Seeing the forest for the trees

Watching my 5 year old son playing on one of those simple and addictive mobile phone-based games reminded me of the behavior of many an investor. The central focus of my offspring is not the game in itself but rather the points tally shown on the top of the small screen. Unremarkable as that may seem, it does however bear a striking resemblance to the real-life actions of investors.

There’s little difference between my son’s dealings and the typical attitude of so-called investors. The latter openly declare themselves as buyers for the long-run and yet seem to measure their success (or more likely their failures), on the basis of the minute-by minute quotations provided by the internet, financial news networks of the daily press. Why grown adults choose to be judged in this manner is something that to this day eludes me.

Surely if some thought has gone into the buying decision (and that is a big “if”), the same thorough process ought to be followed for the reverse course of action. On various occasions in the past I have made a point of the almost total irrelevance of the daily financial banter that is passed off as “news”. As a matter of fact, switching the TV off and not reading certain financial newspapers may actually be an advisable route for those with an impending urge to act.

Acknowledging that in today’s hyper-connected society the afore-mentioned, “cold-turkey” hibernation-style strategy is a tall order and very unlikely to be applied consistently, I offer another approach. How about giving some though to the very few factors which actually move a stock’s price? As few as 2 in fact (if we exclude the ever diminishing impact of dividend policy).

For you see, the fact remains that since the dawn of time only 2 drivers determine stock prices and hence should be of concern to us:
1. Earnings (absolute and growth levels)
2. Market-assigned price multiples (general valuation)

With this remarkably simple framework as a starting point, it becomes a whole lot easier to ignore all the irrelevant, short-term “noise” around us and simply make our decisions on sound policy. After all, who cares if the dollar-yen exchange rate has trended downwards last week or if the rate futures market for pork-bellies is in the words of yet another market analyst “somewhat overbought”?.

To the extent that these concerns have no impact on one’s equity holdings earnings expectations they should be ignored!. In fact the only circumstance in which it may pay to take into account the usual macro-based sound-bites is when they are used to act in the exact opposite manner to that which is suggested by its broadcasters. In other words, when all is positive around you, tread with great caution.

My own experience in this field however, suggests that nothing is as simple as it sounds and the temptation to act and to judge our performance on the basis of the quoted price points is a strong one for us all. By way of example, I purchased some 6 months ago a pharmaceutical stock whose price declined some 30% within weeks of the purchase date, only to rise some 25% in the last 2 months and to level currently at some 10% below my entry point. For sure throughout this volatile ride there were times when I was tempted to “cut my losses” and let the points score (remember my son’s game)?, determine my course of action.

However a revision of the original thesis to validate the assumptions made going into the purchase served to convince me of its long-term value and keep the focus where it should be: its earnings power and financial solidity. At this point my thoughts have turned to adding to the position rather than liquidating it.

Watching the game and focusing on the few things that matter will mean that ultimately the “score” will take care of itself!.