How many times throughout the technology and telecommunications bubble did you hear people justifying their purchases of certain stocks based upon the growth prospects of the industry in which they competed?
"Of course you should buy Cisco (NASDAQ:CSCO)! We're only at the beginning of the growth of the Internet!" Or "CMGI (NASDAQ:CMGI) is the zaibatsu of the Internet age!" "Of course you buy Corning (NYSE:GLW)! Fiber is the future!"
All three of these items and a myriad of other shibboleths about the rising importance of technology were true, and they were accurate. The trouble is that the people who uttered these statements forgot the other half of the equation: whether the market had already taken them into account and already priced these prospects into the shares.
Especially when you are talking about growth stocks, this can be a very important consideration. Think about Cisco, for example, circa 1999. Let's pretend even that the "growth to the sky" analysis was fully valid. Cisco's market capitalization at one point in the year 2000 exceeded $600 billion, and its price-to-earnings multiples remained in the triple digits. What growth scenarios possibly could not have been assumed in these multiples?
The fortunate thing is that most market participants -- even the large mutual funds and especially much of the surging hedge fund constituency -- are increasingly short-term in their focus, as evidenced by the prevalence of 100%-plus turnovers both in fund portfolios and in the float of the average company. You might be naive to believe that you know something about the prospects of a company over the next year that the market does not, but you might be just as ill-served to consider that the market knows -- or cares about -- anything taking place over the longer term.
What's your secret?
There's a reason why the market is known as a "discounting mechanism." What a company's share price is supposed to represent is a communal determination of the present value of all future cash flows coming from the company. The trick, of course, is that stocks are not treasuries -- there isn't a line item in the annual report that is delineated "future cash flows." When it comes down to it with most companies, this is a guess, and the overall determination by the market participating in the buying and selling of an individual equity should more or less approximate this guess.
To my way of thinking, this doesn't fully explain why even the largest companies endure stock market swings each year that can exceed 50%. Nokia (NYSE:NOK), for example, has swung from having a market valuation approaching $100 billion, slipped back to sub-$50 billion, and now sits at $57 billion, all within the past year. This company, of course, had some very pleasant guidance earlier this year, only to disappoint investors when it couldn't meet the targets it set for itself.
So Nokia started moving higher during a time when "everyone knew" that people would upgrade their mobile phones in the wake of wireless number portability and other influences but then dropped lower in recent weeks when "everyone knew" that the cellular phone industry writ large is bedeviled by overcapacity and an inventory glut. How helpful was either piece of knowledge to the average investor? Not very, because what everyone knows is already priced into the stock, even if what everyone knows turns out to be false.
What else does everyone know right now? Well, that oil is running out, for one. That there is a health-care crisis in this country, for two; that interest rates are going to go higher, for three; China is soaking up massive amounts of building materials, for four; and the economy is improving, for five. For another, the dollar is collapsing. We could debate whether any and all of these things are actually true (and we should -- I happen not to believe all of them to be entirely valid), or sustainable for that matter; but that's not really the point. Energy stocks such as Imperial Oil (AMEX:IMO) and Valero (NYSE:VLO) have rocketed higher based on the reality that demand for their products has far outstripped supply and the impression that things are only going to get worse. In spite of the best housing market any of us has ever seen, a homebuilder such as Hovnanian (NYSE:HOV) trades at paltry multiples because we all know that rising interest rates are going to end the good times soon.
But to run out and sell Hovnanian now because rates are going to go up is just plain crazy. Yes, rates might go up, but if you think that you're the only participant in the market to have considered this possibility, then you're sorely mistaken. The market writ large is fully aware of this potential -- that's a critical reason why Hovnanian's P/E is 8. These things aren't secrets.
And yet, and yet. Just as any perusal of a technology message board circa 1999 would yield "the Internet's gonna be huge" reasoning by the boatload, so many trading decisions now are based upon factors that the market has fully factored in. This is particularly true for any perceived factors over the shorter term: It is extraordinarily naive to think that the market is not fully aware of the potential performance of any one company over the course of a single year.
May your perceptions vary, or at least be longer-term
None of this is to say that the process of thinking about how a business is doing is hopeless. Far from it! In fact, it is the very short-term nature of the reasoning of many participants that allows the enterprising investor the opportunity to perform a little logical jiujitsu and use the market's tendency to overreact against it. What is required is a variant perception. OK, what's really required is insider information, but let's not kid ourselves that there is much of this floating around, despite what the spam emails would have you believe. You need to think a little deeper about companies, and think a little more long-term.
I'll give you an example. In 2001, when the price of oil sat at about $20 per barrel, I took an interest in refineries, which were at the time getting shellacked. The perception, where such existed at all, was that refining was a nasty business with dirt-poor margins. This was reflected in the share prices of the few pure-play refining companies, mainly Ultramar Diamond Shamrock. I saw something else, though -- an industry with a capacity level that was almost irretrievably capped, where demand was still growing. So I researched Ultramar Diamond Shamrock and found that it was going to be purchased by another company, Motley Fool Hidden Gems selection Valero -- which itself owned refineries throughout the country -- and found that very small improvements in its operating margins would equal large gains in profitability. It is nearly axiomatic that an industry where demand outstrips supply is going to be able to increase its margins, and that is exactly what has taken place. It took some time (actually far less than I had anticipated), but those who focused on the short-term issues were all debating a bunch of stuff that was priced in, whereas the longer-term perception of strength, I believed, was being ignored.
A dissent; OK, a clarification
Let's make sure we're clear here -- my point isn't that you might as well give up picking individual stocks, because every possible outcome is already priced in. There is a large academic community that believes this very thing, which is fine, as far as I'm concerned. What I am saying is that, especially with fast-growing (or shrinking, for that matter) companies, you must be mindful of what events are priced in, and what are not. That so much of the market concentrates on the ultra-short term gives you an advantage in this regard.
Fool on!
Bill Mann, TMFOtter on the Fool discussion boards
I forget what 8 is for. Bill Mann owns none of the companies mentioned in this article. The Motley Fool's newest investing service, Inside Value, specializes in variant perceptions of companies. Dunno what this means? It means that we seek value where the market perceives there to be none. Come see what we mean, with afree trialsubscription today. The Motley Fool isinvestors writing for investors.
