What makes the market shine?
Photo: Ivan Melanchthon Serrano. Source: Morguefile
Over time, companies earn profits. Good companies earn consistent, growing profits in both good times and bad. The profits don’t necessarily grow every year—after all, if you sell oil and the price of oil falls 80%, your margin has to fall. But a managers can still earn a profit, because they haven’t bet the ranch on a the future price of a volatile commodity.
Investors pay for the rights to the profits. When investors are in a good mood, they pay a lot for these rights. When they’re in a bad mood, they don’t pay so much. That’s the “Mr. Market” that people talk about: a moody fellow who is either manic or depressive. That’s really all there is to the stock market: profits and emotions.
It’s better to buy from Mr. Market when he’s in a funk, and sell when he’s elated, but don’t get too hung up on that. If we own good quality companies, or a broad range of companies, over a long period, profits go up a by lot. Investor sentiment, though, tends to cycle back and forth. In 1985 Proctor & Gamble—the maker of Crest toothpaste–earned $700 million. Last year, they earned $11 billion—growth of over 9% per year. During that period, the stock price went up 10% per year—pretty close. Compound interest means the stock’s now worth 17 times what it was 30 years ago.
P&G’s stock price. Source: Bloomberg
What makes for a quality firm? Different investors have different views, but my opinion is that it’s strong, predictable cash generation that increases over time from a moderate investment base. In accounting terms: a consistently high return on capital, high cashflow relative to earnings, and steady sales growth. A well-diversified portfolio should have companies that get their revenue from different sectors, industries, and countries. This reduces the risk of having to take a permanent loss.
That’s really all there is to stocks: investor sentiment, company profits, diversification, and the magic of compound interest. As writer Richard Brautigan says, the simple things in life go on, while we become more difficult.
Douglas R. Tengdin, CFA
Chief Investment Officer