Steve Ballmer announced that he would retire. All gone again in three weeks.
Microsoft is pretty much the same business after the announcement as it was before. Why should the price be much different.
Three weeks is about how long it takes for rational to prevail.
Thus the idea that efficient pricing is nonsense. It is efficient over time but it is not efficient NOW. So you must decide, trade the noise or trade in long enough time intervals that the three week noise factor disappears.
Buy cash flow.
A business is only a proxy for what you really want, which is free cash flow. You need to buy the business to get it but your analysis should be around the cash flow, the requirements for reinvestment, its predictability, (industry and management) its growth potential, (competitive position, technology and demographics) financing options (debt, EBITDA, free cash flow and equity sales) and its distribution model, (dividends and redemption.)
You cannot spend or invest a business, you can only use cash.
Look for businesses that have strong free cash flow and manageable debt.
Obscure products appear unfashionable but tend to produce solid predictable value over time. How about Stella-Jones. You will likely need to look it up. They make hydro poles and railroad ties. Not exactly fashion, but they do okay.
If I had $425 billion and had to keep it invested for 10 years, I think I would prefer to spread it around 250 Stella-Jones like companies instead of owning all of Apple. But then I think bottom up investing works. Maple trees spread many seeds with the expectation that some will flourish. In contrast to governments who like the one big plan that might fail catastrophically.
Sometimes a big overview shows you things you cannot see when you look at details. Prices are right in the long run so you tend to not be able to overpay by much. If you understand the principles and the three week rule.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
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