Can You Trust The Market?

Investment Perspective – August 2020

Peter Flannery CFP AFA

 

 

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

Can you trust the market?

I know I have raised this question in the past.  In case you have forgotten, the answer is no.   

The reason is because the market is a disparate and fragmented collection of investors, fund managers and speculators.  They all have different agenda.  Basically, a bit like a box of chocolates if you know what I mean. 

The bottom line for most is that, they want to maximise their returns today and they live in fear of risk, which they often see as unexpected news or volatility of trading prices. 

 

The Dull Approach Works

Although investing is quite challenging and can be quite exciting for those who are into it, ideally though it should be a relatively dull looking process from the outside. 

We are not looking for unexpected excitement, although we quite like the idea of pricing volatility as value/eco-Investors.  For the uninitiated, this is excitement (usually of the wrong kind).  For us though, it is business as usual … the same old. 

There is nothing new about volatility, although the market tends to make out as though each time some market or economic related news emerges, that all of a sudden, the global economy is on the brink of collapse. 

 

Dumb Stuff That Can Hurt You

One of the ‘dumb’ things that goes on across the markets is share splits. 

Basically, this is when a company like Apple, which is a recent example, decides that it will split the stock. 

In Apple’s case, they recently announced a 4 for 1 split.  Basically, this means for every share you hold as an Apple shareholder, as of the record date of 24 August 2020, you will receive four shares as of the ‘ex-date’ which is 31 August 2020.  In simple terms, you now hold a lot more shares and of course, the trading price will drop accordingly. 

So why do companies split their stock?

They claim it is because they want to give smaller investors the opportunity to invest in their stock – somewhat valid. 

It is really so that they can maintain interest in the stock and obviously, the more people that invest, the more share brokers will follow it, the more share brokers will promote it and all things equal, the higher the price will rise. 

That means their market capitalisation increases, which some lending institutions and other organisations take as a real valuation of the company (at WISEplanning, we do not). 

Perhaps a simpler example is as follows:

  • Company XYZ has 100 shares on the market, trading at $10.00 per share;
  • Company XYZ carries out a stock split of two for one. There are now 200 shares on the market;
  • At the same time, the share price that was trading at $10 per share before the split, is now reduced to $5 per share;
  • The outcome is that shareholders in XYZ company have twice as many shares and the trading price has dropped in half; and
  • Another outcome is that the company has just added another layer of cost to its operations, which of course detracts from profit!

Note bullet point five above and like me, you will no longer think that stock splits are a good idea. 

I remember back in the 1990s, share brokers promoting companies that were regularly undertaking stock splits as a signal that this was a great stock to invest in, because it was undergoing stock splits (!). 

Sure, the company may have been growing and the share price rising; however, it was also significantly increasing the number of scrip available across the market and adding in another layer of cost.  Ultimately, we could also argue, diluting the real value of the shares long term, particularly if things changed and the share price dropped significantly.  In that case, shareholders have a lot more shares in a business that are worth a lot less – not ideal. 

The opposite of that is a good example like Berkshire Hathaway.  They have Class A and Class B shares but they do not do share splits. 

By the way, as you may recall, they do not pay dividends either.  Instead, they redeploy the cashflow from growing businesses in BRK back into growing businesses that use capital well.

 

More Dumb Stuff

Berkshire Hathaway again, because we know it well, is a good example of where some dumb stuff goes on – not within the management of Berkshire Hathaway but outside of it. 

Over the last year or two, the stock price has lagged the rise in the broader market and in particular, tech stocks like Apple, Amazon, Netflix, etc.  The market has taken the view that Berkshire Hathaway and companies like it are dull and have become bored with them.  The result is slow moving or declining trading prices. 

In the meantime though, those businesses within Berkshire Hathaway continue to grow. Right there, we have the diversion between the trading price and the underlying intrinsic value. 

Recently, it was announced that Berkshire Hathaway undertook a share buyback, which is not something that they do often. 

The good news is that Berkshire Hathaway shareholders all just got a bit richer with no additional money invested. 

The share buyback of course is not dumb stuff but rather a good idea because it means that cash (Berkshire Hathaway has lots of it) is used to buy back some shares and remove them from the market, which means that there are less shares available for BRK.  Shareholders in Berkshire Hathaway own a little bit more of the business and have just got richer because of it.  That is smart stuff.  

 

Which one are you?

Whilst Berkshire Hathaway has been undertaking a share buyback, the market generally has been worried about COVID-19. 

While all that worrying has been going on, some have been taking advantage of declining trading prices in the tech sector, particularly over March – May this year; although, let’s just be a bit careful. 

A number of those businesses are solid businesses and I believe have a sound future but not all of them.  Some of them are seeing their share prices rise on the back of speculation and greed.  Inevitably, that is unsustainable. 

Anyway, are you the one that worries about markets and is hesitant or are you the one that has invested in the likes of Berkshire Hathaway and enjoying the benefits of the stock buyback, regardless of the pandemic? 

 

More Dumb Stuff

The above graph compares global share prices to economic growth.  The higher the ratio, then theoretically, the more expensive trading prices become. 

The above is a screenshot of a tweet on Twitter.  It is a commentator making the point about Warren Buffett’s so-called ‘Buffett-Indicator’, which compares trading prices to economic growth. 

The idea is that when trading prices become much higher than economic activity, then prices are becoming expensive.  It is actually useful as a general guide to trading prices and one that I know Warren Buffett has used for a very long time. 

On the other hand though, it is not necessarily an indication that there is no opportunity.

For example, quality businesses, who have seen their share prices decline for whatever reason, can represent buying opportunity. 

Similarly, small caps, who have a promising future, also represent a worthwhile opportunity, particularly if their trading price is depressed as a result of the pandemic or other issues. 

The Buffett-Indicator then does mean that prices are higher, although I point specifically to the characterisation of this chart and in particular, the words, “A market cap to GDP ratio greater than 100% mean stocks are in bubble territory”

The use of the words ‘bubble territory’, in my view, is a bit dramatic and the type of banter that you often see across markets (hence you have to wonder what information you trust and whether or not it is ‘fake news’). 

As I have mentioned to a number of my clients over the last several years, reports from journalists in mainstream media, whether it be on the internet or in the newspaper is a very long distance from fundamental investment analysis. 

To the uninitiated, they may look just the same, which is why many people take what they read in the mainstream popular media as news (the truth), to their peril sometimes.

The above graph simply tracks the Morgan Stanley Capital Index, which is a measure of global shares.  The ACWI index is the MSCI’s flagship global equity index that tracks the large and midcap stocks across 23 developed and 26 emerging markets. 

The graph above is pretty straightforward and I am specifically including it here because of a comment made by the person sending out this tweet.  Specifically, highlighting that “it makes no sense to try to time the markets or listening to crash profits …” 

We need to be very selective about what we believe when reading general ‘news’ presented across the market.  Hence the question, “Can you trust the market?” 

Indeed, quite a bit of that information is useful; although frankly most of it is useless for us because we invest in the business – not the stock. 

As dull as it sounds, there remains a lot to be said for adopting a fundamental approach like the value/eco-Investing method available at WISEplanning and sticking to it.  Not complicated really.

 

Average investors can become experts in their own field and can pick winning stocks as effectively as Wall Street professionals by doing just as little research.”

                                                                                      Peter Lynch

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