Nelson: The 16 Most Important Steps To Understand The Stock Market
publication date: Jan 18, 2018
author/source: Brian Nelson, CFA
A previous version of this article appeared on our website July 21, 2013. Refreshed and updated throughout.
By Brian Nelson, CFA
After earning my MBA at the University of Chicago Booth School of Business and training over one hundred stock and credit analysts from large organizations over the past decade or so, I have heard just about every question (though I admit I am still surprised by many things and remain a very humble student of the markets). I've also spent years perfecting the discounted cash flow process for large research organizations such as Morningstar and studied under one of the most famed aggressive growth investors of all time, Richard Driehaus.
My knowledge runs the gamut from value through momentum investing and everything in between, yet I continue to be surprised at how frequently investors can be misled this day and age. Sometimes I wonder if all of the readily-available (and free) information out there is actually a bad thing. Hopefully, the 16 steps below, which should be read in order, will help investors understand what the stock market and stock investing is all about. This piece is meant to be more conversational, with much less financial jargon. I hope it's helpful!
Note: This is a working document, and readers should expect updates in the future.
1) The Stock Market Is a Market. Let's start with the very obvious. The stock market is driven by the actions of people. People are imperfect. People make mistakes. People have biases. Some people are greedy; some people are fearful. I think when individuals first start to invest, they believe that the stock market is orderly, calculated -- that it may be as precise as accounting, as in assets equal liabilities plus owners equity, for example. In other words, new investors think that if a company does well fundamentally, then its stock should do well, too. Unfortunately, the stock market is often nothing like this, and even good, moaty, competitively-advantaged companies with strong brand names can make for bad stocks, if bought at the wrong price.
The stock market and the price of a company's stock will always be based on, or a function of, the future expectations of the company's earnings, and more specifically its free cash flows, estimated long into the future and discounted back to today. While this is the case, the buying and selling of the stock on the basis of future expectations will always be responsible for price changes. Said differently, if the earnings of a company advance 10% in a particular year, it is almost equally plausible that the same company's stock price may have gone down 10% or up 10% or stayed flat for that same year (on the basis of buying and selling). Even if earnings for that company have gone up over a 10-year period, the stock price could still be lower than it was at the start of that 10-year period (though this is somewhat unlikely, it is not improbable). This concept is very important for new investors to understand.
The stock market will always be a market filled with individuals making decisions about what to buy or sell on the basis of future expectations, and these buy and sell decisions -- and only these buy and sell decisions -- move the stock price -- not the reporting of historical earnings or dividends, but an actual purchase or sell order. If there is one experience that I think every investor should have, it would be to watch a small/micro-cap company's share price move after a large buy order is filled. Or see a company "break out of a base" as technical investors pile into the stock with purchase orders. Most sell-side analysts have never seen this; most buy-side analysts have never seen this. And certainly, most individual investors have never seen this. The market moves because investors move it with their buying and selling activity.
Only through these experiences (or the understanding that these dynamics exist) can the investor tear off the shackles of deception that so many investors want so desperately to believe. We as individuals try to make rational what is not. We want good companies to be good stocks, but this isn't always the case. We try to find complex answers for things even though at times they are so simple. In this case, in the first step of 16, the stock market is just a market. And it doesn't get simpler than that. Key takeaway: The stock market is neither rational nor precise, and it is driven by the buy and sell decisions of participants (including your doctor, lawyer, shoe-shiner, and yes, even your taxi cab driver-or should I say, limo driver). But it is also because of this dynamic that opportunities in the market exist!
2) There is No Long Term. The financial industry loves long-term investors--and rightfully so for them: there is lower flight risk of your assets if you are a long-term investor, or perhaps better described as a holder of stocks for a long period of time. It just sounds so good, too: "investing for the long term." And so innocent! But to some market participants, the long term is nothing more than just more fees--not to mention, that the concept is one of the stock market's biggest fallacies.
Long-term investing is not leaving your assets in one place for a long time, but instead, it is considering the long-term earnings and free cash flows of a company in your investment analysis. At any point in time, for example, the stock price of a company will always be based on the expectations of future earnings and free cash flows. In 10 years, the stock price of the company will still be based on expectations of future earnings and free cash flows at that time. We, as investors, will never reach the long term -- in fact, there is no long term, even as we say that all of the value of any asset today is based on expectations of its future earnings and free cash flows over the long term.
Please understand that this concept is much different than the saying that "in the long-term, we are all dead" -- coined by John Maynard Keynes, which means that the long term isn't as important as the short run for decision-making. The long term does matter, and in almost all cases, it is more important than the short term. But what I'm saying in Step 2 is that stock prices will always be based on current expectations of future earnings and cash flow over the long term (at any point in time in the future). There is no magic switch 10 years from now that will change the market from a discount mechanism of future earnings and free cash flows to a precise mechanism that translates earnings one-to-one from the company to the shareholder. Trust me, it will not happen. If it does, the stock market will no longer be a market (it will be some pass-through entity).
Long-term investing is based on analyzing the long-term dynamics of a business and making a stand that at some point other investors will drive the stock toward your intrinsic value estimate (over the long haul). It does not mean that all of a sudden the company will be valued differently because we're now 10 years into the future. Or that the stock price will be higher 10 years from now because earnings have expanded. If you're willing to hold a stock for 10 years, it is very simple: you could have a winner or loser (or something in between). The difference is expectations of future earnings of these companies 10 years in the future.
Let's try this example. Many investors may consider 2050 to be the long term. But the value of a stock in 2050 will be based on the market's expectations of the company's future earnings and cash flow in 2050 and over a "new" long term, not from today through 2050. A brand new long-term has been "created." The long-term was never reached. In this and every example, the long term will remain elusive -- always in the future and never attainable. Key takeaway: The core of stock investing will always be based on expectations of future earnings and cash flow at any point in time in the future. There is no long term.
2a) The Psychology of the Markets
“The stock market is a discount mechanism of future expectations. Period. Sometimes prices are rational and based soundly on reasonable future fundamental expectations and sometimes they’re not.” – Brian Nelson, CFA
Stop thinking chronologically, and start thinking psychologically.
Many investors believe that they can just buy any old stock that pays a growing dividend and hold it for decades, and that’s long-term investing. Selection bias aside, this has worked in the past for many an investor. There are hundreds of examples of this. But I think it is incredibly important for investors to understand how to think about the long term, regardless of your investment time horizon. The long term is generally taught and presented chronologically (i.e. hold a stock for years), but instead it is a far more psychological phenomenon.
First, any intellectual conversation of the long term must consider the discounting mechanism of stock prices in how they discount future information, whether it is risk through the discount rate or value through the magnitude of free cash flows. The long term, therefore, is a far more complex concept than many make it out to be. In the future, for example, stock prices will reflect the expectations of a "new" future at that point in time, not the fundamentals of the past or performance from the past to present. This is why in “The 16 Steps to Understand the Stock Market,” we say the "long term" can never be attained. It’s fallacious to think so. As time passes, there will always be a new “future,” and a new “long term,” and stock prices will always change to reflect the moving target of these changing long-term expectations.
Apple (AAPL), for example, is/was/has been a great performing stock because its future today has a larger free cash flow stream expected in it (and lower risk ascribed to it) than that of the future of its past. Its future value today is larger than what it was in the past. The present value of expectations of its long term, a "new" long term, have changed over time. This is very important to understand. It is not the passing of time (chronologically), per se, why stock prices advance/decline, but instead it is the change in the market’s future financial forecasts of them (free cash flow and the like) +\- net cash on the books at any point in the future that causes the stock price change (driven by buying and selling activity based on these changing expectations).
It's psychological, not chronological. Because expectations of the future are always changing, and the future is inherently unpredictable, there can theoretically never be a determinate or definitive “long term.” In fact, there is only a series of iterative expectations of the long term that drive the stock prices of today and stock prices as time passes. If you understand this, you’re moving closer to understanding what makes the markets tick.
3) Stocks Do Not Magically Converge to Intrinsic Value or to a Target Price. Often, investors hear that a stock is undervalued or overvalued, and this informs their investment decision as if some magic wand will cause the stock to magically converge to intrinsic value. Stocks can stay overvalued for decades, and stay undervalued for decades, or stay fairly valued for decades. Only when there is buying or selling in the stock based on its undervalued or overvalued state does a stock actually converge to intrinsic value.
In other words, it doesn't matter if you think a stock is undervalued or overvalued. It matters if others (after you) think a stock is undervalued or overvalued, and then they buy or sell that stock driving it higher or lower--only then will it converge to intrinsic value. The market is not magic--other people have to eventually agree with you (and vote with their money) for your ideas to work out. As an investor, you are highly dependent on what other people think. You must hope that they eventually come around to what you believe. Or else your stock will never converge to intrinsic value.
The only reason why Warren Buffett may not want to talk his book and/or want a stock that he holds to decline is so he can buy the whole company (and more importantly, its future free cash flows) on the cheap. For us stock-market-only investors, we want the stock to eventually go higher. Key takeaway: Stocks do not have to converge to intrinsic value. Only buyers and sellers can drive a stock to intrinsic value. We, as investors, are highly dependent on what other people think of our ideas in the future.
4) Everything in the Stock Market Is a Self-Fulfilling Prophecy. I hope you're still with me because this step is so very important. I cannot tell you how many times I have heard that technical analysis (chart reading) is a self-fulfilling prophecy because it is driven by the actions of buyers and sellers reacting to or anticipating patterns in a chart. Those same individuals then claim that value investing or growth investing is not a self-fulfilling prophecy. Once I hear that, I know that most value investors haven't read Step 1 above. If you have, you already know more about the market than they do.
Please understand: technical analysis works sometimes because people buy and sell based on technical analysis, driving a stock higher or lower respectively. Value investing works sometimes because people buy and sell based on value principles, driving a stock higher or lower respectively. The same can be said about growth investing or other widely-followed methodologies. The more people think that a firm is truly undervalued, the more it will be bought and its price will be driven to fair value. The more people think that a firm is truly overvalued, the more it will be sold and its price will be driven to fair value.
Stock prices converge to intrinsic value because investors collectively think the stock is worth its intrinsic value and vote with their capital to drive the stock price to its intrinsic value. If nobody thought a stock was worth its intrinsic value, it would never reach its intrinsic value. If everybody thought a stock was worth its intrinsic value, it would trade precisely at its intrinsic value. If you think a stock is worth intrinsic value, but nobody else does or ever will then I'm sorry you have an underperformer on your hands. It is this self-fulfilling mechanism that makes the stock market what it is. Key takeaway: The stock market is and always will be a self-fulfilling mechanism. If all investors think one thing, it will be true in the stock market.
5) The Stronger the Competitive Advantage the Lower the Stock Return. This can't be! No way! You refuse to admit it! Everybody can't be wrong! But what about Buffett? Well, you don't have to take my word for it. Ask one of the most well-known investment firms out there that does Warren Buffett's economic moat analysis. All else equal, the firm concluded that companies with wide economic moats underperform stocks with narrow economic moats, and that stocks with no economic moats had the best returns, over the time period studied -- Source: Miller, 1/1/2013, Morningstar. This relative outperformance of no-moat stocks is driven more by the context of valuation as opposed to any competitive-advantage assessment. Higher risk stocks, by definition, will advance at a higher annual pace than lower-risk stocks over time, all else equal (they have higher discount rates in a discounted cash-flow process to reflect their heightened risk profile – think risk premium).
But there’s also another dynamic at play. As markets remain benign through up-cycles, riskier stocks are re-priced higher using lower discount rates (credit availability is improved). The longer duration cash-flow profile of higher-risk, no-moat companies is then magnified when the cost of borrowing is reduced. This makes no-moat firms very volatile through the credit cycle, but it also is responsible for their significant outperformance during good times. Moaty stocks are less impacted by credit availability, and therefore, their discount rate and intrinsic value does not experience much volatility. Investors sometimes like stocks with moats because they tend to be less volatile, not because they are better performers. Most investors cannot sleep at night if their portfolio experiences wild swings, and moaty stocks, by definition, should be less volatile through the course of the credit cycle than no-moat stocks. Investors accept lower volatility for lower returns over certain market cycles.
As empirical research has concluded over recent history, wide moat stocks tend to underperform no-moat stocks across almost every valuation bucket. Investors should expect the values of (not price of) stocks to advance at their discount rate in a discounted cash-flow model less the dividend yield over the long term. This percentage is higher for no-moat stocks (most don’t pay dividends) than it is for wide moat stocks, and both empirical and academic research supports this view. Investors should probably expect a long-term annual value advance of about 5%-8% for moaty stocks and long-term annual value advance of about 8%-10% for no-moat stocks. But investors shouldn't buy stocks with the worst fundamental qualities either. We can’t forget about individual bankruptcy risk and the potential evaporation of equity in higher-risk small and micro caps that may occur under tightening credit cycles.
That said, investors may do well with a basket of no-moat stocks over a long-enough time period, but without broad diversification across firm-specific risk, an individual investor can be harmed should any particular no-moat equity fail -- that is, if a firm declares bankruptcy. A concentrated portfolio of fundamentally poor companies is simply a bad idea, in my view. For us at Valuentum, our Best Ideas Newsletter portfolio seeks to attain low levels of volatility while capturing significant outsize returns -- the best of both worlds. Thus far, the Valuentum strategy has generated significantly more return for the level of risk taken. Key takeaway: Competitive advantage analysis alone will not lead you to the best-performing stocks. It actually has been shown that it will lead you to underperformance.
6) Earnings Surprises Are Analyst Misses Not the Company's. A company is not doing better or worse just because an analyst or a group of analysts (consensus) fails to accurately predict quarterly results. Companies beat or miss earnings expectations because analysts are wrong with their forecasts. Nothing against analysts, as it's nearly impossible to accurately predict quarterly earnings all of the time, but this is an important point.
Let's ask ourselves these two questions: What if a company continues to miss earnings expectations every quarter into infinity? Will its stock price keep going down forever until it reaches 0? The answer simply is no. Stock prices are determined by expectations of future earnings and free cash flow. A company will still have value even if it continues to miss earnings. If a company that has exceeded earnings estimates in the past has been a strong performer, it has to do with the idea that expectations for future earnings and free cash flow have increased -- not because it has exceeded earnings estimates. Consensus estimates and even whisper numbers move around often, and I've even heard of speculation that some analysts actually raise their target prices and lower earnings estimates (at the same time for the same company), so that specific company can beat estimates (and hopefully traders drive the stock price higher to their target price). Well-seasoned market participants may have encountered this potential conflict of interest that I speak of.
Still, it is the future that matters. Once a company reports numbers in a quarter, the quarter is over (and it is history). The only thing investors care about is the future. Stock prices will always be determined by expectations of future earnings and free cash flow over the long haul. Key takeaway: Earnings beats and misses offer very little value to the investor. Stock prices are determined by future expectations of earnings and cash flow.
7) The Recent Trend Toward Dividend Investing May Be Good (and Bad) for the Individual Investor. On one hand, individual investors that are interested in dividend-growth investing find strong, stable, dividend-paying companies such as Johnson & Johnson (JNJ) or Procter & Gamble (PG), and this is great. It prevents them from getting involved in speculative, high-risk companies (remember the dot-com craze), which in many cases is the last thing a retiree is interested in doing.
But on the other hand, dividend-paying companies have in many cases been transforming into speculative companies. Many master limited partnerships (MLPs) and mortgage/residential real estate investment trusts (REITs) remain overly-dependent on the healthy functioning of capital markets, necessitating global credit health for survival. And many investors are stretching for those 10%+ yielding entities that may not survive for long. This is not a good thing at all.
Many dividend-growth investors may not want to admit it, but dividends are just a component of cash flow distributed to shareholders, and a company's intrinsic value is based on its entire future free cash flow stream. Investors can seek yield, but a total return consideration should never be ignored. Key takeaway: Dividends are just a component of cash flow, and a company's intrinsic value is based on its entire future earnings and free cash flow stream.
7a) Dividends Are a Symptom, Not a Driver of Intrinsic Value
“The ‘dividend’ has done more to confuse investors about investing than anything else in modern-day society.” – Brian Nelson, CFA
Dividends are a symptom of value, not a driver of intrinsic value. The intrinsic value of a company is based on a company's net cash position on the balance sheet and what it generates in future free cash flows, discounted back to today. All other qualitative factors (management, strategy, new products, and the like) must translate into future income/cash flows to have any monetary value. Because a company pays a dividend out of free cash flows (or net cash on the books) and not from earnings per share (which is merely an accounting measure, not a cash measure), the dividend is an output to the valuation of the company (it is a symptom), not a driver behind it. To hit this point home, for example -- there are many companies that could be considered fantastic investments that pay no dividends at all. Warren Buffett's Berkshire Hathaway (BRK.B) is perhaps the best example. It has never paid a dividend.
We pay close attention to a large number of different variables in our work at Valuentum, but the price-to-fair value variable is probably one of the most important, if not the most important. If an investor can buy a stock for $0.70 (price) on the $1.00 (value), that's a good deal, and what we consider to be the cornerstone of investing. Estimating the company's value correctly is one of the most important things investors can do, and that's outside the context (independent) of the dividend. Can you imagine if investors refused to own Apple during its massive stock price run just because it didn't pay a dividend at the time?
How dividends impact valuation: https://www.valuentum.com/articles/20140114_1
8) The Price-to-Earnings (P/E) Ratio Is a Short-Cut and Used Incorrectly. Unfortunately, many investors are not mathematically-oriented. This is not meant to be offensive in any way. But remember all of your friends that hated math in school? Well, the fact of the matter is that the stock market is highly mathematical. It combines math, accounting, finance, psychology, economics, and pretty much every discipline out there (depending on the sector you're investing in from energy to healthcare).
Many investors, however, don't like the math "part" and think the P/E ratio (the price-to-earnings ratio) is a substitute for calculating an intrinsic value on the basis of future discounted earnings and free cash flow, or using a research firm that applies intrinsic-value analysis. It's not. The fact of the matter is that a P/E ratio is just a short-cut discounted cash-flow model, but instead of thinking about the assumptions in a long-term discounted cash-flow model to arrive at an intrinsic value assessment (and a cash-flow derived P/E), investors sometimes assign a P/E multiple to a future earnings number. Investors often use a company's own historical P/E ratio average or that of comparable company to assign to a company's earnings. Unfortunately, this is wrong.
A company's P/E ratio should be based on its very own future earnings and free cash flow stream, as the value of a firm is based on its own future (not an assessment of its past or a comparable company). Investors won't stop using the P/E ratio because they read this, but you should be aware of the pitfalls of using this metric. Key takeaway: The P/E ratio is a short-cut discounted cash-flow model and investors continue to use the P/E ratio incorrectly.
8a) Don’t Revenue and Earnings Have to Advance for Stocks to Go Up?
“In short, no. If a stock is undervalued on the basis of its future free cash flow stream, price-to-fair value convergence can occur even if future fundamentals are less-than-desirable.” – Brian Nelson, CFA
The price-to-earnings (PE) ratio is a short cut and used incorrectly, almost all of the time. The price of a stock almost never equals its true discounted cash-flow based intrinsic value, so regardless of where revenue or earnings go in future periods, a company can either be undervalued, fairly valued or overvalued today--meaning that its price will often differ from its true intrinsic worth. It becomes clear under such a framework that even undervalued stocks with expectations for declining revenue and earnings can advance if price-to-fair value convergence occurs.
The discounted cash flow model, the method that we use to estimate intrinsic value, captures future expectations of revenue and earnings growth/declines today, and those future expectations are embedded in the current fair value estimate today, meaning future expectations are captured and discounted back to today (they are factored into the current estimate). Only deviations from those expectations (as expectations can and should change) will cause changes in the fair value. The future is all that matters when it comes to investing.
Importantly, thinking in terms of multiples may not be as rigorous of an approach as investors may like. Multiples at times can be meaningless in the case of negative ones, extremely small ones, astronomical ones, ones that exclude net cash, and others based on non-GAAP earnings. There are a great number of factors beyond just growth that can impact a company's multiple, which is driven by all of the drivers behind the discounted cash flow model. Please have a look at the following for some great reading: https://www.valuentum.com/articles/20120313_1.
Critically, the tendency for systematic overvaluation of industry and sector groups runs prevalent when only comparable multiple analyses are applied, too. This is what happened in the master limited partnership (MLP) space during mid-2015, as the price-to-distributable cash flow metric fallaciously took precedence over enterprise free cash flow estimation. Multiple analysis can be hazardous to your portfolio.
9) Value Is a Range and Not a Point Estimate. I can't begin to tell you how surprising it is to hear even well-seasoned analysts say a company's shares are worth precisely $25 each or a firm's stock is worth exactly $100. The reality is that, in the first case, the company's shares are probably worth somewhere between $20 and $30, and in the latter case, the stock is probably worth somewhere between $75 and $125. Value is not a precise point estimate, but a range of probable outcomes. Why? Because all of the value of a company is generated in the future (future earnings and free cash flow), and the future is inherently unpredictable (unknowable).
If you or I could predict the future with absolute certainty, then we can say a company's shares are worth precisely this, or that a firm's stock is worth precisely that. But the truth is that nobody knows the future, and we can only estimate what a company's future free cash flow stream will look like. Certain factors will hurt that free cash flow stream relative to forecasts, while other factors will boost performance. That's how a downside fair value estimate and an upside fair value estimate is generated, or in the words of Warren Buffett and Benjamin Graham a "margin of safety." We call the "margin of safety" a fair value range at Valuentum. Only the most likely scenario represents a point fair value estimate.
Any investor that says a stock is worth a precise figure--whether it's $1 or $100--doesn't understand one of the most important factors behind valuation. Key takeaway: The value of a company is a range of probable outcomes based on its future free cash flow stream. Value is not a precise point estimate.
10) Investors Will Not Get Everything Correct But Getting Everything Correct Is Not The Goal of Investing. If you believe that you will get everything correct as an investor, you may want to consider outsourcing your investment decision-making to a money-manager because it's almost certain you will be disappointed. Individual investors sometimes think that every idea should work out, and immediately at that. This, unfortunately, is wrong. If you are a good investor, your winners will outperform your losers and you will make money. If you're an excellent investor, you'll still have a lot of losers, but you'll end up beating the market.
The fact of the matter is that you will be wrong at times, but that's okay. You will make mistakes, and they won't be tragic (hopefully). Some of your investments will lose money. It's inevitable. Investing is about achieving goals, not being correct all of the time. I remember one time I received an email from one of our members. He proceeded to tell me that he was so happy that we picked 8 winners, but he was extremely disappointed that 1 of our ideas did not work out. For some reason, he didn't understand that an 8 to 1 ratio is not only good, but unbelievably fantastic!
Importantly, it seems that no matter how many times investors read this step, it never quite takes with them. For example, in the Nelson Exclusive publication, we attained a success rate (win rate) of ~75% through May 2017, but some inaugural readers were disappointed with such performance. Instead of being revered as fantastic stock pickers, we instead felt more like we let some readers down. Key takeaway: I don't care if you are Warren Buffett. You will be wrong at times, and that's okay.
11) Growth Is a Component of Value. Unfortunately, the mutual fund industry has confused just about everyone with respect to this concept. There are really not growth stocks and value stocks. There are either undervalued stocks, fairly valued stocks, or overvalued stocks. Growth is a component of value. For example, Google (GOOG, GOOGL), which is growing fast, can be undervalued, while a company with a single-digit P/E can be overvalued. Though we know this is an ambitious statement, every analyst and investor should build a complete discounted cash flow model at least once in their life to see how growth fits into a value assessment. We'd be happy to help. We make available a discounted cash-flow modeling tool on our website. We think there is no better way to learn this important concept that Buffett has been known to utter a time or two. Key takeaway: There are really not growth stocks and value stocks. There are either undervalued stocks, fairly valued stocks, or overvalued stocks.
12) You Can't Control the Stock Market. You cannot control the returns you receive from the market, but only seek to achieve your investment goals from the market. Unfortunately, I think there may exist a group of investors that believe they can control the stock market.
Let’s say an income investor bought a stock today and it doubled in price tomorrow, meaning that it generated 100% in income-equivalent in just one day--or let’s say at a hefty 10% annual required yield-equivalent, 10 years’ worth of income. The investor can sell the stock and lock in 10 years’ worth of income, or he or she can let it ride. Some long-term investors may choose to let it ride, but what if that same stock’s price is cut in half tomorrow and those 10 years’ worth of income are completely wiped out? Would there be regrets, even if the income idea is still a strong dividend payer? I think so--10 years’ worth of income-equivalent would have been completely wiped out.
13) Time Often Does Not Determine the Time Horizon. Do you know if you are a trader, short-term investor, long-term investor, or somewhere in between? Well, the answer for us isn't quite as simple as you might think. Let me explain.
In a stock market like that of mid-2017, where for example, the average consumer staples stock is trading north of 20 times forward earnings on meager revenue growth (if any at all), it's very difficult to be a long-term holder of stocks as reversion-to-the-mean dynamics could end up becoming extremely painful to one's portfolio. A reversion to 15 times forward earnings on these stocks, for example, could wipe out 25% of investor capital and that's if (yes, I said if!) earnings forecasts hold true, which in the event of a stock market decline, it's more likely that consensus numbers are falling, not holding steady. That's the risk long-term investors are facing in the market of mid-2017.
Now that said, in the times of legendary investor and arguably the father of value investing, Benjamin Graham, it was much easier to be a long-term holder of stocks because stocks at that time were often trading below their very own net current asset value (NCAV), meaning that most could be liquidated and still have greater value than what they were trading at. There was tremendous 'option' value in these equities, and downside in such cases was actually upside because liquidation meant getting more for shares than you bought them for. One could sit on the stakes of these equities for as long as it took for the market to become rational again. Holding stocks for a long time in the days of Benjamin Graham was easy pickings.
Fast forward to today (mid-2017) on the other hand, where the stock market has more than tripled from the March 2009 panic bottom, and the long-term picture might be one painted with a very tumultuous environment if stocks do revert to more normalized, long-term tendencies. So how does this factor into our thinking about the time horizon? Well, if we feel strongly that the market is unfairly beating down an equity and we think shares are absurdly undervalued, we might keep that idea open for a long period of time, as in the spirit of Benjamin Graham's value-oriented framework. However, if an idea has rapidly converged to our estimate of intrinsic worth or if the idea has generated a tremendous annualized return that is unreasonable not to lock in, then we might consider closing the position. We want to be as prudent as possible, and the stock itself, to a degree, and not the passing of time determines whether it is a short-term or long-term holding.
As investors, the market is often going to tell us when profit taking might be prudent. For example, if a stock is purchased at $10 and doubles to fair value in a matter of weeks, an investor may be interested in unloading it for a profit at that time...in a matter of a few weeks...as upside from that point may be rather limited. On the other hand, if a stock is purchased at $10 and it takes 10 years for it to double to intrinsic value, the holding period for an investor might be 10 years, if he or she would like to sell at an estimate of intrinsic worth. The price-to-fair value equation matters much more in determining the time horizon than the passing of time, per se. For example, one wouldn't hold a significantly overpriced stock just for the sake of holding it because they made money too quickly, would they? Key takeaway: Think in these terms with respect to the time horizon: price versus fair value, not in increments of time.
14) Most That Think They Are Investors Are Actually Speculators. There are many definitions of investing and speculating that run the gamut from the views of investor Benjamin Graham to famed trader Jesse Livermore, but I have rather simple definitions of investing and speculating.
Investing involves estimating a company’s intrinsic value and buying a stock when one thinks the price is far below intrinsic value and holding that security until price reaches intrinsic value, or through the high end of an informed fair value range, for example. This definition of investing and the art of intrinsic value estimation are core and vital to the Valuentum process (in fact, they are the very first components!). Speculating, on the other hand, is something very much different than investing. Speculating involves betting that a stock or market price will advance over the long haul irrespective of present fundamental assessments, or betting that a stock or market price will advance even when intrinsic value measures don’t support it. It’s easy to see why investing makes so much more sense. After all, as an investor, you’re actually evaluating the business that you are investing in and spending time estimating what it may be worth on the basis of a forward-looking evaluation. On the other hand, when one thinks about the definition of speculating, it speaks to a much more foolhardy proposition where risk management is essentially thrown out the window.
In many ways, I view the practice of indexing as a lot more like speculating than investing. After all, indexers are betting on a stock market advance over the long haul, irrespective of current intrinsic value estimates or risks involved that could impair their capital permanently. Indexers are essentially buying everything at any price and holding it no matter what. That can be very risky. Key takeaway: Many people confuse investing with speculating. If you are indexing or buying theme-based ETFs on hopes that their prices will be higher in the future with no justification or thesis, you are speculating and playing the "greater fool" game.
15) Value and Momentum Outperform Everywhere. Momentum is the biggest embarrassment to efficient markets (according to Eugene F. Fama, the "father of modern finance" and Nobel laureate), academic research continues to conclude that 'Value and Momentum' combined outperform in every market across every asset class, and we continue to demonstrate the strength of a combined value-momentum process in the portfolio of our Best Ideas Newsletter and Nelson Exclusive publication.
Probably one of the biggest mistakes I made when starting our firm Valuentum was that I used the word momentum (at all). Even some of my closest friends dismissed the strategy of Valuentum, saying it wasn't for them, even when I was doing a lot of what they were doing with respect to value analysis and only adding on the technical/momentum work. They just never looked at it. They saw that I was using some form of technical and momentum analysis and said "it's just not for me." I understand them. Momentum has terribly negative connotations for some reason, but it exists. Portfolio managers often build (eliminate) positions in stocks over time, and buying (selling) drives the stock higher (lower), creating momentum. Price-to-fair value convergence could not happen without the buying and selling of stocks.
When I was first started in the stock market, I remember reading somewhere about how technical and momentum analysis was not worth the time. People have been conditioned to not like technical analysis…fair or not. But by definition, the Valuentum process may encapsulate everyone's strategy (from value through momentum). It is not only value, not only growth, not only GARP, and not only momentum. It's Valuentum. It's very likely that for any investor-type, Valuentum's research and analysis may help an investor run an optimized portfolio of their respective style, and they may not even know it! Key takeaway: Value and momentum combined outperform in every market across every asset class.
16) Keynes Was Right. I remember reading Keynes' work years ago, and at that time, it never really resonated with me. But then, let's say, I wised up. After reading just about everything I could get my hands on, spending years and years in school, and training hundreds of analysts in both equity and credit research, I have concluded that Keynes was one of the most brilliant thinkers in the modern era. This step isn't about his economic policies that you've read about in economic textbooks, but it's about how he thought about the stock market.
Keynes compared the stock market to a beauty contest. He said that to pick winning stocks, investors need to pick the contestant (stock) that they think other judges (money managers) like, not the contestant that they like. This is absolutely genius, in my view, not only because it is true but because he put this into text decades ago! The secret to successful stock selection is to have a complete understanding of all investment disciplines in order to find the best stocks at the best time to buy (Valuentum investing). After all, investors need deep-pocketed money managers to eventually agree with them for their stock calls to work out (see Steps 3 and 4), and this requires a deep understanding of which stocks they will put their money into in the future.
This doesn't mean we're trying to front-run others -- but it does mean we do extensive discounted cash-flow analysis to derive an intrinsic value assessment, an extensive relative value assessment to understand what many traditional investors are thinking, and a technical momentum assessment to help identify where the fast-money may be looking to allocate capital. The Valuentum strategy is a comprehensive process that is focused on picking winners, and it has worked wonderfully thus far. Key takeaway: The best stocks, in our view, are those that are undervalued and are just starting to exhibit strong momentum qualities, revealing the greatest likelihood of price to fair value convergence. Said differently, we like underpriced stocks that are just starting to go up.
Thank you for reading!
The Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio are not real money portfolios. Any performance, including that in the Nelson Exclusive publication, is hypothetical and does not represent actual trading. Past performance is not a guarantee of future results. Valuentum is an investment research publishing company.
About the Author
Brian Nelson, CFA
Brian Nelson is the president of equity research and ETF analysis at Valuentum Securities.
He is the architect behind the company’s research methodology and processes, developing the Valuentum Buying Index rating system, the Economic Castle rating, and the Dividend Cushion ratio. Mr. Nelson has acted as editor-in-chief of the firm’s Best Ideas Newsletter and Dividend Growth Newsletter since their inception.
Before founding Valuentum in early 2011, Brian worked as a director at Morningstar, where he was responsible for training and methodology development within the firm's equity and credit research department. Prior to that position, he served as a senior industrials securities analyst covering aerospace, airlines, construction, and environmental services companies.
Before joining Morningstar in February 2006, Mr. Nelson worked for a small capitalization fund covering a variety of sectors for an aggressive growth investment management firm in Chicago. He holds a Bachelor's degree in finance and a minor in mathematics, magna cum laude, from Benedictine University. Mr. Nelson has an MBA from the University of Chicago Booth School of Business and also holds the Chartered Financial Analyst (CFA) designation.
Brian is frequently quoted in the media and has been a frequent guest on Nightly Business Report, Bloomberg TV, CNBC, and the MoneyShow.
Mr. Nelson is very experienced valuing equities, developing discounted cash-flow models used to derive the fair value estimates for companies in the equity coverage universes of two of the largest independent investment research firms.
Brian worked on a small cap fund and a micro cap fund that were ranked within the top 10th percentile and top 1st percentile within the Small Cap Lipper Growth Universe, respectively, in 2005.
Brian led the charge in developing Morningstar's issuer credit ratings, creating and rolling-out one of the firm's proprietary credit metrics, the Cash Flow Cushion.
About Our Name
But how, you will ask, does one decide what [stocks are] "attractive"? Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth,"...We view that as fuzzy thinking...Growth is always a component of value [and] the very term "value investing" is redundant.
-- Warren Buffett, Berkshire Hathaway annual report, 1992
At Valuentum, we take Buffett's thoughts one step further. We think the best opportunities arise from an understanding of a variety of investing disciplines in order to identify the most attractive stocks at any given time. Valuentum therefore analyzes each stock across a wide spectrum of philosophies, from deep value through momentum investing. And a combination of the two approaches found on each side of the spectrum (value/momentum) in a name couldn't be more representative of what our analysts do here; hence, we're called Valuentum.
Image Source (steps): Tim Green