Price volatility is an unavoidable aspect of investing in common stocks. During periods when emotions are dominating reason, price volatility can become more pronounced than is normal during calmer times. The insidious part of this fact is that the more volatile stock prices are, the more fear and stress they generate, which only feeds even greater volatility. Of course, the same can be said when greed raises its ugly head. The purpose of this article is to provide some logic and reason that can be applied to stock price volatility that simultaneously weakens its potential damage.
However, in order to accomplish my objective, it is imperative that the reader be willing to consider what I believe is the undeniable reality that stocks are often mispriced by Mr. Market. This concept flies directly in the face of the so-called “Efficient Market Hypothesis (EMH)” accepted by proponents and followers of Modern Portfolio Theory. According to the Efficient Market Hypothesis, stocks are always accurately priced because existing share prices always incorporate and reflect all relevant information. Therefore, stocks are always trading at their fair value. I consider this notion preposterous, and in the context of this article, I intend to offer evidence that clearly disproves it.
Stock Prices are Often Pathological Liars
In his famous work, the Picture of Dorian Gray, Oscar Wilde perhaps said it best when he said“nowadays people know the price of everything and the value of nothing.” Unfortunately, this famous quote may be more appropriately descriptive of stock market investing, than in any other aspect of life. To make my case, all I have to do is direct people to look at most every stock chart, on any financial site or blog, and they will discover a picture solely graphing the company’s stock price movement over whatever time frame is being graphed.
For example, let’s look at a 10-year price only graph on Dun & Bradstreet Corp (NYSE: DNB), courtesy of Google Finance. From this picture, it would be very easy to assume that Dun & Bradstreet Corp (NYSE: DNB) was a good stock for the first five years on this graph, and a bad stock for the last five years. If you’re talking strictly about the stock’s price, then these assumptions would be rational and correct. For the first five years the price generally trended up, and for the last five years it has generally trended down. Therefore, from this graph we know a lot about the “price” of Dun & Bradstreet the stock, but very little about the intrinsic “value” of Dun & Bradstreet, the business behind the stock. Consequently, I would argue that there is very little wisdom offered by this price graph.
In contrast, if we look at Dun & Bradstreet through the lens of FAST Graphs™, the fundamentals analyzer software tool, over approximately the same time frame, our perspective on Dun & Bradstreet the business and the stock is radically altered. Here, in addition to price only, we have added some essential fundamental information on Dun & Bradstreet. The orange line on the graph plots earnings-per-share at a fair value P/E multiple of 15. The slope of the line, however, is 12%, which is the operating earnings growth rate that the company achieved since 2003. The light blue shaded area represents dividends paid out of the dark green shaded area (earnings).
There are several important facts that we can immediately ascertain and learn about Dun & Bradstreet the business once we have the perspective of price correlated to essential fundamentals (earnings). First of all, we discover that Dun & Bradstreet’s stock was generally being overvalued by Mr. Market for the better part of the years 2003 to 2008. The black monthly closing stock price line was above the orange earnings justified valuation line. Next, we see that the great recession caused the stock price to revert to the mean, thereby, bringing price down into being more in alignment with the orange earnings justified valuation line (intrinsic value).
Furthermore, by focusing only on the orange earnings line, we discover that operating earnings growth was very strong up through 2008, before modestly falling during the recessionary years 2009 and 2010. Then, we discover that earnings rebounded strongly in 2011 and 2012, and are estimated to grow at double-digit rates in 2013. Consequently, we also now discover that based on its recent strong earnings recovery that Dun & Bradstreet appears to be moderately undervalued.
Moreover, the blue shaded area representing dividends tells us precisely when the company reinstituted a dividend policy, and we have a graphic depiction of approximately what percentage of the earnings (the green shaded area) they are currently paying out (the payout ratio). Furthermore, by looking to the right side of the graph we discover that Dun & Bradstreet offers a current dividend yield of 1.8%, and has 0% debt to capital and a current market cap over $3.7 billion.
The point I am trying to express with this Dun & Bradstreet example is how much more wisdom can be gained when you can review a company based on some very basic, and I would argue essential fundamentals, in addition to merely holding an opinion on a company based on stock price action alone. But unfortunately, most investors know the price of their stock, but alas very few know the value of the business behind the stock. I believe this is dangerous, because it can cause people to make very bad decisions based on either fear or greed. In other words, it can cause people to sell when logically they should buy, and buy when they should sell.
How Long Can Mispricing Last
Thus far, I have been developing the undeniable principle that markets will often inappropriately appraise the value of stocks. However, there is a corollary that follows this principle that may be even more important to successful stock investing than the original principle itself. During the times when the market is incorrectly valuing a business, great investors have long understood that inevitably the miss-pricing will correct itself. The following quote by the venerable investing legend Peter Lynch corroborates my position:
“You can see the importance of earnings on any chart that has an earnings line running alongside the stock price. On chart after chart the two lines will move in tandem, or if the stock price strays away from the earnings line, sooner or later it will come back to the earnings.” Peter Lynch – ‘One Up On Wall Street”
Although my experience has taught me that Peter Lynch is expressing an absolutely true statement, the mystery rests within the words “sooner or later.” Unfortunately, they do not ring a bell on the Stock Exchanges that depicts when tops or bottoms are established. Moreover, it should be understood that when the market is incorrectly valuing stocks, it is simultaneously behaving irrationally. The big problem with irrational behavior is that there is no way to quantify or predict it. Therefore, the investor must rely on faith that dialectic thinking will eventually prevail. But unfortunately, the precise timing when it will correct is unknowable. The following examples are offered to illustrate my case.
Oracle Corporation (NASDAQ: ORCL)’s Bubble Pricing 1999-2001
During the time frame 1999-2001, infamously referred to as the irrationally exuberant period for tech stocks, Oracle Corporation (NASDAQ: