What's in a price?

What’s in a price?

What does a stock price represent? What?is?it? What decides its?level, and its?direction?

The simple answer is that, just as on a square market for apples, the price is determined by a?negotiation?between a buyer and a seller, not by value, nor by surprises, but by a confluence of hidden variables.

The seller of a stock is happy to part with it at a certain price, since they have an alternative and “better” use for the money, given they are paid enough for their shares. Maybe they want the money for “personal reasons”, maybe for buying another stock they like more at the prevailing prices, maybe they are going to park the money on a bank account, hoping for better opportunities later. Maybe they have made an analysis pertaining to that particular stock and consider it too “expensive” from some kind of absolute perspective, whatever that might mean.

The buyer simply has idle cash?available that they could keep as is, or buy any stock or asset they like, but they have zeroed in on this particular stock for some reason. They simply had an impulse. Maybe they read a news article. Maybe the company just published a strong earnings report that triggered their interest. Maybe their neighbor or Uber driver said something that piqued their interest. In any case, they logged onto their Robinhood account and placed a bid for the shares at what they considered a “fair” price,?however that assessment is made.

Most people, including fund managers, trend followers and certain kinds of algorithmically governed funds, don’t make a thorough theoretically based valuation of a stock before buying or selling it (nor perform a rigorous technical analysis of price patterns either). Most just buy and sell based on emotions, on perceptions of price trends, and the?narrative?around a company. Most actually couldn’t care less how a company actually creates value and makes money; they buy a story, a narrative. The story is part about the company, part about the stock price itself. “Is AI hot right now? Is Nvidia the place to be? Is the stock moving upward? Is the price trend just starting, is it stable, is it reliable?”. Mostly the story is about themselves and their neighbours; they feel a fear of missing out.

In fact,?the correct way?to evaluate a project or a stock is so long-term and theoretical as to render it?mostly useless:?Over very long periods of time, the value a company creates is the sum of its profits or cash flow. If the net winnings from paying for inputs and collecting sales proceeds over the total lifetime of the company is $100, then that’s the total value of the company, $100, minus deductions for the time cost of money. If you get that net $100 in just 1 year, it’s much more valuable than if it takes 100 years.

Hence, most use various shortcuts instead when investing in equities, such as identifying short-term stock price trends (applying Technical Analysis methods) or using valuation multiples (multiples of one year's profits?or revenues, as an estimate of the sum total value of a stream of 10-20-50-100 years of profits). What these investors are really doing is akin to observing the town square fruit negotiations, and making more or less well informed guesses on the next price for an apple, a pear, an orange, potatoes etc. “Who cares what an apple is?really?worth? What’s important is if I can sell it at a higher price to somebody else, and then repeat the trick with another fruit”

In the short term, up to a decade or so, the market is a guessing machine, a beauty contest, a trend guessing system, in effect a flock of blind sheep leading each other back and forth across the landscape. In the short-term there are always just as much buying force as selling force on the market. The buyers are convinced in their narrative of brighter times ahead, of a rising stock price, due to a for them profitable combination of future profits and future valuation multiples. But the sellers are equally convinced that there are better alternatives, that the future does not promise a better combination of Earnings and P/E-ratios than today, or at the very least that other stocks are more promising in those respects.

In the long-term, however, the market is a weighing machine. The prices are pulled toward a centre point, where the price paid for a stock relates to the company’s earnings in such a way that the buyer on average gets a 10% return per year. For the total stock market that equates to around a P/E-ratio of 15 for next year’s earnings after tax, or a Price/Sales ratio of 1. That’s how it’s been for the last century. The market has always sooner or later gravitated to a level where the coming twenty years provided a return of 10% per year.

The valuation swings have been pretty big though, sometimes the valuation fell to such depths that the coming decade provided 20% returns per year (compound average: CAGR), sometimes euphoria pulled valuations so unwarrantedly high that the coming decade provided zero or even negative annual returns.

But a bad decade was typically followed by a good one, so on average over just about any 20-year period the last 100 years, the return was 10% per annum. When one paid 1x revenues or 15x next year’s earnings after tax for the stock market, one got approximately 10% annual returns over the ensuing 10 years. Please note that Price/Sales is the more reliable of the two valuation gauges. It’s much more stable than P/E and holds a much higher predictive value for future returns. Pleas also note that, an average is an average due to recurring periods below the average as well as above.

The “1x sales leads to 10% annual returns, and the market always finds its way back there or lower” heuristic is good to keep in mind. It means that unless human psychology or the functioning of the economy shift materially and permanently, we have an absolute valuation anchor, a time-tested market wisdom of what is a “fair” price for an asset. It’s 15x earnings for the average company, growing at an average pace, with average profitability. Or, rather, it’s 1x sales (a more robust and useful measure) for a company with market-average characteristics, not least its profit margin.

What’s?fair?unfortunately doesn’t help us that much?in the short term, especially not regarding individual stocks. But it helps in determining whether the general market on average will constitute a kind of headwind or tailwind over the coming decade. When the market on average is priced below or around fair value and is in an uptrend, all stocks get a tidal lift upward. Any stock story gets the benefit of doubt. Such long, predictable, and reliable, tidal waves begin from low market valuations, at or below P/S=1. Right now, in July 2023, we’re at about 2.5 times that level. That’s higher than right before the two major downturns over the last century, that started in 1929 and 2000 respectively, and only surpassed by the stimulus-induced bubble of December 2021.

Anyway, let’s get back to the main message of this article, that stock prices at any point in time are governed by the?negotiation?between a buyer and a seller, two entities who came to diametrically different conclusions about the attractiveness of a share. They have access to basically the same information about the company’s operations, profits, reputation, brand, management, stock price trend, valuation metrics, narrative, competition, about the general market, about investment alternatives, including other stocks, bonds, cash, gold, education, real estate etc. And yet, the same number of shares are sold as are bought at any point in time.

So, what does actually govern prices, if all that information makes for just as eager buyers as sellers anyway?

Make no mistake, the market is?not?right; one side is the right one and the other one is making an error. One side is collecting and cross-referencing the available information better than the other. They might base their decision on technical analysis of short-term price trends, or of whether the company is fairly valued or not and are ready to stick around until the rest of the market realizes the same thing. The right side knows more about history and the lessons it holds for investors. The right side is better at assessing risks and opportunities, in discerning trends in fundamentals, prices and narratives. The right side has a strategy, a method, is competent, agile and patient.

Some are of course just lucky in choosing the right side, while some are skilled at noticing trends and understanding value creation. In?The Investing Course, I explain my framework for combining company based fundamentals with trends and narratives, as well as portfolio management and risk management methodologies for optimizing risk-adjusted returns and controlling the absolute downside risk. In short, I help extract and guide the skilled and intuitive investor residing in all of us, but is temporarily distracted by the confused noise in the media and among amateur investors.

A common question is whether a stock price moves upward or downward based on the level of some piece of news, or of the deviation from expectations, i.e., the “surprise”. I think the answer is neither, at least not in a useful sense of the words. An individual investor doesn’t rush to buy or sell stocks based on the surprise. The person, fund manager, and algorithm buy based on emotions, instincts, pre-programmed criteria, based on stock screens suddenly identifying something as “cheap” or “with a positive price trend” etc. A positive earnings surprise or other news measured against some kind of “consensus” doesn’t automatically make short-sellers cover or holders of liquidity decide to buy new shares (from just as many sellers). That’s a way to simplistic view of how reflexive, herd-psychology driven market places work. An apple at the town square, or a share of Apple on the stock market, is bought and sold at a certain price based on a myriad of more or less opaque reasons and reasoning.

Sometimes a strong earnings report coincides with a large short seller pulling the trigger after a prolongued research period, resulting in a lower stock price for the day. Sometimes a negative surprise and initial price drop lures bargain hunters that create a positive momentum leading to a higher final share price for the day. Sometimes absolute earnings levels eventually make a value investor push the buy or sell button.

The market is a complex place, with millions av participants, some value-oriented, some more primarily governed by price trends or incremental information surprises. Their interactions with each other, and affected by micro and macro news are as complex as the human brain. More so actually, since there are a million brains involved in the final price point.

In the short-term, the market is frustratingly fickle and unpredictable, and the trend really is your friend, guiding and governing stock prices.?The trend is always governing human relations, we always subconsciously find comfort in the group, the tribe, whether its our choice of education, clothes, music, work or investments. But the trend is only our friend until it turns. And turn it does sooner or later, because over 10+ years, the trend can’t hold a candle to the wind of the gale of valuations.

Eventually valuations will pull market prices toward a level consistent with a fair compensation?for time and uncertainty. That compensation is as we know 10% per year, and the valuation level is a Price to Sales ratio of 1. Lest we go looking elsewhere – not in the moment but on average over the following years.

Over six weeks in?The Finance Course, I guide the TIC members through techniques for making forecasts of fundamentals, valuations and stock prices. The first five weeks deal with valuation, screening for new ideas, company research and forecasting, investing and timing with technical analysis and macroeconomic considerations, and portfolio and risk management. Week six is dedicated to a case study from A to Z, using free online tools for identifying, researching and investing in a specific stock.

Valuation and trend following are more art than science, but as with any art you can be more or less skilled. When it comes to investments all too many jump into the deep end of the pool risking their hard earned money with zero preparation or knowledge, wasting hundreds or thousands of dollars, or more, on simple and common mistakes that could easily have been avoided with just a little education. I can’t?promise?immediate and stellar returns, just as a tennis teach can’t promise immediate tournament victories. But I?can?show you the methodologies, techniques and tools to commence your journey from beginner/intermediate investor to good or even expert/professional.

The art lies in constant adaptation and improvement, in applying both time-tested fundamental valuation anchors embedded in market wisdom absolute multiples, and insights into herd psychology and short term trend analysis. Narratives are fundamentals too.

In the short term, “surprises” to some extent govern price direction, but in the long term it’s valuation levels that decide where the market goes. The smart investor knows when to rely more or less on either factor.

Join the waiting list for The Investing Course?here, if you want to know more about my investment framework that I’ve used as a hedge fund manager since the year 2000. The first (temporarily discounted) instalment of TIC will start soon. Let’s just hope not too many join us, since if all market participants were rational fundamentals-based investors the investment opportunities wouldn’t be as many or as large in the future.

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Until next time,

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