Why do stocks remain overvalued for extended periods of time

(This is a continuation of introduction made in earlier lesson)

To start with, whichever way you look at it, fundamental value is defined by either the earning power of the underlying assets or in relation to the fundamental value of other stocks. This is because in any case, you are dealing with a business and a business’s purpose is to generate money for the owners in form of earnings. The market price ideally is supposed to tend towards its fundamental values.

The general misconception is that any differences between current stock prices and the fundamental values can be attributed to future developments in the companies concerned that are not yet known but are correctly anticipated by the stock market. Stock price movements are therefore assumed to precede the developments that eventually justify them. This has even been accepted by people who don’t put much faith in fundamental analysis but is almost always never the case.

Borrowing from George Soros’ explanation on the life cycle of a stock also known as the ‘boom and bust’ we shall assume that there is an underlying trend. The underlying trend in this case shall refer to the trend in fundamentals. I have picked the exact same illustration George Soros used in this particular case because I found it to be very simplistic compared to what other text books use. In the illustration that is provided below, we shall use earnings per share to represent the fundamentals. assumes that fundamentals are properly measured by earnings per share

Explanation on the path that stock prices normally follow

A-B: There is a lag in investors identifying the underlying trend in the earnings per share despite the fact that the trend is growing and at this stage the stock is still underpriced. Despite the failure of investors to recognize this in form of stock prices rising higher, the trend remains strong enough to manifest in earnings per share.

B-C: Underlying trend is finally recognized and is reinforced by rising expectations and as we can see from the graph, stock prices momentarily rise above the earnings per share. However, doubts arise and the process aborts, but trend in fundamentals survive. Alternatively, the trend waivers but reasserts itself. In real market situations, such testing may be repeated several times and may extend for a prolonged period of time especially if investors are suffering from a previous trauma experienced in investing in the same or similar stocks.

D-E: Conviction develops and it is no longer shaken by a setback in the earnings. Investor confidence is high and previous and current investors are rewarded by their shares trading at higher multiples.

E-F: Expectations now become excessive and fail to be sustained by reality which in this case would mean that the stock is highly over-valued. Investors are getting very little return on their investments for every share they buy. Eventually the bias is recognized as such and expectations are lowered especially when earnings start reflecting what investors were not anticipating.

F-G: Stock prices lose their last drop and plunge. Panic may further fuel the drop.

G: The underlying trend is reversed, reinforcing the decline

G-H: At this stage pessimism by participants is overdone and market stabilizes. By the time market is done with the downfall, bulls are usually disillusioned and that is where you get to see a lot of negative sentiment from the general public. The process repeats itself.

From this we can conclude that stocks can remain over-valued until investors recognize the underlying trend and change bias, as long as underlying trend continues to rise, eventually investors will recognize it and stock market price will rise to match fundamentals. Break in price ranges tend to cause rise in volatility and this is what can cause rise to be sometimes very sharp.

Can market price influence fundamentals?
Yes, I do believe in the theory of reflexivity because it is very practical. High market prices can positively influence the fundamentals of a company in different ways especially if instead of making acquisitions by cash, it makes acquisitions by offering its shares at much higher value. This would mean that the company can continue to increase it earnings to justify higher prices simply by acquiring other companies. To illustrate, assume business A and B are of the same size but business A has a higher market value than business B and is actually double, when it comes to acquisition, A can offer B its shares at a much higher multiple and hence increase its earnings by 50%. Investors on the other hand will see that the company is doing well by increasing earnings and therefore reward it with even higher market prices.  This can be dangerous especially if acquisitions are of poor quality because it acts like a smoke mirror.

Low market prices can influence company’s credit rating (Affecting its ability to raise debt), consumer attitude, raising of money through rights and bonus issues (May have to really dilute shares and affect exercising of rights) etc.

If you did not understand the terminologies used, we will provide a tab with important definitions.

Introduction (Understanding the Stock Market)

Lesson2:Why do stocks remain overvalued for extended periods of time

Lesson 3: Illustrating How Listed Companies Operate Using Small Business model

Lesson 4: Flow of money through a business

Lesson 5: Valuing a business in terms of earnings it makes

Lesson 6: Balance Sheet & Margin of safety in a business

Lesson 7: Explanation on shares in a business

Lesson 8: Quick Basic Stock valuation Techniques

Lesson 9: Gauging Whether Company is Being Managed by Vigilant leaders

Introduction (Understanding the Stock Market)

(The next few lessons will be based on investment approaches of Soros who is famed for his excellent performance in the market and is famously known as the man who ‘broke’ the bank of England and of course Warren Buffett whose specialty is in value investing. Soros participates in all markets, debt, currency and stocks but at a leverage hence his high average performance. )

Stock Market

A stock market is a mechanism through which company’s shares are bought and sold. Simply put, it is a public market. It is used for the trading of company stocks and securities at an agreed price through an auction process. Prices are established when buyers and sellers settle and shares exchange hands.

Methods used in analyzing the stock market

Investors use different methods of determining when to buy or sell shares. Amongst the most popular approaches are; Fundamentalists, Technical and Academics

We shall not focus on technical approach in the next few lessons because it studies market pattern and the demand and supply of stocks. Of course inarguably it has undoubted merit in trying to predict probabilities but it does not show the actual course of events. It is important that any investor should always be equipped with a proper understanding on what actually influences the price movements rather than just studying the price movements by themselves. As Buffett put it, you don’t want to be in a party, hoping to leave one second after midnight only to realize when it is too late that the clocks on the walls have no hands. In this case it equates to buying shares then realizing that they were worthless and that you actually got caught at the peak of a bubble amid the rising prices excitement. Besides, it has little theoretical foundation other than an assertion that stock prices are determined by their supply and demand and that past experience is relevant in predicting the future.
We shall also not focus much on the academic approach which is based on an assertion that prices behave in random manner and are highly unpredictable hence the random walk theory. This theory has continuously formed a justification for funds that invest in the stock index.  Countless investors have disapproved this theory based on evidence of consistently outperforming the market over a very long period of time. In trying to enhance brevity in the lessons, I shall not dwell much on the subject.
Back to what shall be the subject of several subsequent lessons.

People who use the fundamentalist approach believe that stocks are supposed to have a true or fundamental value that is distinct from the current market price. The question of fundamental value varies from investor to investor and depends on one’s judgment and is therefore always subject to bias. Among the most commonly used yardsticks amongst many others developed by analysts in trying to determine valuation are; earnings, dividends, asset value, free cash flow. The weight given to each varies from investor to investor. When we will be dealing with the subject of financial analysis we will focus with the main ones that Warren Buffett successfully used and has notably always commented about just to sufficiently equip the reader in having an edge in the market.

Lesson2:Why do stocks remain overvalued for extended periods of time

Lesson 3: Illustrating How Listed Companies Operate Using Small Business model

Lesson 4: Flow of money through a business

Lesson 5: Valuing a business in terms of earnings it makes

Lesson 6: Balance Sheet & Margin of safety in a business

Lesson 7: Explanation on shares in a business

Lesson 8: Quick Basic Stock valuation Techniques

Lesson 9: Gauging Whether Company is Being Managed by Vigilant leaders