Anyone who is serious about success needs a plan – failing to plan is planning to fail. A sales team develops and pursues a sales plan. A CEO prepares a company’s business strategy. The Springboks formulate and execute a game plan to win rugby matches. The investor must do the same – he should formulate an investment plan to be successful, a plan built on investment philosophy. The investor’s plan should be centred on helping him to decide which stocks to buy, when to buy them and then when to sell.
Why is philosophy so important?
People act in line with their beliefs or their philosophy. What you believe will influence your plan and your plan will determine what you do. If a car dealer believes Toyotas will sell better than Chevrolets, he will trade Toyotas – his actions stem from his beliefs. It is crucial, therefore, to discover and believe as much truth as possible. Investors must beware of formulating a plan based on false beliefs. For example, if the car dealer trades only pink cars because he believes all women wish to drive pink cars, then his plan would probably fail and he’d go out of business (because not all women want to drive pink cars). However, if he believes Toyotas will sell better than Tatas because they are more reliable, then assuming that was true, he would have a plan based on a sound philosophy.
The same is true for the investor. If the investor believes sentiment drives share prices then his decisions will be affected by what others are doing or what is happening in the market. Conversely, if he believes company fundamentals drive share prices, then he will focus on understanding the fundamentals and ignore the actions of other market participants.
Share prices – are they driven by sentiment or company fundamentals?
The first belief investors should clarify is whether they believe share prices are driven by sentiment (a thought, view, or attitude, mainly based on emotion instead of reason) or company fundamentals (the basic business principles and facts relating to a company).
Share prices are driven by sentiment in the short term and by fundamentals in the long term. This point is illustrated in the following graph of Mr Price Limited (MPC):
Graph source: I-Net
The case for sentiment
The blue line tracks the most recently declared earnings per share (EPS) and the red line tracks the closing share price. From 2003 until 2007 both the share price and EPS increased. Then, midway through 2007, the share price began to fall quickly until it bottomed out halfway through 2008. This happened despite EPS continuing to grow over the same period. The reason for this was that during that time investors were fleeing from retail shares for fear of a retail meltdown due to the financial crisis. This proves that in the short term a company’s share price can be driven by sentiment – fear, emotions or expectations based on false beliefs – and thereby go against fundamentals. After the share price hit bottom, sentiment changed again – from negative to positive – and the share price rose quickly from 2008 until the present day.
To be successful in the short term the speculator or trader would need to time the market by buying low and selling high. One would have had to buy in 2003, sell before the decline in 2007 and buy again once it had bottomed out in 2008. But at any one of those points how would one predict future sentiment? The truth is that it is impossible to predict sentiment or correctly time the market because firstly, the market is made up of thousands of investors all making decisions for different reasons. Second, the market is forward-looking but no one knows precisely how far forward it looks and what exactly is incorporated in the price. Is it looking 12 months ahead? Or 13 months? Or even 18 months? Predicting future sentiment requires trying to predict what all other investors collectively are predicting and basing the investment decision on that.
Furthermore, each day the speculator will wonder if an increase or decrease in the share price is the sign of a change in sentiment or if it’s just an anomaly in the prevailing sentiment. Is it a bull market or is it a bull run in a bear market? How long will it last? How far will it ‘run’?
Warren Buffet, the world’s most successful investor, echoes this belief: “We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”
The case for fundamentals
A more compelling case can be made for the long term investor who is focused on fundamentals.
If we analyse the entire 7 year period of the MPC graph, we can clearly see that MPC’s share price has tracked EPS growth, through the ups and downs in-between, proving that in the long term fundamentals rule. The long term investor could have purchased MPC in 2003 for 600cps and, without the stress of trying to predict market movements, would have seen the value of his shares increase by more than five times to the present day, while collecting dividends along the way. For the long term investor, he can be sure that if he can pick a solid company with good earnings growth potential, he can ride out the short term sentimental downturns, and even use them as buying opportunities.
Don’t predict sentiment, predict earnings
It is impossible to predict market sentiment and attempting to do so is psychologically taxing and time consuming. It is easier, wiser and proven to be more successful to be a long-term investor who ignores sentiment. Research should be focused on whether the company in question will deliver consistent EPS growth and returns on capital.