Stock Prices Are Not Always Right

wandl

I recently came across an article memorializing the Facebook initial public offering that happened a year ago this month, and I wanted to share a story with you that provides perhaps the cleanest illustration of why I do not try to predict the prices of particular stocks over the short-term (and, in many cases, even the medium term).

This time last year, I was a senior in college at Washington & Lee. Because of a legacy scheduling quirk called “Spring Option”, seniors do not have to take any classes during a special four-week trimester that comes at the end of the academic year if they have already completed all of their credits necessary for graduation. Because I had already completed all of my classes, and being no fool, I gladly took the opportunity to create a nice little month-long vacation for myself.

This meant that I got to spend a lot of time hanging out at the Lambda Chi Alpha frathouse. On the day of the Facebook IPO, I was eating lunch at my fraternity house when I began discussing the stock market with a sophomore member of my frat. He was spending a large portion of his spring term working his way through a bottle of Jack Daniel’s and trading stocks.

Given the hype that the Facebook public offering was receiving at the time, the social media giant’s public offering prove to be the inevitable conversation topic. When I asked him if he was considering buying any shares, he mentioned that he had already bought the stock four times that day, and was starting to get ticked off at the falling stock price. When it was all said and done, I am guessing that he was sitting on a 15-20% loss.

Obviously, not all trades involve alcoholic undergrads getting in and out of hot IPOs.  Yet, that case was a useful (albeit extreme) reminder of what exactly stock prices represent: the price that someone else is willing to pay for a stock.  Think of someone you know who is both affluent and mentally…imbalanced. That person likely owns stocks. By virtue of doing so, he has contributed to the stock market price of some security in some small way.

Obviously, there are intelligent people that purchase stocks, too. But sometimes people have to sell for reasons that have nothing to do with fundamentals. Maybe a kid needs to go to college, maybe the house needs a new roof, maybe a couple is upgrading to a nicer house, etc. There are plenty of reasons why people sell stocks that have nothing to do with valuations: there is no sign from someone indicating, “Hey, I’m selling this stock because it’s a dog!” They could be selling the stock because they want a new TV in time for the World Series. Who knows.

What is the implication of this? There is no guarantee that stock prices are rational at any given time. There are countless examples of this. Let’s look at the big ones:

Unless you think most consumer staples worth billions of dollars have actually doubled in intrinsic worth within the past four years, then they were either undervalued in 2009, overvalued now, or some combination of the two.

Considering that the stock prices are just the result of an auction house for businesses, I do not see a reason to attribute infallibility to a stock price on any given day. A stock price is nothing more than the recent price someone agreed to sell their shares for multiplied by the amount of shares outstanding. There is no logical basis to assume that these things must be “right”, unless you believe in the wisdom of the crowds.

In the 1920s, Dupont held a substantial block of General Motors shares that was never realized in the share price until Dupont released that block of stock from the corporate umbrella.

In 1957, Procter & Gamble bought Clorox, and the value of Clorox was never realized in the share price until after the FTC sued P&G and made them spinoff Clorox in 1969 (the shares of both companies exploded soon thereafter, minus a substantial hiccup in 1973-1974 during the third worst bear market in the past 100 years).

In the 2000s, McDonalds owned Chipotle, and as we’ve seen in Chipotle’s performance since Chipotle’s independence, the long-term value was never adequately realized in the price of McDonalds stock back then.

Although this remains to be proven, I bought Bank of America with the expectation that, within twenty years, there will be a Merrill Lynch spinoff that could put Bank of America in the running for best long-term investment of my life.

We see inefficiencies in the market all the time. Brown Forman and Hershey trade at 25-30x earnings? They haven’t done that since the dotcom bubble (and in Brown Forman’s case, it wasn’t even that expensive then). Reversion to the mean is a powerful concept for large businesses with relatively stable earnings models, and we will again see a day when those companies trade around 20x earnings. It is a matter of “when”, not “if.”

The best tool we as investors have is our own mind. It’s up to us to evaluate the data, make some educated guesses about a company’s future profits, and then make a judgment call as to whether the current price offers an adequate margin of safety if we choose to initiate a position. In the short-term, stock prices can do anything (they could double or fall in half at any point in time over the next year), but once we start talking about periods longer than ten years, stock prices start to match earnings.

Incidentally, that is why I feel comfortable having a cavalier attitude about short-term stock prices. Volatility does not bother me: if Conoco Phillips fell to $50 per share, I’d be happy as hell to add to my position because I know that the company has $172 billion worth of reserves and is producing 2.67 million barrels of oil (and oil equivalents) every single day. As long as the world needs energy, Chevron is likely a good bet. I don’t care whether other people value Chevron at $100, $110, $130, or whatever, once I have my position, I am content to own because the company is expected to generate over $14 in 2013 profits and pay out $4 per share in dividends.

If you can make a decent ballpark estimate about a company’s future profitability, the stock price will eventually reflect that. But in the short-term, Mr. Market can be a hell of a good comedian, valuing companies at laughably high or laughably low valuations. If you can make educated guesses about future profits, you should easily be able to tell which is which.