My Investment Philosophy: The Stock Market
This is for those who are brave enough to invest in what they believe in.If you are having trouble understanding this entry, please re-read it until you do. Otherwise, feel free to reach out to me for a clearer explanation. Apart from searching for terms, Google / ChatGPT will not be helpful in this circumstance. Believe me, they will not do my investment philosophy justice. Although this is not advice, this is my best shot so far at explaining how I think about the stock market. Enjoy.
Have you ever asked yourself what the stock market really is?
Yes, it is a mechanism that enables individuals and institutions to trade shares of companies, but let me reframe it. The stock market is an extremely accurate valuation machine in the long-term, and an extremely inaccurate one in the short term.The only reason a company is given a strong, consistent valuation, is if it has provided immense value to the market. Companies are fundamentally either money producing assets or money reducing assets. The stock market is constantly attempting to pre-emptively assign the correct value to these assets. The market knows that a long-term valuation will be assigned when projected positive or negative cash-flows actualise, however due to natural uncertainty around this, there is volatility in the short-term.
Lets go through a simple hypothetical example
Lets say it costs Burger Inc. $1 per burger they sell. They sell 1 burger for $2 each, making $1 profit per burger. Burger Inc. is making $100 a year in profit while selling 100 burgers annually. If public, Burger Inc. will be assigned a valuation by the stock market. Lets say, we are willing to pay $1,000 for the whole of the Burger Inc. business. Now lets say, there are 100 shares of Burger Inc. in the stock market. This means the stock price would be $10 each at a $1,000 valuation ($10 each x 100 shares = $1,000 valuation). The $1,000 valuation (also known as market capitalisation) is 10 times the annual profit of Burger Inc.'s $100 yearly earnings. This is called a Price to Earnings (PE) ratio, in this case it is 10:1 or just 10. If we are purchasing shares in Burger Inc. we are willing to pay 10 times it's earnings. Again, $100 annual earnings x 10 = a $1,000 valuation.What happens when there is news that beef is getting more expensive? If this is true, the burgers will cost $1.50 each, a 50% increase in costs. If all the other variables stay the same, the market will now have to justify a PE ratio of 20 (100 shares, $1,000 valuation, $50 annual profit | $50 x 20 = $1,000). In our perfect little simulation, the stock price falls to exactly $5. Now the PE ratio is back to 10. This is an efficient valuation of the business, in the case that the news true.
The market will fluctuate, constantly attempting to predict weather the price of the burgers will actually go up that much. It will do it's best to assign a probability of the event happening in the stock price. If the news is likely to be true, and a PE ratio of 10 is reasonable for Burger Inc., the share price will be close to $5 however, if the news is less likely, it might only drop down to $7, $8, or $9. In our scenario, we have a perfectly efficient stock market that assigns a reasonable probability of the event occurring, and if the event does occur, the stock is perfectly valued at $500, or $5 a share, maintaining a PE ratio of 10. The reality is, the market is extremely good at doing this over the very long-term but terrible at it in the short-term.
On the flip side, if Burger Inc. claims they have invented a burger flipping system that would save them 50% of their total expenses, a perfect market will assign a reasonable probablity of this happening; the stock will move. This might come in the form of a 15 PE ratio, meaning a higher valuation with the same income. Despite the savings not having actualised, the market is pricing in an increase in profit margin. This happens in reality but it is often done poorly.
A great example of this is when Steve Jobs released the very first iPhone. Two weeks of trading later, Apple stock (AAPL) moved down 4%. The value of the revolution that would ensue was poorly evaluated by the market. 17 years on, Apple shares have increased by 5,000%, largely off the back of the iPhone. That's a 50x.
There are no short-cuts!
You might think you can take advantage of short-term fluctuations, however, the real world is not as simple as our Burger Inc. one. There are an unknown number of variables at play. It is impossible to predict the short-term movements. As an investor, it is your job to identify where the market is misallocating capital. You need to know what you are willing to pay for the business i.e. determine an appropriate PE ratio. If our Burger Inc. is suddenly producing $100,000 per annum and the market is still willing to assign a 10 PE ratio, the shares will be worth $1,000 each. Quite the increase from $10. In short, if the future cash-flow is going to grow or decline, the valuation will match it in the long-term. In the short-term however, the stock market will attempt to predict what it will be, and almost always get it wrong, either to the upside or the down.If the money you are investing in the stock market is not needed in the next 10-30 years, you have a magnificent advantage over Wall Street (I don't know the Australian equivalent). The unpredictability of the short-term does not worry you. If you have confidence that your company will have greater income than it does today in the future, you can be sure that the market will appropriately value that in time. Sometimes it takes a longer than expected, sometimes it comes earlier. You must be careful that the market has not overvalued the company you wish to invest in. Sometimes, years of growth is priced into a stock, however, rarely will that hold for too long. The key is to be investing at a discount to future cash-flows of the business. The further out you look, the less it will be priced in, but the more uncertainty there is.
You might start to think that because of this relationship between time and risk, there is no way to out-smart it. Remember what I said in the beginning, the stock market is an extremely accurate valuation machine in the long-term, and an extremely inaccurate one in the short term. As a result, if you can understand 1 or 2 businesses better than most, you can make calculated long-term investments that pay off handsomely.