Much of the recent stock market collapse can be explained by panicked forced selling, rather than fundamentals. Sure, we’re going to have a long, deep recession – especially in certain sectors of the economy. But you must also keep in mind that stocks are denominated in paper money. Central banks and governments are fighting this credit crunch with the greatest wave of inflation in history. I’m betting they’ll succeed, albeit with many consequences.
During the panic, I read many misleading statements about stock valuation. From day to day, stocks are, obviously, worth whatever the potential buyer is willing to pay. In panics, sellers overwhelm buyers.
But over time – in normally functioning markets – a stock’s price will reflect its ability to deliver free cash flow to shareholders. The next two or three years of earnings are only a small fraction of any stock’s value.
Yet many great companies, including National Oilwell Varco, quickly crashed by 70% or 80%, just because earnings might temporarily slow. NOV’s real value did not fall that much. This was an emotional overreaction, so we took advantage and picked up some cheap call options.
The value of any company depends on factors like future sales growth, profit margins, and capital investments necessary to sustain its business. In short, the value of companies, or stocks, doesn’t really change very quickly from week to week.
But the market can change its expectations very quickly, especially when fear overwhelms rationality.
Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, recently described how fear and stress can impact the stock market:
“The whole story of how humans deal with stress is really interesting, but there’s one facet worth emphasizing. When people get stressed, they tend to dramatically shorten their time horizons. If you’re a zebra being pursued by a lion, turning off systems for digestion, reproduction, immunity, and growth makes all the sense in the world because the chase will be done, or you will be done, in short order. But humans, who have many of the same physiological responses, are not dealing with a short-term threat, but rather a long-term system called the stock market. So taking a long-term view is absolutely crucial, although really hard.”
Most investors have clearly been acting under dramatically shortened time horizons. Redemption requests and margin calls have forced many fund managers to sell what they don’t want to sell at ridiculously low prices. But it finally seems we are heading back into a normally functioning market – where investors can make informed decisions without so much fear and stress.
A more orderly stock market will give us plenty of attractive short ideas. I’ll be looking for situations in which the market has already priced in a rosy scenario for a stock. We can all become better investors by honing our abilities to distinguish between the trading noise and the investing signal. In other words: What really matters to the value of this company, and what does not?
It’s amazing how often the market projects the fundamentals of the past year into the infinite future. Those who invested in bank stocks two years ago have discovered the hazard of investing on the assumption that the future will look just like the past. The same goes for traders that chase the latest hot stock up to the stratosphere, to the point where it must keep growing earnings at 30% per year for a decade to justify its valuation. Once there’s a hint that growth will fall short of expectations, formerly “hot” stocks can crash 30% or 40% in a day – especially if earnings were never sustainable to begin with.
In times of panic, the market tends to project the past year’s negative fundamentals into the future. For example, how much does the fact that U.S. gasoline demand is down 4% year over year matter to the value of oil stocks? It matters if gasoline demand keeps falling at a 4% annual rate over the next decade.
But you probably agree that this has little chance of happening, since oil consumption generally doesn’t fall quickly in response to higher prices. Yet most oil stocks now trade at valuations that anticipate an endless spiral in demand and prices.
I think the shortsighted fear about U.S. oil “demand destruction” is noise. It’s distracting investors from an important signal: sustainable worldwide demand and supply constraints that will determine the long-term price of oil. So you have the opportunity to take a contrarian stand, buy cheap oil stocks, and hold them as long as fundamentals stay intact and valuations stay reasonable.
Dan Amoss, CFA
for Markets and Money