“Don’t fight the tape” is one of those old Wall Street adages that shows up in different permutations and derivations when you read financial commentary. Humphrey Neill once said “Don’t follow the crowd, learn the tape!” Ace Greenburg once advised investors to sell any stock that goes down five days in a row. Yale Hirsch told investors to buy their stocks on Monday and sell them on Friday. Heck, even one of my investing heroes Benjamin Graham once said something along these lines when he advised to “never buy a stock right immediately after a substantial rise or sell after a substantial fall.”

There is a fundamental problem with all of these pieces of advice that should be apparent to anyone with a long-term business owner’s mentality in their approach to stockpicking: none of these quotes have anything to do with valuation. They speak solely in terms of price performance, without any regard to long-term earnings power. I’ll let you in on a secret that I picked up from Charlie Munger when I read his biography “Damn Right: Behind The Scenes With Berkshire Hathaway Billionaire Charlie Munger” by Janet Lowe. He said that when he makes investments, the only thing he does is look at how much profits he expects the company to earn five to ten years in the future, assigns a probability to the odds of that happening, and then determines whether the current price quotation provides an opportunity for satisfactory returns if those projections materialize. God, what clarity.

I love how simple keeps his thought process. It’s all about expected future profits in relation to the current price of the stock. Kellogg currently earns about $3.50 per share in profits. By 2017, the company is expected to earn $5.30 per share. My personal estimate is that there is a 65-70% chance of that happening. However, I would guess there is about a 90% chance that Kellogg will be earning at least $4.50 by 2017. Kellogg currently trades at $64 per share. My guess is that the company’s long-term P/E ratio will be around 17. If it earns at least $4.50 by 2017, which I estimate has a 90% likelihood of occurring, we are talking about a $76.50 stock. If it earns $5.30, which I guess has a 65-70% chance of happening, we are looking at a $90 stock. By conservative estimates, I would guess the stock price has the potential for 20% upside over the next four years. By moderate estimates, I’d guess 40% upside. Calculate the expected dividend payouts over that time frame, and that is a quick and dirty way to get a handle on the company’s valuation.

The point of this article obviously has nothing to do with Kellogg. I’m not trying to talk you into buying, holding, or selling that stock. My point has to do entirely about thought process. Forget all the stuff about “don’t fight the tape.” And at the risk of getting struck down by lightning sometime tonight, I would say you should even disregard Benjamin Graham’s advice about what to after a run up or run down.

I can easily think of a situation in which it would make sense to buy a stock immediately after a quick run up. Let’s say that we learned that BP was cleared of all legal liability regarding its Gulf Oil Spill in 2010, and the stock shot up from $40-$42 per share to $50 per share. Even though we just witnessed a 15-20% stock price increase, I would argue that the stock would still be cheap relative to its earnings growth prospects, shareholder friendly dividend policy, and newly improved earnings quality. It would probably be closer to a $60 stock at that point. In that situation, I would not hesitate to buy BP on the way up because it would be in response to improved fundamentals that warranted an even higher share price than what the run-up indicated.

One of the most important things to remember about stock market investing is that it is a giant auction block. That is all the stock market is: a giant auction house for stocks. The implication of this is that a stock price is only a reflection of what other people think at a given point in time. Warren Buffett, Charlie Munger, Walter Schloss, Donald Yacktman, and Marty Whitman have put together fantastic lives for themselves out of exploiting the difference between what a stock is actually worth and what other people think it is worth at a given point in time. Think independently. Reach your own conclusions. Don’t defer to the wisdom of crowds when making your investment decisions. Even if you fail, in Frank Sinatra terms, you can still say you did it your way. 

Originally posted 2013-06-16 04:59:16.

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