Over the last several weeks stock price volatility has increased significantly above norms. All of a sudden it is not uncommon to see stock prices moving 5%, 10% or more in a single trading day. Interestingly, this volatility is occurring both to the upside and the downside. Common sense would suggest that the intrinsic value of a business cannot change by those orders of magnitude from one day to the next. Logic dictates that the market is either inaccurately pricing the stocks now or it was incorrectly pricing them yesterday.
Stock price volatility is an unavoidable and undeniable reality. The stock market is an auction, and as a result, prices are continuously fluctuating both up and down. Of course, that is stating the obvious, because every investor in common stocks surely understands the associated daily volatility. However, my experience in talking with investors suggests that not every common stockholder embraces the complete unpredictability of stock price movements in the short run.
However, once you accept the undeniable reality that it is impossible to predict where the price of a stock will go in the short run other than by chance, your perspectives on investing in stocks changes dramatically. For starters, you quit attempting to worry about the unpredictable and are inclined to focus on matters that are more reliable. When investing in businesses (stocks) you begin to understand that business fundamentals are more predictable and trustworthy than attempting to guess price action.
The venerable mutual fund manager Martin J Whitman put it quite succinctly as follows:
“I remain impressed with how much easier it is for us, and everybody else who has a modicum of training, to determine what a business is worth, and what the dynamics of the business might be, compared with estimating the prices at which a non-arbitrage security will sell in near-term markets.” Martin J. Whitman, Chairman of the Board, Third Avenue Value Fund”
[drizzle]A dangerous side effect of not embracing the unpredictability of short-term stock prices is extreme bouts of anxiety when stock prices do not behave as the investor hopes they will. Forgetting that short-term stock price movements can also be irrational can cause investors to question their decisions even when their decisions were sound and prudent in the first place.
Anxiety typically leads to knee-jerk reactions and excessive trading in their portfolios. In short, emotionally-charged investors have a tendency to sell when they should buy and buy when they should sell. Fear engenders irrational sell decisions, and greed provokes unreasonable and aggressive purchases. In both cases, investors are more likely to lose than they are to gain when emotion dominates reason. As a result, I suggest that investors heed the Wall Street maxim – “in times of crisis, money moves from weak hands to strong hands.” As investors, we should strive to be those with the strong hands.
Stock Prices Are Often Pathological Liars
On October 13, 2016, I wrote an article titled “Why I Am Now Interested In CVS health Corporation.” In the article I pointed out that the market was significantly overvaluing the shares of CVS Health Corporation (CVS) for most of the years 2014 and 2015. In other words, this was a classic example of the market pricing a stock in excess of what fundamentals would indicate. Over this timeframe, I am putting forward that the market was telling a lie regarding the true worth or value of this excellent company. Consequently, the approximately 32% drop in CVS’s stock price since July 31, 2015 was predominantly attributed to overvaluation.
My point is this, when a stock is being excessively valued by the market it becomes vulnerable to any issues that may occur. This is where the real risk of overvaluation comes into play. When a stock is excessively overvalued, you could say it is priced to perfection, and therefore, extremely vulnerable to any hint of bad news.
However, so-called bad news is not always readily apparent. Here is a copy of the CVS graph as presented in the article. Consensus earnings estimates for fiscal year 2016 were $5.86, and earnings for 2017 were estimated at $6.55. Based on these numbers, the company was approaching fair value, and therefore, I indicated that I was becoming interested in researching the stock deeper because it was beginning to look attractive.
However, on November 8, 2016 the company reported earnings and softened their guidance below previous expectations. Consequently, moderately bad news that was not apparent when I wrote the article had suddenly become apparent. This is what CVS’s earnings and price correlated graph currently looks like based on updated estimates.
The following forecast calculators reflect a longer forward looking timeframe than the historical oriented graphs. The forecast calculator for CVS looked like this on October when I wrote the article.
Here is the updated forecast calculator as it looks today. The point I am highlighting here is that price volatility was significantly more dynamic than changes in the company’s fundamentals (earnings).
So my message is straightforward and clear, judge your holdings by how well their businesses are performing rather than what an often “schizophrenic” Wall Street may be saying. If fundamentals are good and the price falls, hold or buy more as appropriate. If the price rises to unjustifiable valuations, sell and replace to protect against risk regardless of fundamentals.
I believe and realize that attempting to forecast markets or stock prices in the short-run is an exercise in futility. Short-term market movements are driven and dominated by emotion and not rational thought. At any given moment in time, the powerful emotions of fear or greed can and will overshadow reason. However, in the longer-run, rational thinking and fundamental strengths prevail. The following Warren Buffett quote speaking about Ben Graham summarizes my views:
“Ben Graham said you should look at stocks as small pieces of the business. Look at (market) fluctuations as your friend rather than your enemy – profit from folly rather than participate in it. He said the three most important words of investing: “margin of safety.” I think those ideas, 100 years from now, will still be regarded as the three cornerstones of sound investing. Warren Buffett”
Is the Stock Fairly Valued or a Value Trap
To add clarity to the thesis of this article, I am advising that investors focus more on fundamentals than short-term stock price movements. The true message underpinning the Marty Whitman quote I presented above can be better understood by thinking about the timing of real information versus daily and hourly price variations.
Companies report earnings quarterly or only four times a year. I contend that it is primarily through these quarterly financial reports where relevant information about a company and its fundamental health can be found. As previously stated, in the short run, stock prices are often pathological liars. Additionally, stock price volatility is relentless and continuous.
Consequently, I do my best to ignore short-term price volatility other than to measure it against the fundamental valuations that I see in each company I invest in. However, I am keenly focused on evaluating the company’s financial performance when each quarterly report is posted. Sometimes the real news is good, and sometimes it’s not so good. However, it is only at these times that I